I need to borrow money. Where do I start?
Borrowing money is one of the most important financial events your life. It can open doors to things that are unavailable to you without help from lenders.
But before you start, you need to do some homework.
First of all, you need to understand how lenders look at you in terms of risk. The interest rate on your loan will depend on this risk assessment. But the lenders don’t really do this assessment themselves; they rely on third parties to assess risk. This is done by the three main US credit bureaus - Experian, TransUnion and Equifax. They offer credit scores on almost everyone in the United States.
The bad news is that secret algorithms at these opaque companies determine your credit worthiness. Often the data they have on you contain errors and mistakes, so sometimes your score can be inaccurate. And fixing these errors can sometimes be difficult and time consuming.
The good news is that the federal government has mandated that these organizations give you free access to your reports once a year. You can do this from the AnnualCreditReport.com web site. When you get your report, make sure all the information that each credit bureau has is accurate and there are no mistakes. If there are mistakes, get in touch with the credit agency involved and have it corrected immediately.
The one weakness to the reports is that they do not contain the “score” that your lender sees. The score is important because it will tell you where you fall on the credit worthiness scale. The lender will use the score to determine whether you get credit and what your interest rate will be. The score is also important to you because it will allow you to track your credit rating over time (so you can see what happens when you start paying your bills on time!).
In order to obtain your score, you need to pay some money. The cheapest way to do this is to get your score at the same time as you get your free credit report. You only need one. But make sure you get the same score from the same company every year. Each company has their own scoring system, so you cannot compare scores from one credit bureau to another. If you want to see how well you are managing your score over time, you need to look at the same score every year.
The score will come with an explanation of what it means. But essentially your score will suffer if you:
- Miss payments or are late with payments
- Use too much of your available credit
- Have a limited credit history
- Have only one type of credit
- Have lots of credit applications in a short time
It takes time to raise your credit score, so make sure you get a handle on it early!
So once you have a handle your credit worthiness, next you have to look the debt you’re interested in getting. The most important part of a loan to focus on is the interest rate. Interest rates can vary widely so you need to make sure you are getting the lowest rate possible.
Interest rates are how lenders compensate themselves for risk. The biggest risk to them is that a borrower will default on a loan and not pay it back. In order to cover themselves for this potential loss, they charge interest on the loan. The larger the risk, the more interest they charge.
Here are the two types of loans that typically come with lower interest rates: Secured loans and installment loans. Secured loans are loans that are backed with collateral. These loans are considered lower risk to lenders and come with lower interest rates because if the borrower defaults on the loan, the lender will take possession of the collateral. This is how mortgages work; using the house as collateral, which allows the lender to offer lower interest rates.
You can also get other secured loans. Car loans are secured, as are home equity loans. You can even get secured credit cards, where you put cash in an account that is held as collateral against the credit on your card. Secured credit cards are an excellent way for people who have poor credit to get a credit card and boost their credit score.
The other way to get a lower interest rate is by using installment loans. These are loans that have a fixed duration and set monthly payments. Because they are predictable and structured, they are easier to manage and pay off than revolving credit.
With installment loans, make sure you take on the shortest term (length of time) you can manage. It is true that the shorter the term, the higher the monthly payments will be. But a shorter term will also mean that you will pay less interest overall than a longer term loan.
So now that you have all the information about loans, what kind of loan should you get? It depends what you need the loan for. Let’s go over some possibilities:
- House: If you want to buy a house, you’ll need a mortgage. The most important thing to do is to shop around for offers. Only 50% of Americas do this! Even a half a percentage difference in your mortgage can save you tens of thousands of dollars. Focus on fixed rate mortgages. They are predictable, and your payments will not increase even if interest rates around you rise.
- Car: If you plan on keeping a car for the long term, buying a car using a loan is more economical than a lease. Rates can be extremely competitive, so make sure you shop around. Look to banks as well as car manufacturer for quotes. But be very careful of used car loans from small dealers. They can have extremely high rates.
- Student Loans: Make sure you look to federal loans first. Their rates are competitive, and most importantly they have far more avenues for restructuring and forgiveness (if you need it later) than private or state loans.
- Appliance: You would think that buying an appliance in installments would save you money right? It’s an installment loan with collateral after all… But no. Retailers seem to take advantage of consumers who need the credit and charge extremely high interest. Don’t be fooled by 0% offers (interest is often just deferred). Check the interest rate and compare it to your credit card. It may be cheaper to buy an appliance using your credit card and pay down the card balance as quickly as you can.
- Credit Card: Because credit card debt is unsecured, interest rates are quite high. Try to avoid running up your credit card if you can. Also shop around for low rates. Sometimes you can get a 0% rate if you switch cards. There is usually a fee associated with the transfer, but if you can pay down your balance before the offer expires, these transfers can be a great way to get rid of some debt. Also know your penalty interest rate and what triggers it. Your interest rate could jump from 15% to 29% if you miss one or two payments. Finally, avoid taking cash advances at all cost. The interest on these loans is extremely high.
- Consolidation Loan: These loans pool several of your loans into a single installment loan. These are a great way to reduce your debt burden. These loans allow you to take all of your high interest credit card debt and pool it into a single lower interest loan. Just make sure you don’t run up those cards again!!
So make sure you do the math on your repayment terms and understand the consequences of what happens if you miss a payment. And if you ever feel pressured to sign something you don’t understand – DO NOT SIGN! Ask questions, seek advice, and do the math until you fully understand what you’re signing – your future self will thank you!
Is there such a thing as good debt? (Yes!)
Debt can be a terrific thing. It can help you buy and enjoy things that are too expensive to buy outright. It is often the only way to make big purchases that would normally be out of reach, and pay for them over time. Enjoying things while you pay for them is an amazing idea, and one that has helped fuel modern economic prosperity.
But the burden of debt can also be debilitating. People can be so overwhelmed with debt that it affects their ability to pay for essentials. It can also be such a huge burden that it affects people’s mental well-being. In these cases, debt is far from a positive force, and is more like a curse.
So let’s talk about debt and focus on good debt and how to avoid the bad.
There are two things that define good debt. One is that it carries a low interest rate. The other is that it pays for something of value.
Let’s start with the best kind of debt. The best debt out there is a fixed rate mortgage. Interest rates on mortgages usually have the lowest rates of all debt. And when you pay off your mortgage, you’ll own a house, which (we all hope) will be worth at least what you paid for it. So you win with a low interest rate, and you win by buying a valuable asset. Just make sure that the payments are manageable.
Adjustable rate mortgages are a little less beneficial than fixed rate mortgages only because they are unpredictable. They may have lower current rates than fixed rate mortgages, but there is no way to tell what the rate will be in the future. If rates ratchet up, holders of adjustable rate mortgages could have trouble making their payments. Borrowers of adjustable rate mortgages need to make sure that they have enough spare income to cushion any possible future rate increases.
And avoid any exotic mortgages like interest only loans. They tease borrowers into signing with low initial payments then crush them with higher rates when the promotional period ends.
A small step down is a car loan. Car loan interest rates can sometimes be lower than mortgage rates. But, when you buy a car, it loses value very quickly. So the asset you buy will not be worth what you paid for it. But your car does retain some value, and if it comes with a low interest rate, it can still be considered good debt.
Also make sure you look at used cars. They can sometimes offer better value. Just make sure that if you finance a used car, don’t do it through small self-financed used car dealers. They can charge exorbitant interest rates.
Federal Student Loans
Federal student loans can also be considered to be good debt. Although you can’t actually put a price tag on what you gain from a college education, there is undeniable evidence that you will be significantly better off financially with a college education. Interest rates on federal undergraduate loans are usually quite low. So again, you get something of value at a low interest rate.
As a side note, some state and private loans can have severe restrictions with respect to repayment, rate reductions and forgiveness, so they can often fall into the bad debt category.
Home Equity Loans
Now we get into a grey area. Home equity loans. These are loans you take out against the value of your house. Right now they are only about 2 or 3 percentage points higher than fixed rate mortgages. But defining them as good or bad debt depends on what they are used for. Often times it is to renovate a house, which can add value to your home. Which is great. Other times it is used to consolidate higher interest debt. Which is also great. But a Discover Home Equity Loans survey found that the number one reason Millennials (30-34) take out a home equity loan is for… vacations! Ouch! We’d consider that bad debt.
And at the bottom of the pile is credit card debt. Credit card debt comes with high interest, usually around 15% to 17% and usually pays for things that hold no intrinsic value (food, movie tickets, beer, shoes…). It makes little economic sense to carry credit card debt. Avoid carrying credit card debt if you can.
And at the bottom of the bottom are payday lenders. They charge exorbitant interest and fees, and their clients get stuck in never ending loops of short-term loans. Stay far, far away from these types of loans.
So if you are carrying debt, make a plan to pay down the highest interest debt first. You’ll have more money in your pocket each month that will no longer go to interest payments. Use this handy debt reduction calculator to make a debt reduction plan.
And make sure you shop around!! It’s crazy, but almost 50% of Americans don’t comparison shop for mortgages. Shop around for multiple quotes. It can save you a lot of money!
What is an APR & why should I care?
What is an APR? For some people the term APR can send a shiver down their spines… What’s so frightening? APR stands for Annual Percentage Rate, and represents the cost of interest and fees charged by a lender on an outstanding loan. If you owe a lot on your credit card, APR is truly a frightening thing. The higher the APR, the bigger the chunk of money you will be sending to your lender every month.
Different kinds of loans will have different levels of APR. Generally, the riskier the loan, the higher the APR. So if you have a bad credit score, lenders will charge you higher rates because they consider you higher risk.
Lower rates apply to loans that are secured, or have assets attached to them. So car loans or mortgages often have low APRs, because if things go bad, your lender can always take back your home or car. But unsecured debt, like credit card debt, is much harder to collect if things go bad, because there is no asset attached to the loan. These types of loans have higher APRs.
But APR can be your friend too. When you are the lender, a high APR is terrific, because you’re the one getting the interest. Take your bank account for example. This is a basically a loan you make to your bank. They then take your deposit and lend your money out to others. For this right, your bank pays you interest, or an APR. Unfortunately, at this moment in time, because interest rates are so low, the APR your bank gives you will be extremely low.
One thing to be aware of is something called an APY, or Annual Percentage Yield. An APY takes the power of compounding into consideration. On bank accounts, compounding happens when you earn interest on the interest you’ve already earned. Compounding is the fuel on which finance runs. So if you get a 5% APR, which is given to you monthly, you will get compounding on the interest you already earned, kicking your 5% APR to an actual 5.11% APY earned. But be warned. If your bank quotes you an APY on your bank account, they are actually referring to the compounded return. The actual interest they will give you each month will be calculated using the lower APR! Sneaky!!
APRs can also vary. For adjustable rate mortgages, the APR can change year to year. These mortgages can be riskier for borrowers because there is a chance that rates can jump unexpectedly. At the moment, variable rates are lower than fixed rates, making them tempting… But things can change!
APRs on credit cards can also change, and usually in response to failed payments. These “penalty rates” can be as high as 29%. If this happens, know that your credit card company must lower your rates back down to the normal rate after 6 months of successful payments.
Finally, if you have multiple loans or lines of credit and you have extra cash, pay down your debt with the highest APR first. Generally anything over 6% or 7% interest is considered bad debt and should be paid off as fast as possible.
So now you know about APRs. The lower the better if you borrow, and the higher the better if you are the lender.
How do I lower my APR?
APR is one of those expressions that bubbles up from the acronym soup that the financial word is so good at brewing. But what does it mean, and why is it important?
First of all, APR refers to the Annual Percentage Rate of a loan. It includes not only the interest rate, but also any fees attached to the loan, so it gives you a good overall view of how much your loan costs. A high APR means that your lender is charging you a lot of money to borrow their money, and a low APR means that the lender is giving you cheap money.
APRs vary widely, and right now can range from 2% for a car loan to 29% on a credit card. The difference in dollar terms is huge. On a $10,000 car loan, the 2% will cost you about $200 in interest in the first year. If you instead bought that car using a credit card with a 29% interest rate (a terrible idea by the way!), you would pay $2,900 in interest. That’s a huge difference!
So here are some ways to reduce your APR.
- If you have a credit card, the issuer has two rates, the regular rate and a penalty rate. The penalty rate is always much higher, and kicks in if you miss two payments. So NEVER miss a payment. Set up an auto pay to make sure something goes to pay your credit card bill every month. And secondly, if you do trigger the penalty rate, make sure you make the next 6 consecutive payments. Your credit card company must lower your after the 6th payment.
- Consolidate your debt. If you have a bunch of debt that has an APR in the double digits, think about rolling that debt into a consolidated loan. These are installment loans, so they have fixed payments over a fixed term that are focused on paying the debt off. You cannot use this debt like a credit card and buy new shoes with it. But they are terrific ways of lowering your APR and paying off your debt.
- Home equity loan or home equity line of credit. If you own a home, you can borrow against it at competitive rates, and you can usually use the money for whatever you want. Rates are usually in the mid single digits. So if you pay off your 16% debt using a 7% home equity loan, your overall APR will drop substantially.
- Roll your credit card debt to one that has a 0% introductory interest rate. These are great ways of getting TEMPORARY relief from your high credit card interest rate. But be careful. There are fees associated with these products (usually 3% of your balance). If you use these products, make sure you use the time pay down your credit card balance; otherwise this break makes no economic sense.
- Refinance. Interest rates are hovering at super low rates. See if you can refinance your existing mortgage or home equity loans at a lower rate.
- Get help with you student loans. There are fantastic programs for federal loans that base your payments on your income or allow for loan forgiveness. Look to see if you qualify. If you have a private loan, ask your lender for a graduated or reduced repayment plan. Go to the Consumer Finance Protection Bureau for more information.
In conclusion, when you get some debt relief, make sure that you don’t rack up more debt with the money you’re saving. Once you’ve reduced your overall APR, work to ensure it doesn’t creep back up again.
And finally, stay VERY far away from Payday Lenders. They hide their APR by calling it “fees”. In reality their APRs can be as high as 300%! Stay away.
Lowering your APR may not be as fun as a new pair of shoes, but it will definitely keep more money in your pocket.
Should I rent or buy my home?
For most people, their home is their single biggest expense, and sometimes, their only investment. Owning your own home is a symbol of security, and a big commitment, so there is a lot of emotion that goes into that decision. But is buying a home the right thing to do? Is renting a home a better option? To get a better handle on this question there is some math you can do. And it can help you take the emotion out of the decision to buy or rent.
First, in order to do a fair comparison, you have to be able to compare the purchase price and the rental price of a comparable home. If you know the size and location of the home you want, find a comparable home on a site like Zillow.com. You need to know what it would cost you to rent one home and buy the other.
For a quick comparison, you can turn to something called a price-to-rent ratio. This is a super-simple way of comparing rental and purchase prices. Take the purchase price of a house and divide it by the annual rent you would pay for the same house (House Price / (Monthly Rent x 12)). If you get a number above 21, it generally means that it is cheaper to rent than to buy. If the number is below 21, then it usually means it is cheaper to buy than to rent.
But life is never as straight forward as that. The price-to-rent ratio is a good place to start, but there are a lot of things that can impact this calculation. Most have to do with the added costs of owning a home. Let’s look at them.
- Interest rate: Your interest rate is the single largest expense associated with a mortgage. And the longer the term of your mortgage, the more you’ll pay in interest. Even low interest rates still have a significant impact on the cost of home ownership.
- Mortgage insurance: This works to compensate lenders if a borrower defaults on a mortgage. It is charged as a percentage of the outstanding principal of your mortgage
- Added fees: When you buy a home, you may need a home inspection, appraisal or survey. You may also need to pay recording charges, a credit report fee, title fees and an origination fee. These can add up.
Once you take possession of a home, you’ll need to pay all the costs associated with owning the home. These include:
- Maintenance fees
- Property taxes
- Condo fees
And don’t forget that when you eventually sell, you may also have to pay costs like:
- Broker fees
- Capital gains taxes
- Closing costs
If this wasn’t enough, you also have to add something called opportunity cost to the expense of owning a home. If you put $20,000 on a down payment for a home, you have to give up the gains that you may have received had you invested that money instead. That opportunity cost should be added to the cost of owning a home. And historically, if you invested that money in the stock market, it could return about 7% per year.
So are there any financial benefits that homeowners get over renters? Yes, in the US there is a tax deduction you can claim for the interest that you pay on your mortgage. So you can lower your taxes when you have a mortgage.
So how does this all add up? You can see that it’s a bit complicated, so we suggest you go to one of these three terrific buy vs. rent calculators at Trulia, Realtor.com and The New York Times.
When you go to these sites, you will find one more variable that affects this calculation. We’ve left this to last because we think it’s the hardest to predict. It’s the length of time you stay in your home. Essentially, the longer you stay in your house, the more economical it is to buy.
Most of the on-line calculators use time as a break-even measure to tell you when it is more favorable to buy vs. rent. Time a good way to think about the economics of buying a house. The longer you stay where you are, the better it is to buy.
So finally, there is one more wrench to throw in all of this. The future… Because we cannot yet see into the future, we cannot say what our property will be worth when we sell, nor will we know what our rent will be in the future. But we do know that the average annual increase in home prices from 1900 to 2012 has been 3.1% and historical rent increases, have been around 5% per year. Most of the calculators mentioned above allow you to play with these variables. We suggest you do that so that you can see the impact of future value.
And finally, remember that making big decisions like renting or buying also needs to take into account quality of life factors. Owning a home, for example, has the benefit of security and stability that some people can’t live without. So sometimes emotion plays a big part in this decision too. And that should be taken into consideration.
So in the end, look at all the variables, play with the calculators, take a hard look at your assumptions and see what the results are. If you do all this homework, you’ll get a fairly good idea of the best options available to you.
How do I find a mortgage?
Buying a mortgage is the most important purchase most people will make in their lifetimes. And it will also be one of the most expensive.
It is very important to make sure you are ready for a mortgage. The most important thing you need to do is get your credit rating as high as you can. Your credit rating will directly impact the interest rate you are offered. So make sure you start doing these things are early as possible:
- Pay all your bills on time
- Use as little of your available credit as possible
- Pay down your current debt as much as possible
- Don’t cancel any credit cards.
Over time, these actions will help raise your credit score. It’s also good to get a copy of your score so you can get a more accurate picture of your mortgage options. You may have to spend some money to get your score though. The cheapest way to do it is by getting it as an add-on when you get a free annual credit report from AnnualCreditReport.com.
Next you need to save for a down payment. In order to qualify for a conventional mortgage, you will have to put down a down payment of between 5% and 20% of the home. If you don’t have enough for a 5%, deposit you may still be able to qualify for a mortgage, but your options will be much more limited. And if you don’t want to pay mortgage insurance, you’ll have to put down more than 20%.
If you can’t manage a substantial down payment, you need to ask yourself if you are really ready to handle the burden of a mortgage. Saving for a down payment is excellent practice for the ability to manage a mortgage. And a big down payment will give you better rates, will pay down the principal you owe and lower the amount of interest you will have to pay. So if you can’t manage saving for a down payment, you may not be ready to handle a mortgage.
So what you should be looking for in a mortgage?
- The lowest interest rate you can get. Because a mortgage is the single most expensive purchase you will make, even a half point reduction in your interest rate can save you tens of thousands of dollars on your mortgage.
- The shortest term you can afford. The shorter the duration of the loan, the less total interest you will pay over the life of the mortgage. But the side effect of a short term is that you will have to pack the mortgage into fewer payments, thus raising the cost of each monthly payment. So try to get as short a term as you can, but one that is manageable.
Next, you’ll need to decide what kind of mortgage you want to get. You can get fixed rate and adjustable rate mortgages. Fixed rate mortgages are often preferred because they are predictable. You’ll know exactly what you’ll be paying until the day the mortgage is paid off. There will be no surprise changes to what you pay in the future.
Adjustable rate mortgages have interest rates that fluctuate. Usually they will have lower initial interest rates than the fixed rates mortgages on offer. But because the interest rate changes at fixed intervals in the future, the payments required to pay off the mortgage can change. Sometimes your payments will go down. But when interest rates are already low, they are more likely to go up. And when they go up, the added financial burden can be substantial.
There are also exotic adjustable rate mortgages with teaser rates that rise substantially later in the term of the mortgage. These mortgages are difficult to understand and even more difficult to manage. Avoid them if you can.
Now you have all the pieces of the puzzle. Armed with all of this information, use a mortgage calculator to figure out how much you can afford. There are great calculators at Bankrate.com, Zillow.com and Realtor.com. Look carefully at the monthly payment that the calculator generates. This is the cost you will have to shoulder month after month until your house is paid for. Make sure you can afford it!
Also compare your prospective payment to your income. This is called a debt to income ratio. The higher it is, the harder it will be to manage all of your debt. To find your debt to equity ratio, add up all you monthly debt payments (credit cards, car loans and the projected mortgage) and compare it to your monthly income (before taxes). If your debt ratio is 43% or above, your debt burden is very high, so high in fact that banks may not even lend to you. You should aim to have a ratio under 36% to make sure your mortgage isn’t too burdensome and that you have spare income to get through any financial bumps in the future.
Now that you know what kind of mortgage you want and how big a house you can afford, you can go look for a house!
You should have noticed that so far, you have not have gotten a quote for an actual mortgage yet. Which is good. When you start looking for mortgage quotes, the enquiries can actually ding your credit rating. The key is to get the quotes quickly (all within a month). So it makes sense to only shop for a mortgage when you are ready for one.
And make sure you get multiple quotes. Only around 50% of Americans get more than one mortgage quote! This is one of the most expensive decisions you will make in your life. It is essential that you get more than one quote.
So where do you look for a mortgage? Look to your own bank first. They know you and should give you a good rate. If you can’t get a good rate there, look to Credit Unions if you can. They can be more lenient with their requirements and can have competitive rates.
Mortgage brokers are the most flexible when it comes to different ways of financing a home. But be careful here. Being flexible can also mean being more costly.
If you have weak financials, a mortgage broker may offer you exotic adjustable rate mortgages that may look cheap today, but could hurt your wallet down the road.
Also look to sites like Lending Tree, which are loan marketplaces where lenders compete for your business. These sites are terrific ways of getting competitive quotes.
Once you get a quote, you will get a three-page form called a “loan estimate”. It will have all the information you need to gauge the full cost of your loan. Read it very carefully so that you understand what is ahead of you. The Consumer Financial Protection Bureau has a great list of questions you should ask yourself or the loan officer to make sure you’ve covered all issues with your loan.
Don’t ever feel pressured into signing the paperwork on a mortgage. You are under no obligation to sign if you are not completely comfortable with the loan. Your loan officer should answer every single one of the questions you have.
When you do sign, be ready for closing costs… But once everything is said and done, you will have an amazing place to call home, and an investment as well! Enjoy.
How do I pay off my debts quickly?
Debt can be a terrific thing. It can open doors to things that are normally out of reach financially. Homes, for example would be almost impossible to afford if you had to pay for them in cash. And the best part about debt is that by using debt, you can actually enjoy those awesome things while you’re paying for them! What a terrific idea.
But debt is not free. You’re borrowing someone else’s money after all, and you’ll have to pay them something for that privilege. And over time, that cost can be substantial. So it’s always a good idea to try and pay off your debt and limit the extra cost in interest payments you have to give to your lender.
The most critical component of debt is its interest rate. The interest rate is the amount of money your lender is charging you to borrow their money. The higher the interest rate, the more you are paying to borrow. It’s also important to note that debt with a high interest rate has a tendency to grow if it isn’t managed properly and can often balloon out of control.
So if you want to deal with your debt, the first thing to do it take stock of all the debt you have. The first thing to do is look at all of your debt and try to figure out the interest rate you are paying on each pool of debt. Better yet, look for the Annual Percentage Rate (APR). This rate reflects not only interest, but also other fees that you are charged on your debt. APR is a more accurate measure of how much your debt costs. Most lender statements will list the APR.
Next, order your debt from highest interest rate to lowest interest rates. You’ll notice that there is a wide range of APRs. They can go from low single digits for mortgages to mid double digits for credit card debt.
In dollar terms the cost difference can be significant. Let’s look at $1,000 of debt. If that $1,000 debt is credit card debt, it can cost you between to $130 to $300 in interest payments per year. If that $1,000 debt is in a mortgage, it will only cost you $40 in interest per year. That’s a big difference.
So here is the key to paying down your debt: Attack your high interest debt first. In the above example, you will see that if you can pay down the principle on your mortgage by $100 this year, it will save you $4 in interest payments next year (and every year after that). If you reduce the principle on your credit card by $100 instead, it will save you $13 to $30 in interest payments next year and every year after that.
As you can see, paying down the principle on your high interest debt is a more effective way of paying down debt and reducing the interest you owe. Remember that if you pay down more high interest debt first, you will reduce more of your future interest payments, and have more money in your pocket each month.
So here are the keys to paying off your debt:
- Focus on your highest interest debt first
- Pay more than just your interest, pay down your principle
- Don’t add more debt to the loan you just paid down
So make sure you’re attacking the principle that you owe. If you only pay the interest you owe, you are not paying down your debt and your monthly payments will remain the same. Ignore the “minimum due” line on your statement. Look instead at the “interest charged” line in your credit card and pay as much above that as you can.
Most importantly, make sure you don’t add more debt than to what you just paid down. The key here is to figure out how much principle you just paid off and not add more than that. For example, if you just paid $500 on your credit card debt, of which $100 went to interest, you just paid down $400 of your principle. So in the next month, do not spend more than $400 on your credit, otherwise your principle will have actually gone up, and you’ll owe even more in interest!
The hardest payment is the first payment. Set yourself a goal of paying down your principle. In the above example, if you can pay $500 on your credit card and limit your spending to $300 per month, then will have paid down your principle by $100.
But the amazing thing about paying down debt is that, its benefits can accelerate. So in the above example, in the next month, you will only owe $98.75 in interest. So that same $500 payment will pay off $101.25 in principle. After a year, that same payment is paying almost $115 in principle. And in less than 5 years, you will have completely paid off an $8,000 debt and you will have the $100 in interest and $100 in extra principle in your pocket every month. That extra $200 in your pocket every month can be used to pay down other high interest debt or put into savings.
Again, the first payment is the hardest. If you can manage paying down your principle in that first month, you should be able to do it every month. Just stick to your plan and keep paying down your principle.
If you want to know how long it will take to pay off your credit card debt, you can use this calculator from CreditCards.com. If you want to sort out the benefits of paying down student loans, try this calculator from StudentLoans.org, or this calculator from Finaid.org. For other installment loans try this calculator from CNN.
The benefits of paying down your debt quickly pay off with less money paid in interest and more money in your pocket. Win-win!
Should I invest now or reduce debt first?
Debt is something of a double-edged sword. On one hand, it offers you ability to buy something that would normally be out of reach financially and allow you to pay for it over time. But on the opposite side, debt comes with a cost. You are borrowing someone else’s money, and for that privilege, you need to pay money.
So when is debt too costly? If you have extra money on hand, when does it make more sense to pay off debt, and when does it make sense invest the money instead?
Well... It all depends on interest rates.
The line between bad debt and good debt depends entirely on how expensive that debt is. And the higher the interest rate on the debt is, the more expensive it is to hold. So debt that is considered bad, should be paid down, and if it is considered good debt, then the urgency to pay it down is lower.
So what is the dividing line between good debt and bad debt? A quick answer to that question is to say that right now, 6% or 7% is the dividing line between good debt and bad debt. But the issue is not as clear-cut as that. There are a lot of grey areas,
Instead, you should ask yourself if you should pay down your debt, or whether there is something “better” that you can do with your money? So instead of paying down your debt, is it a better idea to invest your spare cash?
To make that decision, you have to look at what kind of returns you can get from investing your money. If the returns you can get from investments are higher than the interest you pay on your debt, then investing your money may be a better option.
So what kind of return can you get from investing? That’s a big question. Historically, average annual returns of from the US stock market (including from dividends) has been around 11%. We’ll note here that this number is debatable, and depends on the time-line you use and how you measure “the stock market”. But over the long run, US equities have generated handsome returns.
But for the sake of argument, let’s temper our expectation of returns. Let’s say we are conservative investors and expect a 6% return. Let’s see how that impacts your decision about paying down debt.
Historically, credit card debt has carried a double-digit interest rate. Average rates hover around 15% and penalty rates can be as high 29%.
Let’s assume your credit card interest rate is 15% and you have an extra $100 that you can use to pay down the money you owe on your credit card. If you pay down your principle by that $100, it means over the next year, you would have saved the 15% interest that would have been charged on that $100, which would be $15.
If you instead took that $100, and invested it, and everything went according to plan and you earned a 7% return, you would have made $7. So you’re $7 richer than when you started. But remember that you didn’t pay down your credit card debt. So you paid $15 in interest you could have avoided had you paid down your credit card debt. So in this case, you’re $8 worse off than if you had paid down your credit card debt.
Any way you look at credit card debt, it is almost always better to pay down this high interest debt than it is to invest. There will be some years where stock market will preform above expectations, and will give you better returns than paying down your credit card. But these are definitely the exception, and over the long run, paying down credit card debt is the better option than putting that money into investments.
On the opposite end of the debt scale are mortgages. Because they are backed by the value of a house, they tend to be lower risk for the lender and offer some of the lowest interest rates of any debt. In this case, the savings you get from paying down an average mortgage is usually lower than the gains you get on an average year of investing. Again we say “average” because in some years this will not be the case. But over the 20 or 30-year span of a mortgage, it wouldn’t make sense to stay away from investing while you pay extra on your mortgage. (You should still always pay your monthly payments though!).
While the logic of paying down debt is clear on both extremes of interest rates, the logic is much less clear when the interest rate is somewhere in the middle. There are no rules when it comes to making decisions about debt with moderate interest rates. So here are some guidelines.
- Check your gut. Look at how well you tolerate risk. If you can stomach the ups and downs of a bumpy stock market, then maybe investing your extra money in the stock market is a good idea. On the other hand, if a bumpy stock market will cause you undue stress, then paying down your moderate interest debt may be a better idea for you.
- Go you like guarantees? The savings you make by paying off your mortgage are guaranteed savings. You know that if you pay down your debt, you will save money. There are no such guarantees in investing.
- What does the future look like? If the market is in turmoil, or there is economic uncertainty on the horizon, think twice about putting more money into investments. Paying down moderate interest debt might be a better option.
Here’s an important note for people carrying student loan debt. If the interest rate on your loan is low, and you can manage the payments easily in your monthly budget, try to prioritize saving and investing. Starting investing early can have a huge impact on your future financial success.
Finally, remember that there are no guarantees with the stock market. There is no way to predict which way the market will go in the future. So there is no guarantee that investing in the stock market will get you a better return than paying down any debt. The stock market can (and does) go down. All you can say is that the historical odds are in your favor over the long run. So if you do decide to use your spare cash to invest, make sure it is for the long run so you can ride out the bumps.
What's a home equity loan and should I get one?
Owning a home is a great thing. It puts a roof over your head, protects your family and gives you roots in a community. It’s also a good financial move. A house is a terrific asset to own, and tends to hold its value over time. So the money you put into a house is not money wasted.
A house is an investment in the truest sense of the word. You put money in and if you buy in the right neighborhood, and you take care of your home, and if the economy around you booms, the value of your house should go up. This is the hope that every homeowner has; that their home will go up in value.
One of the drawbacks of investing in your home is that it is not a very liquid investment. When we say ‘not liquid’, we mean that it is very difficult, time consuming and expensive to convert your home into cash. A stock, on the other hand, is very liquid because you can buy and sell it in seconds, and at little cost. So it is the ease at which you can turn your investment into cash that makes it liquid.
But what if you want to renovate your home? Or have an unexpected medical expense? Wouldn’t it be great to unlock some of the value in your home and turn it into cash? It is possible, and it can be done either through a home equity loan or a home equity line of credit (HELOC).
Both of these financial instruments are essentially second mortgages on your home. As with a regular mortgage, these use your house as collateral on the loan. They allow you to unlock your home’s equity either as a lump sum (with the home equity loan), or draw it as it’s needed (through the line of credit).
The key word here is “equity”, and when a bank says that word, it refers to the value of the house that is paid for. And that is the big catch: The amount you owe on your house has to be lower than what your house is worth. So either your home has to have increased in value since you purchased it, or you need to have paid down your mortgage.
When you are looking to get cash out of your house, most banks require you to keep some equity in your house and will not let you borrow against all the equity available. This remaining equity can range from 10% to 20% of your home’s value, depending on the requirements of your lender.
So if your home is worth $500,000 and your outstanding mortgage is $400,000, you have 20% equity in your house ($100,000 in equity out of the $500,000 total value of the house). If a bank has a 10% equity requirement, it means they want you to keep 10% of the home’s equity in the house, and will only lend the other 10% of your home’s equity to you (which would be $50,000). If the bank requires 20% equity, then in this example, the bank will not offer you a loan at all.
The equity requirement means that you’ll be insulated (to some degree) from market fluctuations. With a 10% equity requirement, it means that your house value can drop up to 10% before you are “under water”, or owe more than your house is worth. The great recession showed how devastating it is to be under water, with millions of Americans simply walking away from their homes and their under water mortgages. So the equity requirement can help keep mortgages above water, and people in their homes.
So how do these loans work? Let’s start with home equity loans. These are structured like mortgages, where you get a lump sum, which have a fixed interest rate and you pay off over a fixed period of time. As with a mortgage, you use your house as collateral. So make sure you can pay back the loan, because if you default, your lender can take your home!
These loans are beneficial because they allow you to unlock some of the value of your home and pay it back in a fixed and predictable schedule. The downside to these loans is that you are charged interest on the full amount, even if you don’t end up using all of the funds.
Home equity lines of credit are structured differently than home equity loans. They are still loans that use your home as collateral. But they look and feel more like a credit card than a mortgage. Like a credit card, they have credit limit that you can use as you wish, and you are only charged interest on the amount you actually use. These loans also have a “draw period”, which is a set term during which you have the flexibility on how you use and pay the loan.
If you have expenses that are variable and short term, the flexibility of a home equity line of credit can be a terrific way of unlocking cash from your home for a short period of time.
But there are downsides to these lines of credit. As with credit cards, if you miss payments, the interest rate you are charged can soar. These penalty rates can be two or three times your initial interest rate. Interest rates on these loans are usually variable and reset during the period of the loan. So the cost of these loans is unpredictable, and can go up over time.
The biggest downside of these lines of credit comes when the draw term ends and the loan essentially closes. At this point you can no longer borrow from the line of credit and you must begin the “repayment period”. At this point you have to pay off the outstanding principal and interest. When this repayment period starts, payment requirements can often soar. If the borrower is not prepared for this event, they can be crushed by the burden of the higher payments.
It is essential that anyone considering a home equity line of credit understand all the moving parts of this type of loan. They are built to be used and repaid quickly. They should not be used like a credit card because there is a day of reckoning when the repayment period begins.
One more note to make about these loans. Because they borrow against the equity on your home, they have the same tax advantages as traditional mortgages. So if you quality for a tax deduction for the interest you pay on a mortgage, you will probably also qualify for a tax deduction for the interest you pay on a home equity loan or line of credit on that same property.
And as a final note, be very careful of lenders advertising home equity loans that allow you to borrow up to 125% of your home’s value. These “No Equity Loans” are expensive and dangerous. The interest rates and fees associated with these loans are extremely high, and push borrowers deep into debt. Think twice before you consider taking out one of these loans.
In the end, home equity loans and home equity lines of credit offer terrific ways of turning some of your home’s equity into cash. Just make sure you know the all the details of the loan or line of credit before you agree to them.
What are the pros & cons of a reverse mortgage?
Paying for your house can be the most difficult financial undertaking of your entire life. It takes time, dedication and resources in order to pay for your home. If you are close to paying it off, congratulations! It’s a huge accomplishment.
The best thing about paying for a home is that the money you have spent isn’t money thrown away. Your house is an asset that will retain value, hopefully a lot of value, over time. And this asset can be tapped in a number of ways.
And when you get older, the retained value that you have in your home becomes much more important. After you retire, your income slows to a trickle. Sometimes you will have extra funds in retirement accounts like 401(k)s and IRAs, but more often than not, much of your wealth will be in your home.
In the last few years, a number of products have appeared that can help unlock some of the value in your home. Home equity loans and lines of credit are ways of borrowing money from the retained value of your home in order to pay for high cost expenses like renovations, education or medical bills. But the structure of these loans requires that they be repaid, so it means that you need to have an income that can be used to repay the loan.
If you no longer have an income, a traditional mortgage or loan will not work. So for those without an income, there’s a product called a reverse mortgage that allows people to unlock the value of their homes without the need to pay back the loans.
But it needs to be stressed here that in a reverse mortgage you are essentiality selling your house to a bank. So with a reverse mortgage you slowly, but surely, lose ownership of your home. Because of this, it is very difficult to go get out of a reverse mortgage. With the bank holding partial ownership of your house, often the only way to get out is to sell your home. So a reverse mortgage should only be used as a last resort for your financial needs.
So what are the main things to think of when considering a reverse mortgage?
First of all, you need to make sure that you have no other options other than taking a reverse mortgage. A different option is to downsize to a smaller, more affordable home. By doing this, you will unlock cash from your home and at the same time, lower your property taxes, insurance and electricity bills. It may be a way of keeping a home while still unlocking some cash.
Also, if it is important for you to leave your home to your children, then a reverse mortgage may not be an appropriate option for you.
Finally, make sure that if you get a reverse mortgage, you can still afford to maintain your lifestyle as well as paying for property tax and the added insurance required by the bank. You don’t want to fall behind on your insurance or taxes and have your bank foreclose on you.
So if you decide that a reverse mortgage might be appropriate for you, you need to understand how they work.
First of all, the Federal Housing Administration (FHA) oversees most of the reverse mortgage market, setting the standards for the market. In order to qualify for a FHA loan, you need to be at least 62 years of age and either own your home outright or have a low mortgage balance that can be paid off at closing with proceeds from the loan. You also have to live in the home.
Loan terms vary by a number of factors including the interest rate, the value of the home, and the age of the youngest borrower. The amount you can borrow ranges from 35% to 65% of the value of the house, and generally goes up the older you are. The interest rate also tends to go up the older the borrower is.
The way you receive the money also varies. You can get it as a lump sum, as monthly payments, as a line of credit or a combination of these. You can also set a fixed term for the mortgage, or you can get the proceeds for life.
In the end, the loan is due when the borrower either dies, sells the house or fails to live in the house for 12 months. Because the repayment of the loan can be triggered by the death of the borrower, it is important to consider adding a spouse or partner as a co-borrower. This will allow the spouse or partner to live in the house and continue the mortgage after the primary borrower passes away
A huge benefit of a reverse mortgage is that the borrower can still live in the house even if the loan exceeds the value of the house. So when the house is sold, the borrower is not responsible for any shortfall in value between the house price and the mortgage. FHA mortgages are deemed to be “non-recourse loans”, which means that when a home is sold to repay the loan, neither homeowner nor her family will be required to pay more than the sales price of the home. All FHA loans have required mortgage insurance and it is this insurance that will cover any shortfall, as long as the selling price is at least 95% of the original appraised value.
As you can see, the structure and payments plans for reverse mortgages are complicated. The Consumer Financial Protection bureau strongly suggests that you talk to a housing counselor who has been approved by the Department of Housing and Urban Development (HUD) before you get a reverse mortgage. Visit HUD's counselor search page or call HUD’s housing counselor referral line (800) 569-4287. HUD-approved counselors may charge a fee, typically $125 or less. Here are some great questions to ask the counselor.
And here’s a final piece of advice. If you don’t plan on living in your house for very long, then the economics of a reverse mortgage are not in your favor. There are up-front fees that you have to pay for and the insurance you have to pay will eat up a lot of money right away. The benefits of a reverse mortgage get stronger the longer you stay in your home.
So if you have limited income in retirement, have lowered your expenses as much as you can, and don’t need to leave your home to your children, then a reverse mortgage may be a good option for you. Just make sure that you do a lot of research because once you get a reverse mortgage, you’ve begun a process which can really only end with you selling your house.