Debt and Credit

First things first

Do not borrow on your credit card. Pay your credit card balance in full every month. If you need to borrow money, get it from another source, e.g., a car loan, student loan, personal loan, mortgage, or a family member. Why? Because credit cards charge very high interest (between 13% to 20% or more if you have a bad credit score). The only worse source of funding than credit cards are Payday Loans, which can charge up to 400%.

If you already have a credit card balance, get rid of it. Do not invest your money in stocks, bonds, CDs or anything else before you get rid of your credit card debt. If you have to pay 13% or more on your credit card debt, no investment vehicle can guarantee you equal or better return. So this is a no brainer. Just pay down your credit card debt first. If you have a teaser rate like 0% for six months, you might be tempted to borrow on your card and invest in a 1% CD. Unless you are borrowing $50,000 or more your return will not be worth the trouble.

Make sure to pay the credit card debt with the highest interest first. If you are overwhelmed with debt and you do not think you are able to manage your debt on your own then talk to a credit counselor. The Consumer Credit Counseling Service can be reach by phone at 1-800-388-2227.

Use a credit card for convenience and to earn rewards for travel, shopping etc…not for borrowing. As you use your credit cards responsibly you will improve your FICO score and qualify for better borrowing terms on mortgages, car loan, and insurance.

Where to find good credit cards

Credit Card Guide is an good site for choosing a credit card. You can choose a credit card by type of reward, by issuer, or by credit worthiness (good, fair, bad credit).

Credit cards issued by Credit Unions generally have reasonable and ethical terms. To locate a Credit Union in your area go to http://www.creditcardconnection.org/

Earn and Maintain a Good Credit Score

Having a good FICO score will save you a great deal of money on a mortgage. A borrower with a FICO score between 760 and 850 can save more than 1% on a mortgage loan than a subprime customer with a 620 to 659 score. Subprime borrowers with a score between 500 to 579 will pay 3.5% more than the top tier.

So if you are considering purchasing a home or if you are considering re-financing your current mortgage you can save quite a bit of money if you have a good FICO.

How is FICO calculated?

Your FICO score takes into account your payment history, how much you owe, how long you have had a credit history, new credit, and the variety of credit used. The significance of each factor is as follows:

• Payment history: 35%

• Amount owed: 30%

• Length of credit history: 15%

• New credit: 10%

• Type of credits used: 10%

Improving Your FICO Score

1. Pay all your bills on time. If you have not done that in the past, then start now.

2. The FICO model does not penalize you for keeping a balance on your credit cards. You get penalized only for borrowing too close to the maximum. But, since rule #1 is never to borrow on a credit card (or to pay it off asap) those who apply that rule will be fine in any case.

3. FICO will penalize you for closing old credit cards. So keep at least your oldest credit card active. Even if you do not use it. (Did the banks conspire with FICO on this? Him?)

4. Be careful when opening new account. Avoid retail store credit cards even if you get 10% off your first purchase. To many new accounts actually lower your FICO score. Also do not spend too much time shopping for a Credit Card. This will be used against your score.

5. Once you establish a credit history your FICO score will benefit from the passage of time. So if you are young and do not have a credit history then get your parents to sign you up as an authorized user on their credit card. Make sure your parent are responsible with debt before you sign up.

Get a free copy of your credit report at: annualcreditreport.com

Mortgage, “The Good Debt”

Without a mortgage most home buyers would not be able to buy a home. For most people a mortgage is the largest sum of money they will ever borrow. It is also likely to be the debt with the most favorable terms. Keep in mind that I am not talking about subprime borrowers, or people who do not do their homework before embarking on the biggest purchase of their lives. We have learned from the financial crisis of 2008 that people can end up with a bad mortgage. But, as with most financial decisions, applying common sense to your mortgage decisions can save you a great deal of money.

What is good about a mortgage?

If you buy a $200,000 home with the help of a $160,000 thirty year fixed mortgage you will pay $959.28 per month to the lender. Most of your first payment will be interest (about $800 the remainder will be principle). The first year you will pay $10,337 in interest. If you are in the 25% tax bracket then you will be able to deduct $2,584 from your taxes the first year. So in year 1 your actual payment minus your tax savings comes to $744. That’s a savings of about 22%. With time you will pay less interest and more in principle but your total payment will remain the same. More than 80% of your payments can be deducted in the first 7 years.

Secondly, a house with a fixed mortgage is one of the best inflation hedges. The cost of labor like the cost of most things tends to rise with inflation. Your home mortgage is fixed. You pay in year 29 what you paid in year 1. Your wage in year 20 or 29 will likely be substantially more than in year one.

Thirdly, if the Federal Reserve hikes up interest rates significantly to tame inflation you could earn more in interest on your savings than you pay interest on your mortgage. So you would be benefiting from leverage. If you had rented you would have to pay more for your housing.

Finally, a mortgage allows you to own real estate. That will help you diversify your retirement portfolio. Home prices do not correlate to stock prices (see home prices and the stock market).

What can go wrong?

If you buy more house than you can afford you will default and lose your home. You will also ruin your credit rating. Make sure that your monthly payment plus property tax and insurance is not greater than 33% of your income. Keep in mind that qualifying for a mortgage is not the same as affording a mortgage. The bank is not responsible for deciding what you can afford – you are.

If you buy a 3 year arm (or 5 year arm) be sure you understand what you are getting into. These mortgages are not bad in of themselves but they are not for everyone. Do not try to predict the future of interest rates and base your mortgage decision on that. If you do not expect to be in a home for more than 3 to 4 years then it might make sense to get a 3 year ARM.

What kind of mortgage should I choose?

The 30 year fixed mortgage remains the best choice for most people. It has the following advantages:

a) A predictable fixed payment for the 360 months duration of the loan;

b) Lower payments than a 15 year loan;

c) Lower interest than a fixed interest only loan;

If you know with a high level of certainty that you will move out of your home within 5 or 6 years then consider a 5 year arm. This type of mortgage has a lower fixed interest rate than the 30 year loan during the first 5 years. The interest rate becomes variable after the 5 years. For example, if you are paying 5% on a $100,000 loan for 5 years your payment would be $537 per month. Then after the 5 years, assuming interest rate are higher, your bank may charge you 7% or $665 per month. The rate could continue to go up in subsequent years. Most people are not prepared for a 25% increase in their mortgage payment. So be careful when purchasing this type of mortgage: 3-year-arm, 5-year-arm, 7-year-arm etc…

An interest only loan (IO) is a loan where the borrower is required to pay only the interest on the loan up to a specified period, usually 5 to 10 years. The borrower has the option of paying more to reduce the principle. A borrower of a typical amortized mortgage (30 year fixed interest) pays interest and a portion of the principle with every payment. The interest only loan does not begin to build equity until 5 or 10 years later when they begin to pay down the principle. The IO loan is also about 0.25% more expensive than the amortized loan. This type of loan provides some flexibility in terms of principle payments. But, this advantage is not sufficient to offset the extra cost for the loan.