Credit
Credit can nonetheless be an effective component of your long-term financial plan, particularly in education and housing—not all education and housing, but in certain instances and when properly managed. Higher education can increase earnings over a lifetime. Home-mortgage debt can help you avoid rent and acquire and enjoy a residence, while owning an appreciating asset. Using a loan to acquire transportation is much more problematic because of the swift and substantial decrease in the value of the vehicle asset. Approach with caution any debt other than that which you use to purchase an appreciating asset. Poor, impulsive, short-term decisions can affect your financial future.
⤠ Greed brings trouble on your own house. ⤟
Education
If you owe student loans, prioritize repayment. With federal subsidies, your student-loan interest rate may be lower than vehicle or mortgage interest rates. You may also be able to defer loan repayment for graduate or professional school, unemployment, disability, or other financial hardship. Student-loan programs may also offer loan forgiveness for public-interest work, after a period of years. Student loans, though, may not qualify for discharge in bankruptcy. Treat student loan repayment as a priority because of their limited relief and strong enforcement.
Repayment
Student loans can offer more variety in repayment options than other loans. The best option remains prompt prepayment of extra principal until you quickly retire the full obligation. Devote cash gifts, inheritances, bonuses, second-job earnings, and cash from sale of personal property to paying off student loans early. Student-loan programs may also offer graduated repayment plans in which your payments gradually rise over time, presuming that your income will also be rising. Graduated repayment plans are more expensive because the smaller initial payments go more to interest while paying down less principal. Choose graduated repayment only if you must do so. Student-loan programs also offer income-sensitive repayment tying payments to the level of your income. These programs have the same problem as graduated-repayment plans in that they tend to increase the loan’s total cost because of the delay in repaying principal. Extended repayment plans are an even more expensive option in that they extend the life of the loan beyond 10 years to 12, 15, or even as long as 30 years. Every extension increases the total cost of the loan. Avoid these latter programs at all costs, whenever possible.
Ratios
The ratio of your debt to your income is another helpful guide to ensure that debt does not destroy your money management. The ratio of your total debt payments to total take-home pay should not exceed 40%. For example, if your annual take-home pay after taxes is $52,930, then your total annual debt payments should not exceed $18,783 (40% of $52,930). Importantly, total debt includes mortgage payments or rent. If you do not have an obligation for mortgage payments or rent because you own your home or are living rent-free, then your debt-to-income ratio should not exceed 20% of take-home pay. These guidelines are not licenses to incur additional debt needlessly. Debt works only when used to purchase appreciating assets like a home and not discretionary, short-term consumables like vacations or entertainment.
⤠ Those who are dishonest with little will be dishonest with a lot. ⤟
Debt
Your goal should be no debt. Those who have met their financial goals and are among the wealthiest in the U.S. say that the way to build wealth is to pay off debt and stay out of debt. When you borrow, you work for the lender rather than for yourself. When you carry debt throughout your life, you work your whole life for lenders. As quickly as you can, work for you rather than lenders. Your financial security and personal freedom are at stake. Keep in mind that many of the best things in life are free. Learn to enjoy reading, hiking, biking, and game nights with family and friends rather than expensive recreations. Make your own list of fun free activities, and then enjoy them until you are debt free. Avoid costly interests until you can pay for them with cash.
Home
We need shelter. Owning your own home can make good financial sense. A home, though, remains primarily an expense more so than an investment. Unlike other investments, homes carry significant costs. Those costs include not only mortgage fees and interest but also real-property taxes, insurance, maintenance, and repairs. Continual home improvements can add substantially to the costs. They don’t call homes money pits for nothing. When considering buying a home, think of the home as consumption more so than investment. Treat the decision to purchase a home as a decision to spend more on consumption and less on investment. Consume less in a home so that you can invest more into income-producing assets.
⤠ Grasp little while giving much, and you’ll always have enough. ⤟
Buying
While buying a home involves more consumption than investing, you should still buy the home as if you are investing. You are putting quite a bit of money into your home. Do so wisely. The home’s price, location, and quality all make a difference in your financial outcome when buying a home. Select a home in a secure neighborhood and with good schools, so that the home is likely to retain its value or increase in value. The adage is also to buy the worst home on the best block so that your home appreciates in value as you repair, update, and improve it. The study The Millionaire Mind reports these percentages of millionaires engaging in other surprisingly frugal home-buying practices. About two-thirds of millionaires buy easily affordable homes. Few buy for a short time span. They also do not move very often, with a majority not having moved in the past ten years. Millionaires also seldom build homes.
Price
The price you pay for your home goes a long way toward determining whether your home is a good financial move. The study The Millionaire Mind shows that millionaires almost never pay the initial asking price. Nearly all millionaires research home-sales prices in the neighborhood. Be ready to walk away over price. Take weeks or months to look for a deal. More than half of millionaires test the seller’s price with a deep discount offer. Nearly half look for a foreclosure, divorce, or estate sale. Over 40% of millionaires look for low-maintenance, energy-efficient homes, while nearly 40% look for low property taxes. Millionaires also buy older homes, at a median of 40 years old.
Mortgages
Few home buyers pay cash. Most take out a loan secured with a mortgage against the home. A mortgage involves both a loan note together with a recorded security interest pledging the purchased residence as collateral. Defaulting on a mortgage means potentially losing your home to foreclosure. The study The Millionaire Mind reports that nearly all millionaires own homes, with their median home values on average more than tripling since purchase. Homes, even when bought with a mortgage, can make good investments. But millionaires also buy smart. And millionaires maintain very low mortgage balances, on average just under 7% of the home’s value. Do not buy more home than you can afford. Your monthly mortgage payment of principal and interest, real-property taxes, and insurance premium should generally not be more than 25% of your gross monthly income.
⤠ If you lend to the poor, charge no interest. ⤟
Terms
Mortgage terms can make substantial differences in financial outcomes when buying a home. Home mortgages are the most-substantial debt that most of us will ever incur. Mortgage interest is the largest cost associated with many home purchases. The terms of your mortgage dictate your mortgage interest costs. Mortgages come with either fixed or floating interest rates, and with either shorter or longer mortgage terms. Mortgages also come with interest buy-downs or points, which are fees you pay up front that affect the interest rates your lender offers. See the sections below on how to manage these mortgage terms. When you evaluate mortgage terms, keep in mind the guideline not to have a larger mortgage payment than about 25% of your gross monthly income. Rather than stretch your budget beyond that 25% guideline, consider saving additional money as a down payment, to reduce your borrowing and reduce your monthly payment.
Duration
Payments on a 15-year mortgage are higher than payments on a 30-year mortgage because of the shorter term over which you must retire the debt (the shorter amortization schedule). Lower payments may make a 30-year mortgage look attractive. But the longer term and higher interest rate make the 30-year mortgage far more expensive. With a 15-year rather than 30-year term, you will own the home in half the time, 15 years earlier. For money management and wealth building, you should far prefer the 15-year fixed-rate mortgage or even the 10-year fixed-rate mortgage. If you can manage the larger payments for a shorter term, then do so. If you cannot, then re-think the wisdom of your purchase.
ARMs
Home lenders also offer adjustable-rate mortgages (ARMs) as an alternative to fixed-rate mortgages. ARMs, or floating rates, change the interest rate after a brief initial period, often just one year or two years. ARMs generally begin with lower interest rates than fixed-rate mortgages, making them appear attractive. The temptation is to take the lower floating-rate loan and use the excess cash flow each month for entertainment or other discretionary purposes. Yet when interest rates increase, then monthly payments increase. Small rate increases can substantially increase your monthly payments, even as much as doubling those payments or more. If you cannot afford that increase, you could lose your home through foreclosure. Beware adjustable-rate mortgages.
⤠ Those you can trust with money, you can trust with bigger things.⤟
Balloons
Lenders also offer balloon mortgages. A balloon mortgage offers a somewhat-reduced interest rate with a 15-to-30-year amortization but shortens the loan’s duration to just a few years, at the end of which the borrower must pay the full amount of principal, which will be very close to the full amount borrowed initially. The borrower owes a balloon, or lump sum, at the end of the first few years. The balloon payment typically requires the borrower to sell or refinance the home, either one of which may, depending on market conditions, be difficult, expensive, or impossible. Interest-only mortgages are similar in that they give the borrower a few years to pay interest only and no principal, making the payments somewhat smaller than they would otherwise be if including principal payments. Again, though, the borrower must refinance or sell at the end of the few years, or accept the loan’s new terms for significantly higher payments. Balloon and interest-only mortgages can look attractive but are expensive and risky. Avoid them if possible.
Equity
You may face the temptation to borrow money against your home. The home-equity loan or HELOC takes a second mortgage on your home behind your purchase-money mortgage, to secure the new loan. Homeowners use home-equity loans for necessities like repairing or replacing a leaky roof. They also use home-equity loans to pay down other debt so as to avoid court judgments and garnishments. They also use them for luxuries like updating a kitchen. They even use them for pleasures like family vacations. Be very cautious about home-equity loans. Do not treat your home like a piggy bank out of which to draw money in the form of home-equity loans. Second-mortgage lenders can foreclose. Do not jeopardize your family’s shelter simply because you can save a few percentage points on interest rates and gain a small tax deduction by using a home loan to cover other debts. Be especially careful about the terms of home-equity loans, which are often floating-rate loans.
⤠ The worst thing is to fail to provide for your own household. ⤟
Effects
One good way to think of mortgage debt is that it effectively increases the home’s sales price. Assume you buy a home for $250,000, paying 20% of the purchase price, which is $50,000, while borrowing the $200,000 balance. You then have a residence that you can also treat as an asset that should appreciate over time. Assume, though, that you chose a 30-year mortgage with a 5% interest rate to finance the $200,000 balance. Over the course of the next 30 years, you will pay about $186,512 in interest on top of the $200,000 loan principal. Your total purchase price will be $436,512, not $250,000. If you chose a floating interest rate that increased by a couple of percentage points, you might end up paying an additional $100,000 in interest over the loan’s 30-year life, bringing your total purchase price closer to $530,000. You must then hope that your home’s value appreciates fast enough to outpace the interest costs.
Deciding
Home mortgages are risky bets. Deciding to purchase a home is one of the most important financial decisions of a lifetime. Other factors should influence your decision, beyond the above considerations on cost, cash flow, and interest rates. One of the most important factors is how long you plan to live in the home. If you do not live in the home for at least five years, then you may find it difficult to recover transaction costs such as transfer taxes, closing costs, the cost of moving, and mortgage points. Other significant factors are the cost of upkeep to the home, the value to you of the federal income tax’s home-mortgage-interest deduction, and whether you might have another deduction for a home office. Consider using one of the online rent-or-buy calculators to help you decide which makes the most sense.
⤠ The proud give for show; the humble give out of devotion.⤟
Justification
Home mortgage debt is one of the easier types of debt to justify. Home-mortgage debt can make sense for several reasons. First, we all need to live somewhere. If shelter means paying rent, then paying a mortgage instead could make sense. Second, a home is by far the most expensive thing most of us will ever buy. Few of us are patient and disciplined enough to save for the entire purchase. Third, homeowners may qualify for a tax deduction of home-mortgage interest, depending on whether they qualify for itemizing deductions. You might save a few hundred dollars or more on federal income taxes by paying mortgage interest. Fourth, homes can appreciate in value, creating an investment potential. Weigh each of these factors. A home with a mortgage is not necessarily the financially wisest shelter.
Renting
If you decide to rent, then consider using an online apartment-finder service to improve the quality and reduce the cost of your rental housing. Renting a home can be the right move, especially when you do not have a reasonable down payment of at least 10% and preferably 20% or more. Renting may also be better when you might move within three to five years or your housing needs may change to accommodate children, elderly parents, or other relationship changes. Renting may also be better if you expect or desire a job or career change that may cause a change in income or require a change in location. Ask, too, whether you are willing to commit to a home’s maintenance and upkeep, or whether you travel frequently and would have concerns about leaving the home empty for short or long periods.
Pat and Erin had married about two years after graduating from college. They had at first discussed buying a home while they were still engaged so that they could move into it immediately after the wedding. Yet their balance sheets showed them that they would barely be able to get together a 10% down payment. They would then have no savings. They would also have the financial burden of the mortgage payments, real-estate taxes, and homeowner’s insurance, plus the home’s upkeep, not to mention the improvements they would want to make. Their budgets showed them that they just would not make it financially. So they rented for their first year together, stress free and happily, while they saved for a bigger down payment. When they did buy a year later, they bought within a price range that enabled them to put 20% down. Four years after college, they were married, in a home with one child, had a second child on the way, and felt reasonably secure financially. Best of all, after just four short years of marriage, they had full confidence in one another and (unlike some of their married friends) no arguments over money.
Amortization
When deciding whether and how much to borrow for homes, recognize how slowly monthly mortgage payments reduce the overall debt. Assume that a married couple borrows $250,000 to purchase a $200,000 home, with $50,000, or 20%, as a down payment. A 30-year mortgage having a 5% annual interest rate would result in monthly principal-and-interest payments of about $1,074. After 12 months of payments, the principal amount of the 30-year loan would still be $197,049, which is a reduction of just $2,951 despite $12,888 in payments over those 12 months. At the end of the second year, the principal remaining would be $193,948, a reduction of just $6,052 despite $25,776 in payments. Principal declines very slowly with a 30-year mortgage. If the borrowers made no extra payments to reduce principal, 20 years would pass before they reduced the mortgage balance in half to about $101,225.
⤠ Don’t let wealth’s deceitfulness choke away your life. ⤟
Strategies
You have options to speed up mortgage payback. One option is to shorten the loan’s duration when you first take out the loan or through a refinancing. Another way to speed payback is to make extra principal payments. If you are unsure you can manage the larger monthly payments of a 10-year or 15-year mortgage, then devote any extra cash at the end of each month to paying down your 20-year or 30-year mortgage’s principal. If you pay enough extra on principal each month, you may have the 20-year or 30-year mortgage paid off in 10 or 15 years or even less. Imagine the investments and improvement in lifestyle you can make without a mortgage payment.
When they bought their home a couple of years after marrying, Pat and Erin had managed to fit within their budget the higher monthly payments, but lower interest rate and shorter amortization, of a 15-year mortgage. Their budget remained tight for the first couple of years. Soon, though, their gradual wage increases enabled them to begin to save a little extra each month. At first, they just let their savings accumulate. But then, they started sending a little extra each month to their mortgage servicer with the instruction to apply it to principal. Their balance sheet soon showed the satisfying result. It began to look like they might pay off the mortgage in just ten years, and then in just eight years. In the end, with an extra push, they owned their home free and clear in just over seven years, having saved tens of thousands of dollars in interest payments.
Transportation
Transportation of some kind is necessary. You may have to travel to work or school, or for medical care and to shop for necessities. Needing transportation doesn’t mean you must own a vehicle. You may be able to move and live close enough to work, school, and amenities not to need transportation. Some Americans do without private transportation, and not just those who ride bicycles or walk distances, but even the relatively sedentary, particularly when living in high-density areas or communities planned for full services. Where transportation is necessary, some depend on public transportation, whether buses, subways, trains, boats, planes, or ride-sharing services. Consider carefully your need for private transportation. Vehicles have substantial costs beyond their substantial purchase price, including fuel, parking, registration, insurance, maintenance, and depreciation.
Vehicles
When a vehicle is necessary, the financial question then becomes what vehicle to acquire by what means at what cost. Until you can afford to pay cash for the vehicle of your choice without affecting your financial goals, the guideline is to purchase the most reliable used vehicle using the least debt at the lowest cost. The best financial move is often to buy a used vehicle certified or under warranty from a reputable dealer, or that you had an independent mechanic confirm is reliable, with whatever cash you have available, without borrowing or invading emergency funds. The reason to buy a used vehicle is simple: new-vehicle values decline substantially, by as much as 20%, the moment you drive them off the lot. Buy used, not new, until you can afford a new vehicle with cash.
⤠ When the sun shines, store up for a rainy day. ⤟
Financing
Equally important is to pay cash rather than financing the vehicle, if you possibly can. If you have no cash or so little cash under $5,000 that you cannot buy a reliable vehicle, then financing a vehicle following these strict guidelines. Choose the lowest-cost, most-reliable used vehicle that you can locate. Finance it for the shortest term that you can afford (understanding that the shorter the term, the higher the monthly payments). Keep financing to three or four years, by paying what cash down that you can. Most vehicles depreciate quickly. If you finance for a longer term, your vehicle may have a value less than what you owe on it. You could end up with no vehicle but significant debt if you lose your vehicle to destruction, theft, or repossession.
Pat and Erin had a problem that looked practical but, they knew, had a lot to do with their finances. Erin needed to replace her vehicle not just because it was unreliable and expensive to maintain but also because their kids’ child seats worked so poorly with it. They were nearly finished paying off the vehicle that Pat bought a few years earlier. They loathed the thought of taking on car payments again. Erin’s mentor at her company had urged her to lease a vehicle like many other employees did. Yet Pat and Erin had little interest in doing so after they learned at the car dealership the size of the lease buyout, the low mileage limit and high charge for going over miles, and the large amount they must pay up front to lease the vehicle Erin wanted at a monthly payment that they could afford. As they left the dealership disappointed and out of ideas, Erin noticed the model vehicle that she wanted in the dealer’s used-car lot. Neither of them had thought of buying Erin a used car, both of them believing that she deserved better. They stopped to talk to the salesperson anyway. The vehicle was still under warranty, was not even a year old, and had barely any miles on it. And it was $10,000 less than the same vehicle purchase new. When Pat and Erin realized then that they could pay cash for it, Erin had a nearly new car.
Leasing
Vehicle dealers offer leasing as an alternative. Lower monthly lease payments for a newer vehicle may attract you. With leasing, though, the monthly payments never end. And when the lease ends, the vehicle and its remaining value, often half or more of the original cost, revert to the dealer. You own nothing at the end of the lease. Indeed, you may owe something at the end of the lease. Most leases, known as open-ended leases, state the vehicle’s assumed residual value, say for example $16,000 on a $30,000 vehicle leased for three years. They then require the lessee to pay any difference between the actual value and residual value, whether the difference is due to damage or wear and tear. Leases also limit mileage to 12,000 miles per year or another negotiated figure. They then charge high mileage rates at the end of the lease for any mileage over the negotiated amount. Leasing only begins to make sense if you must have a new vehicle every two to three years, cannot borrow money, do not have a down payment, must have a lower monthly payment, and drive less than 12,000 miles per year.
Checklist
Reflect, research, investigate, and act until you are able to confirm each of the following statements summarizing the advice in this section:
I have a plan in place to become debt free as soon as reasonably possible to increase my long-term prosperity.
My home mortgage is only for a reasonably priced residence fitting my family’s needs, after a down payment of at least 20%.
My home mortgage is on a 10-year to 15-year term, at fixed rather than floating rates.
I make extra principal payments on my home mortgage as often as my budget allows.