Tag: Loans

A Reverse Mortgage for Retirement Planning

A Reverse Mortgage for Retirement Planning

A reverse mortgage can be a valuable financial management tool for seniors and their families.  However, if misunderstood or misused, borrowers and their heirs can encounter any one of a number of different challenges. In this post, I’ll define “reverse mortgage” and provide illustrations of 

Don’t Sweat those Mortgage Terms

Don’t Sweat those Mortgage Terms

A mortgage is key to buying a residence for most people.  Mortgage loan documents are often lengthy and full of technical terms.  As such, many people either don’t read them in their entirety or don’t understand the details.  As with all contracts, I recommend that 

Don’t Make these Financial Mistakes

Don’t Make these Financial Mistakes

The world is going through a very difficult phase. Everywhere we are hearing that we need to get adjusted to the ‘new normal’. Nothing is normal as it used to be. Children are not able to go to schools.   Most people are working from home.  Healthcare professionals are working day and night for the recovery of people who get COVID-19.  In this situation, it’s quite natural that the economic situation is not good. Many people have lost jobs or are facing pay cuts and experts are predicting that an economic recession will set in.  We don’t have any control over this situation. But, what we can do is safeguard our finances, as much as we can, and avoid financial mistakes during this COVID-19 financial emergency.

Here are a few financial mistakes you should avoid.

Satisfying Wants to Avoid Boredom

Have you been browsing online shopping websites and ordering items? Is it because you need them or just to avoid boredom?

When the lockdown started, people were stockpiling grocery items. Now focus has shifted to buying items like clothes, books, entertainment things, and so on. So, in both situations, people are overspending.

But, now is not the time to do so. Rather, you should try to save as much as you can. We will discuss how to save more later in this article.

If you are getting bored at home, nurture a hobby (hopefully an inexpensive one). Do something which you’ve always wanted but didn’t get time to do so. If you wish, you can also do some online jobs as per your liking.

Following the Same Budget

Are you following your budget? You might say that you’re following it and saving. Good! But it’s a mistake. You’ll ask why? Because it’s necessary to re-assess your budget in light of the current situation and make modifications if required. If you’ve done that, well done!

If you still have income, it is time to save as much as possible. Doing so, you can be prepared for any future rainy days. If you save more, you won’t have to worry as much about losing your job. You know that you’ll be able to sustain yourself for a few months.

You can practice frugal budgeting to save more. Frugal budgeting doesn’t mean you’ll have to compromise with eating healthy or compromise with your life; it means to cut unnecessary expenses and increase your savings.

Overspending that Doesn’t Fit in your Budget

It is better to avoid buying big-ticket items during this time. Try to delay satisfying your wants for the time being.

To illustrate the previous point, let me highlight a survey conducted in January 2020 in Nebraska by First National Bank of Omaha.  It showed that about 50% of people in our country have a pay check to pay check lifestyle. So, it becomes quite tough to meet daily necessities when they face job loss, which has happened during this pandemic.

Therefore, you should try to have a good cash reserve. To do so, you need to save more and keep the amount in a high-yield savings account.

Check out how these ways to save more that you might be overlooking:

  • Stop eating out and have nutritious homemade food which is healthier too
  • Have a list when you go grocery shopping and don’t buy anything extra
  • Switch to debit cards if that can help you reduce your expenditures
  • Cancel your gym membership and work out in fresh air
  • Check out your magazine subscriptions and cancel if you rarely read them
  • Opt for bundling offers of television and internet
  • Opt for public schooling of kids instead of private schools
  • Start envelope budgeting to save more
  • Set temperature of water heater to 120 degrees to save electricity
  • Clip coupons and use them to save money

Using your Emergency Fund for Daily Necessities

Emergency funds are for rainy days. But, don’t touch it if you can manage without it.

Check how much you have in your emergency fund. Will you be able to sustain for about 6 months without a pay check? If not, try to have that amount in your emergency fund.

Do not touch your fund unless it’s an emergency. And, if you have to use it, try to save the required funds after the situation becomes normal and you start getting your usual pay check.

Every month, try to save a definite amount in your emergency fund. And, the account should be easily accessible so that you can withdraw funds whenever you need it.

Of course, if your emergency savings is the only thing between you and not paying your bills, you can start spending it.

Not using Available HSA funds

Instead of using your emergency fund for medical treatment, use your pre-tax HSA (Health Savings Account) funds. You can use the funds to get treated or tested for Coronavirus if required. You can even use the funds to consult a therapist if you’re anxious or depressed during this pandemic.

Delaying Filing your Taxes if You’re Eligible for a Refund

As per the CARES (Coronavirus Aid, Relief, and Economic Security) Act, the federal tax filing deadline has been extended to July 15, 2020, including any estimated tax payments for 2020. But, if you’re eligible for a refund, file your taxes.

As per IRS, the average refund is about $2,908 this year. It can help you to cover your living expenses or even make debt payments during this pandemic.

Not Paying the Entire Amount on your Credit Cards

It is a mistake to make only the minimum payments on your credit cards. If you do so, you’ll have to pay the interest on the outstanding balance every month. Therefore, it is always better to pay the entire balance on your cards every billing cycle if you possibly can. So, before swiping your cards, check out whether or not you’ll be able to make the entire payment in the billing cycle.

Also, use your reward points if you’re ordering things online; otherwise, your reward points may expire.

If required and if the creditors agree, you can take out a balance transfer card and transfer your existing balance to the new card. Usually, a balance transfer card comes with an introductory period of zero or low-interest rate. So, repay the transferred balance within that period.

However, after making the payment, do not cancel your existing cards especially if they have a long credit history.  If you cancel cards, the credit limit and the history of credit will reduce thereby affecting your credit score negatively.

Getting Panicked and Selling Stocks

Selling stocks after a stock market decline is one of the major financial mistakes that often people commit. They sell stocks when the market is down. But, have faith. The market will surely recover. Do not touch your investment portfolio at this time. The market recovered even after the economic crisis of 2009. However, it may take a bit more time. So, do not sell stocks right at this moment.

Another thing that the financial advisers always tell not to do is check your portfolio every day. It will make you stressed. Instead, if you have an additional amount after meeting your necessities, you can invest it in stocks as the prices are low.

Withdrawing from Retirement Accounts without Considering the Cons

The CARES Act has made it quite easy to withdraw funds from your retirement accounts, such as IRAs (Individual Retirement Account) and 401(k)s.

Here are a few advantages of withdrawing funds:

  • You can borrow up to $100,000 from your 401(k) plan.
  • You can withdraw $100,000 from any qualified retirement plan without having to pay an early withdrawal penalty.
  • You have 3 years to repay the amount without paying any income tax on the withdrawn amount.

The main advantage of starting to save early in such retirement accounts is to take advantage of compound interest. However, if you withdraw, you’ll lose the benefit to some extent. So, weigh the pros and cons before opting for this.

Not Reviewing your Financial Condition with your Financial Advisor

It is not a good idea to skip reviewing your financial situation with your financial advisor. It is rather more important at this time to have a clear view of your financial situation.

Discuss with your financial advisor how you need to maintain your investment portfolio and what moves you need to take. Talk about your financial goals and how you’ll implement them.

Taking on Debts without Thinking about How to Manage

Mortgage rates are comparatively low. You may feel the urge to take out a loan to meet your daily necessities if you’re facing financial problems. However, it is better not to take out additional debts that you can’t handle.

However, if you’re already having difficulty managing your existing debts, you can consolidate your debt. You don’t have to meet with a debt consolidator in person. You can just call a good consolidation company and seek help.

Sitting in Front of a Screen

At last, I would like to mention that it is quite important to stay physically and mentally healthy during this time. So, do not be stressed. Restrict your screen timing and have some me-time. Do something which you like. Nurture a hobby. Use this opportunity to spend time with kids and family members.

Enjoy quality time and take help from your family members to manage finances efficiently. Not committing these mistakes can help you have a better financial future.

Good Debt vs Bad Debt: Key Characteristics

Good Debt vs Bad Debt: Key Characteristics

Not all debt is bad! The specific definitions of good debt vs bad debt will vary from person to person. For people who plan to retire very early and live on a limited income or for people who know that they have a hard time 

6 Ways to Slay Your Student Debt This Year

6 Ways to Slay Your Student Debt This Year

From Susie Q: I’m not as familiar with student debt as I am with the other topics on which I write, so was pleased to accept this guest post from Kate Underwood.  With Kate’s permission and approval, I’ve interspersed some comments and numerical examples in 

The Basics of Loans: What You Need to Know

The Basics of Loans: What You Need to Know

Loans are the financial instruments people use to borrow money.  Whether they are getting a mortgage to buy a house, borrowing money to buy a car (as opposed to leasing or paying cash as discussed in this post),  or other large purchase, not paying off their credit card in full or borrowing money from a friend, they are taking out a loan.  In this post, I will cover the basics of loans, including:

  • an introduction to the key terms
  • a description of how loans work
  • the factors that determine your monthly payment
  • some common borrowing mistakes

In other posts, I talked about the pros and cons of pre-paying your student loans; more quickly.

The Basics of Loans: Key Terms

There are four basic terms common to almost all loans.  They are:

  • Down payment – The amount you have to pay in cash up front for your purchase.  For large purchases, such as homes, condos and vehicles, the lender requires that you pay for part of the purchase immediately.  This amount is the down payment. The lender wants you to have a financial interest in maintaining your purchase so it doesn’t lose value (as in the case of a residence) or lose value more quickly than expected (as in the case of a car).  For some other types of loans, no down payment is needed. Examples of such loans are student loans, credit card balances and personal lines of credit.
  • Principal – The amount you borrow.
  • Interest rate – The percentage that is multiplied by the portion of the principal you haven’t repaid yet to determine the amount of interest you owe.  Interest rates are usually stated as annual percentages. They are divided by 12 to determine the interest that is due each month.
  • Term – The time period over which you re-pay the loan.

The Basics of Loans: How They Work

How the Money Moves

When you borrow money, the lender usually pays a third party on your behalf.  For example, when you buy a home or use a credit card, the lender gives the money directly to the seller or its escrow agent.  For some loans, the lender gives the money to you, such as with a line of credit. The amount of money the lender gives you or pays on your behalf is the principal.

You then re-pay the loan by paying the lender periodically (usually monthly or bi-weekly).  For most loans, you start making payments immediately. For some loans, though, such as student loans and some car loans, you don’t have to make payments right away.  Most student loans don’t require any re-payments until after graduation. When entering into a loan that doesn’t require immediate payments, it is critical to understand whether interest will be adding up between the time you enter into the loan and the time you start making payments.  Several years of interest, even at a low rate, can increase the amount you need to re-pay substantially.

Payments Include Principal and Interest

Part of each payment is the interest the lender charges you for letting you use its money.  The rest covers repayment of the principal. For example, if you borrowed $20,000 (the principal) at 5% (the interest rate) and started making monthly payment right away, the lender would calculate the interest portion of your first payment as 5% divided by 12 (months) times $20,000 or $83.33.  Your monthly payment also includes some principal. If you have a 10-year term on this loan, your monthly payment will be $212.13. In this case, you will re-pay $128.80 ($212.13 – $83.33) of principal in the first month.

In the second month, you’ll pay interest on $19,871.20 which is the original $20,000 you borrowed minus the $128.80 of principal you paid in the first month.  Your interest payment will be $82.80 and your principal payment will be $129.33. Every month, you will pay more principal and less interest. The chart below shows the mix of interest and principal in each of the 120 payments of your 10-year loan.

Loan Interest and Principal by Month

Factors that Determine Your Monthly Payment

The monthly payment on a loan is a function of three numbers:

  • Interest rate – the higher the rate, the higher your monthly payment.
  • Principal – the more you borrow, the higher your monthly payment.
  • Term – the longer the term, the less your monthly payment.

Sensitivity to Interest Rate and Term

The table below shows the monthly payment on a $20,000 loan for a variety of combinations of interest rates and terms.

Term (in years)Interest Rate
3%5%7%9%
5359377396415
10193212232253
20111132155180
3084107133161

The amount of principal for all of the loans in the table above is $20,000.  Therefore, when the total amount of your payments increases, it is because you are paying more interest.  The table below shows the total amount of interest you would pay for each of the same combinations of interest rates and terms.

Term (in years)Interest Rate
3%5%7%9%
51,5622,6453,7814,910
103,1755,4567,86610,402
206,62111,67816,21423,187
3010,35518,65127,90237,933

Even with the loans with interest rates as high as 9% have much higher payments and total interest than loans with lower interest rates. The interest rates charged on credit cards are often even higher than 9%. This table shows the importance of avoiding the use of credit card debt and refinancing your credit card debt through another lender if it is very large, if at all possible.

What Determines the Interest Rate?

There are several factors that determine your interest rate.

The Economy

The first is the economic environment. If interest rates, such as those on government bonds, are high, the interest rate you will be charged will be also be high.  The US government is considered to have almost no risk of not re-paying it loans, whereas individuals have varying levels of risk. The higher the risk that a loan won’t be re-paid, the higher the interest rate.  Therefore, most loans to individuals have an interest rate that is higher than the interest rate on a US government note, bill or bond with the same maturity.

Credit Score

Along the same line, your credit score is also an important factor in determining your interest rate.  When you have a higher your credit score, lenders believe the risk you won’t re-pay the loan is lower so they charge you a lower interest rate.  My post on credit scores provides lots of details on how to improve your score.

Collateral

A third factor in determining the interest rate is whether or not you pledge collateral and how much it is worth relative to the amount of the loan.  If you pledge collateral, the lender can take it from you if you fail to make your payments. Examples of loans that automatically have collateral are vehicle loans and mortgages.  On those loans, the lower the ratio of the principal to the value of the collateral, the lower the interest rate. That is, if you make a larger down payment on a particular house, your interest rate is likely to be lower than if you make a smaller down payment.  Examples of loans that don’t have collateral are credit cards and student loans. When there is no collateral, interest rates tend to be higher than when you pledge collateral.

Co-Signers

Another approach for reducing your interest rate is to have someone with a better credit score co-sign your loan.  The co-signer is responsible for making your payments if you don’t. For young people, parents are the most common co-signers.

The Math behind Your Monthly Payment

In this section, I’ll briefly explain the math that determines your monthly payment and will provide a bit of information about the Excel formulas you can use.  Feel free to skip to the next section on common borrowing mistakes if you aren’t interested in this aspect of loans!

Present Values

The fundamental concept underlying the determination of the monthly payment on a loan is that the sum of the present values at the loan interest rate of the monthly payments on the day the loan is issued is equal to the principal.  A present value tells the values today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time between the date the calculation is done and the date the payment will be received.  Specifically, the present value at an interest rate of I of $X received in t years is:

Present Value of Single Payment

The denominator of (1+i) is raised to the power of t to adjust for the time element.

The present value of all of your loan payments is then:

Present Value of Monthly Payments

where t is the number of months until each payment and i is the annual interest rate.

Solving for Your Monthly Payment

This amount is set equal to the principal.  The monthly payment can be calculated using a financial calculator, such as in Excel, or mathematically.  The Excel formula is pmt(i/12, t, X). It will give you the negative of your monthly payment. ipmt and ppmt return the portion of each payment that is interest and principal, respectively.  In month y, the interest is ipmt(i/12, y, t, X).

For those of you who really like math, you can also calculate the monthly payment directly.  If payments were made forever (an infinite series), the sum above would equal X/i. We need to eliminate the infinite series of payments after the end of the loan to determine the present value of the loan payments.  Those payments have a present value of X/i divided by (1+i)term.  If we subtract the present value of the payments after the loan term ends from the present value of the infinite series, we get

Principal Formula

That is a bit of a messy formula, but, having gotten rid of the big sum, it can be solved using a fairly basic calculator.

Common Borrowing Mistakes

Some people end up in difficult financial situations, in bankruptcy or even homeless due to poor borrowing decisions.  A few of the more common mistakes are identified below.

Not Understanding the Terms

Many mistakes result from not reading or not understanding the loan agreement.  For example, some loans (mortgages in particular) have teaser rates or adjustable interest rates.  If the interest rate goes up on your existing loan at some point in the future, your payments will also go up.  If you have an adjustable interest rate on a loan, you want to make sure you’ll be able to afford higher payments if interest rates increase.

Another example of a loan provision that can be problematic is a balloon payment.  Under some loans, the monthly payment is calculated as if the loan has a long term, such as 15 or 30 years.  However, after a shorter period of time, say 5 or 10 years, the remainder of the principal must be re-paid and the loan terminates.  If you haven’t built up enough cash to re-pay the principal or can’t get another loan at a rate you can afford, you might default on your loan.

High Cost of Ownership

Many things that people buy with a loan come with other costs that they haven’t considered and might not be able to afford.  For example, when you buy a car, you not only have to make your car payments, but also will need to pay for insurance (including physical damage coverage at a fairly low deductible if required by the lender), gas and maintenance.  Similarly, while you may be able to fit your mortgage payment in your budget, you also need to be able to afford the costs of utilities, homeowners insurance and maintenance. In some cases, these additional costs lead to financial difficulties.

Mistakes that Increase Monthly Payments

Some mistakes cause people to have higher payments than necessary.  For example, if you take out a personal loan from a bank, you often have the option to post collateral.  If you do so, your interest rate is likely to be lower, possibly by as much as 50%.

Another way people end up with monthly payments that are higher than they need to be is to take out a loan that is bigger than necessary.  For example, if you can afford to make a larger down payment than you actually make, the principal on your loan will be higher which increases your monthly payment.  Many loans have pre-payment penalties which make it cost-prohibitive to pre-pay your principal to bring it back in line with the amount you should have borrowed in the first place. Also, if the lower down payment increases the ratio of the principal to the value of your home by too much, it will also increase your interest rate which further increases your payment.

Overestimating the Value of Your Collateral

Another problem people encounter is an inability to borrow as much as they need because they overvalue their collateral.  Common issues that arise include:

  • Lenders get their own appraisals of houses.  The lender’s appraisal is often lower than the purchase price and sometimes even lower than the assessed value.  If the appraisal is less than the purchase price, the buyer must increase his or her down payment so the ratio of the loan to the appraised value is within the lender’s limits.  Even worse, some banks won’t issue the mortgage at all if the difference between the appraisal and the purchase price is too big, even if you increase your down payment. In those situations, you need to either find another lender or re-negotiate your purchase price.
  • Lenders use the National Auto Dealers Association (NADA) Guides to value used cars.  These values can be different from Kelley Blue Book. In particular, the NADA Guides adjust the value based on the specific location of the vehicle.  Also, the values in the NADA guides assume that the vehicle is in pristine condition for its age. If it has had any heavy use at all, the lender will reduce the value before determining the value of the collateral.
  • For used cars, washed titles are also a problem.  When a car has been severely damaged, its title is changed from the more typical “clean” title to a salvage title.  However, when a car’s title is transferred from state to state, its damage history can get sometimes get lost as some states do not require salvage titles.  However, other sources, such as CARFAX, maintain the information about the damage. Lenders will check these other sources before determining the value of the collateral.

While collateral helps reduce the interest rate on your loan, it is important to consider these points in determining the value of your collateral.

Poor Uses of Debt

There are many things for which loans can be used, some of which are valuable and some of which are less so.  This post provides a discussion of the characteristics that can help you identify which loans might be good for you.

The Scoop on Credit Scores

The Scoop on Credit Scores

Credit scores are one of the most important financial numbers.  Credit scores not only affect the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest