Types of Debt We Fall Into
I’ve been writing a lot about wanting to pay off my mortgage as soon as possible because I’m very debt averse. Today, Mr Credit Card (who himself is very debt adverse) going to go back to the basics and list down the types of debt we fall into. And in the meantime, he shares some thoughts on how we can change our mindset to avoid them
Most adults have some form of debt. Today, I am going to look at some common form of debt and discuss whether it is necessary and how we can reduce the debt we take.
Student Loans – The first type of debt that many folks are likely to incur is from their student loans – prevalent in the US!. With inflation rates of colleges at about the 7% area, it appears that college costs will simply keep rising. It seems like the number ranges from $40,000 to $200,000 if you go to an expensive private college. Unlike other types of loans, student loans cannot be wiped out in bankruptcy.
There is actually nothing wrong with taking on a student loan if you get a job that pays you enough to pay off your loans. Doctors for example have lots of student loans. But when they graduate from medical school, they are likely to have a stable high paying (at least high paying in later years) career. Or if you manage to get into consulting or a Wall Street job after your MBA, your student loans are pretty much taken care of.
However, there are folks who graduate with an degrees with “less earning potential” and with big student loans are the ones who will have trouble with debt overhanging them for a long time.
For folks whose parents have saved for their college education, that is a blessing. But I think future college students (and indeed parents) have to make more informed choices as to their choice of college, the price of admission and their choice of studies. If someone is going to study liberal arts and of a subject that may not have great earnings potential, then it would be quite foolish to go to an expensive college.
Credit Card Debt – After student loans, the next type of debt very likely to happen is credit card debt. Sometimes, it happens in college when a student first applies for a college student credit card. If used responsibly (ie PAY IN FULL), it actually helps a young adult build a credit history. Abuse it like an ATM machine, and you will be saddled with more debt. Of all the types of debt we talk are going to talk about, this one is the easiest to say NO to. Unlike student loans (where you could possibly make a case to say it’s “good debt”, credit card debt can never be justified). The real answer to preventing credit card debt is to understand that when you only pay minimum on your balances, it could take many years to pay off and you end up paying double the amount (due to interest!).
Credit cards are best used as a tool of convenience, and its balance paid in FULL every month. Done this way, a cardholder is free to take advantage of cash back credit cards or gas credit cards to earn rewards and rebates (ie save money).
Car Loans – Car loans is another area many folks take a loan. Again, like credit card debt, this one is easy to avoid Simply save up for a car. If you cannot afford the one you want, get a cheaper model or a second hand car. It simply makes no sense to take on car debt because new cars depreciate when driving out of the dealers lot and even second hand cars depreciate.
Mortgage – Today’s society accept that taking on a mortgage is “good debt”. It is regarded as a form of “savings” as you build up “equity”. It is always assume house prices can “only go up” in “the long run”! (tell that to folks who bought in 2005 and 2006)!
I tend to take a different view on this.I believe that if you really wanted to, you could actually save for a significant portion of the value of the house. The conventional wisdom is to save 20% for a downpayment and take on a 30 year mortgage. In more recent years, folks took on no money down adjustable rate mortgages and are paying for it right now.
While having a mortgage seems to be an accepted today, it was not the case in the 1800s and early 1900s. And having a mortgage normally means having a debt hanging over your head for 30 years! It also means you always have to make sure your income is steady throughout your career, not an easy feat in today’s economy.
A lot of posts on this blog is about paying off the mortgage. My challenge to you is to consider saving much more than the 20% downpayment – target 50%. Having a smaller mortgage and have a shorter mortgage. Consider getting one with on 10 years or 15 years.
Home Equity Line Of Credit – In the 2000s, many folks took out home equity lines of credit. Many used them for home renovations – the train of thought being that it “increases the value of the home”. It is still debt though! Some “abused” it and took out HELOC to take vacations!
Like credit card debt and auto loans, this is one debt where you can really say NO to. Taking on debt simply to do a house renovation is not necessary. Simply save up for it and you do have to take on more credit. Taking a HELOC is simply criminal.
Business Loans – Having business loans for working capital purposes is very common among business owners. The trick to getting a business loan is to make sure you are not personally liable for it. This is easier said than done. For you to get a non-recourse business loan, your business must have established a credit history and you probably have to pay a slightly higher rate for the loan than a recourse loan.
Medical Debt – A lot of bankruptcies are filed because of medical debt. Medical debt is many times an unforeseen event. Having insurance is very important. And now with the Health Care bill, it should make it easier for those with pre-existing conditions. Regardless, having adequate coverage in health insurance is a must to avoid this nasty surprise.
Summary – There are many ways in which we can get into debt. The easiest to avoid are credit card debt, auto loans, home equity line of credit. Student loans are a little trickier. I think before you take on a massive student loan, both the parent and student have to consider whether their future earnings potential justify taking on the amount of student debt. The mortgage is probably going to be the biggest form of debt for most folks. Rather than sticking with the conventional 20% down and taking on a 30 year mortgage, I encourage you to be more ambition and save for a higher downpayment and take on a shorter mortgage so you can pay it off sooner.
While it may be impossible to be totally debt free for some, by taking some intelligent steps with regards to your college education and mortgage and avoiding debt you should avoid, you should have a smaller debt load. This would make it easier to pay off earlier in your life and be debt free.
Pay off Your Mortgage Faster with a Money Merge Account
Although we were making good progress on having our mortgage paid off in 5 years by making extra payments I, wanted to pursue something further to enhance the process. We decided to take advantage of a Money Merge Account. There are different variations of how this can be set up, I will explain what we have done.
I want to caution you that you do not need to purchase any software to set up this process and most of the time this software will not pay down your debt as efficiently as possible and may hurt your progress in the long run.
For nearly two years we have been making mortgage prepayments when we have had excess cash in our bank accounts. This made an incredible difference in the projected interest we would pay and the balance itself. Our mortgage balance was approximately $239K after 22 months of prepayments. If we did not make any prepayments our balance would be approximately $311K. Our prepayments made a huge difference.
Every month for the past 22 months we would sit down and work out an amount we were able to prepay against the mortgage. We had to keep track of when money was coming in and when bills had to be paid in order to prepay the right amount without going into overdraft. Although it was very effective it was not the most efficient way to use our time.
We were able to hit a “sweet spot” when rates were increasing and refinanced our mortgage. The penalty and legal fees were absorbed by the interest savings so we switched to National Bank’s “All in One Mortgage”. In my opinion, this is the perfect mortgage product. It enables you to separate the line of credit portion into different sub accounts and use each as a chequing account. All of our income goes into one account and all of our bills come out of it. The line of credit is re-advance-able. When we make a mortgage payment the principle portion becomes available in the line of credit. The beauty of this is we no longer have to plan around our income and expenses. The money is always available.
Currently we are set up like this, $310K All In One Limit, -$189K in a fixed portion at 3.65%, -$43,726.62 in our main line of credit account which receives all of our income and pays all of our bills at 3.1%, -$832.25 in a second line of credit account to cash dam our rental property (explanation post to follow) at 3.1% and $86,441.13 available overall in the lines of credit.
The goal is to not have any money idly sitting around but have every penny we bring in offset mortgage interest. The interest rate on the line of credit accounts will fluctuate with the Prime Rate. As it increases we will pay down our main line of credit account so when our line of credit interest rate is above our mortgage rate at 3.65% we will no longer carry a balance. It would be ideal to have that account always at a $0.00 balance but with income and bills coming in and out that is not practical. The balance will likely fluctuate $1,000 either way.
This account has allowed us to use our money to offset as much interest as possible and has simplified our financial lives. All of our bills, utility, credit cards, taxes, phone, etc are automatically debited from our line of credit account. Well, all except for the AMEX, they won’t do direct debit without a personalized void cheque. We will work on that later. We no longer have to sit down and work things out on a monthly basis. Our finances are fully automated!
Our total debt currently is $233,558.12 which must decrease by $6312 a month in order to be debt free by July 2013 which is the goal. Although that is a lofty goal, we are waiting for the proceeds from the sale of one rental property and may sell the other next year if the tenants do not want to stay.
The only possible down fall with this is not properly managing our spending. We will have to monitor it and keep it in check. That is after our tropical vacation.
The Truth About Refinancing Your Mortgage
There are many resources available instructing home owners that when interest rates go down it is beneficial to refinance your mortgage. Unfortunately, not all of the facts are explained, and in many instances the lure of the lower interest rate and lower monthly payment while very attractive, can be quite deceiving.
One such resource is the online mortgage calculator. These calculators generally explain two things about your mortgage if you refinance. Firstly, how much you will save over the life of your mortgage, and secondly, how much you will save monthly.
One such calculator appeared on three different sites that claimed you could save over $78,0000 in interest on your $300,000 mortgage if you refinanced it from 6% to 4.25%. The payments were actually lowered by $283 a month. This appears to be an incredible savings until you look at all of the facts. A closer look will reveal that these calculators are very misleading. The calculator on all three sites asks you to input the penalty amount and closing costs that will be incurred when refinancing. Two of the sites go on to explain that these numbers are not used in the calculations and one fails to mention this fact completely.
When you sign your mortgage it is a contract for the term you select. The lender expects to get that rate of interest from you during the entire term. If you break the contract before the end of the term the bank will penalize you for any interest that they have lost. The greater of the Interest Rate Differential or three months interest is generally charged when you break your mortgage contract. The IRD is normally calculated by determining the difference between a lender’s posted rate at the time your mortgage was signed, and the lender’s posted rate for a term closest to the time remaining in your term. Lenders charge this penalty to ensure they are not losing money if you refinance your mortgage before the end of your term. Although this IRD calculation is common practice among lenders polices do vary. You should always contact your lender to get an exact penalty amount.
Another flaw with these online calculators and the numbers they project is that they are basing your interest saved on the full amortization of the mortgage. This is deceptive. In the example used above, you will still need to renegotiate your current 6% mortgage at the end of its term, just like you will still need to renegotiate the new 4.25% mortgage at the end of its term. These calculators assume that you will always renew at the same rate which is highly improbable. You will not save money refinancing your mortgage this way. If you have a need to lower your monthly mortgage payment you can do so by refinancing, but you will not come out ahead. You would be far better off consolidating your high interest debt during the refinancing of your mortgage. It is then possible to substantially lower your total cost of borrowing.
If you have equity in your home refinancing to pay off high interest debt could very well save you thousands of dollars. There are also plenty of advertisements showing that consolidating your debts can save you a great deal of money every month. Sounds like a good idea, right? Not so fast. Ensure your banker, or broker is fully explaining the savings found by refinancing. Work with a mortgage professional who can analyze your debt and take the current balances, interest rates and payments of all of your debts and project what your total debt will be in 3 or 5 years with your current mortgage. Compare this to refinancing and paying off all of your high interest debt. There are four options to look at:
1. Increase your monthly cash flow by having your current projected balance and your refinance balance the same after a 3 or 5 year term This will leave you with the same amount of debt, but a lower monthly payment.
2. Lower your total debt by keeping your monthly payment commitment the same with your mortgage and all other debt payments included. This will not free up any cash on a monthly basis but your interest savings at the end of your 3 or 5 year term will be significant.
3. A combination of increasing your monthly cash flow and reduction of the total amount owed at the end of the 5 year term. This will provide some instant gratification with lower monthly payments while reducing the total amount owed at the end of your term.
4. Extending your amortization period to the maximum 35 years to lower your monthly payment as much as possible. This should only be done when lower monthly payments are absolutely necessary as the interest costs will be significant.
Everyone has unique financial situations, short term and long term goals. Find a mortgage professional that you are comfortable with and fully explain your short term and long term goals. Your mortgage professional will be able to fully explain the outcome of refinancing your mortgage and find a mortgage that meets all of your needs. If you do not fully understand how your mortgage professional is arriving at any amounts ask him or her to explain in detail. If you still do not understand, ask again. Hopefully they are not using an online calculator.
Mortgage Questions & Answers
Since I began my blog in June 09 I have spent some time in different forums reading, learning, and answering questions, specifically in relation to mortgages and the calculations involved in comparing different scenarios. I have learned that very few people, including some experts do mortgage calculations properly. While I am confident that errors are occurring due to minor oversights or assumptions they have the potential to cost you hundreds, if not thousands of dollars. In the past, I have provided accurate information to people to be helpful, because I enjoy working with numbers and saving people money. It has recently occurred to me that my responses can be time consuming and of value to people.
If you have a question about the $$$ savings you may experience by refinancing your mortgage for a lower rate, consolidating debt or are comparing different offers from lenders please feel free to email me at mortgagemath@debtfreeby43.com . You will receive a reply within 48 hours. Your email address will only be used to reply to your question and will not be added to any mailing lists now or in the future!
I have set up this email address to send an auto response that will include a link to make a donation to Debt Free by 43. Although a donation is required to have your question answered there is no minimum donation. Simply donate what you feel an answer to your question is worth. It is that easy!
I won’t get rich, but it is my hope that I can generate some cash every month to take my better half out for a nice dinner. That may decrease the number of times she refers to herself as an “Excel widow.” I do love working with the numbers. If you need some help please feel free to email me at the address above. I appreciate your continued support.