Article about debt snowball pay-off for consumer debt

Here’s an article I read recently:

During my twenties, I accumulated nearly $25,000 in consumer debt. I had a spending problem. With time, I was able to get my spending under control (mostly), but I still owned overwhelming debt. How could I get rid of it?

The personal finance books all suggested the same approach:

Order your debts from highest interest rate to lowest interest rate.
Designate a certain amount of money to pay toward debts each month.
Pay the minimum payment on all debts except the one with the highest interest rate.

Throw every other penny at the debt with the highest interest rate.
When that debt is gone, do not alter the monthly amount used to pay debts, but throw all you can at the debt with the next-highest interest rate.
This made perfect sense. By doing this, I would be paying the minimum amount in interest over the long term. The trouble was, my highest-interest rate debt was also my debt with the biggest balance (a fully-maxed $12,000 credit card at 19.8% interest). I’d plug away at this debt for several months at a time, but then give up because it felt like I was never getting anywhere.

This happened over and over. I’d start and fail. Start and fail.

Then I read about the Debt Snowball method in Dave Ramsey’s The Total Money Makeover. The Debt Snowball method is similar to the traditional approach except that instead of attacking high-interest rate debts first, you attack low-balance debts first. Why? Because you’ll get the psychological lift of pinging debts off in rapid succession. And if you’re like me, this makes all the difference. The Debt Snowball approach is:

Order your debts from lowest balance to highest balance.
Designate a certain amount of money to pay toward debts each month.
Pay the minimum payment on all debts except the one with the lowest balance.

Throw every other penny at the debt with the lowest balance.
When that debt is gone, do not alter the monthly amount used to pay debts, but throw all you can at the debt with the next-lowest balance.

When I read about the Debt Snowball method, I was skeptical. I knew it would cost me more in the long run, at least on paper. But I figured I had nothing to lose. I tried it. In four months I’d paid off most of my debts. I was shocked. I’d been trying and failing for years, and now I was able to make a huge dent in just months? It was all because I had changed my approach just slightly.

Humans are complex psychological creatures. They’re not adding machines. Many of us know what we ought to do but find it difficult to actually make the best choices. If we were adding machines, we wouldn’t accumulate $20,000 in consumer debt in the first place! It’s misguided to tell somebody so deep in debt that they must follow the repayment plan that minimizes interest payments. The important thing to do is to set up a system of positive reinforcement, and that’s exactly what the Debt Snowball method does.

Which method should you choose? Do what works for you. The first method can save you money in the long-run. But if you’ve tried it and failed, give the Debt Snowball method a shot. It might be the answer you’re searching for!

WSJ.com article points out importance of 30 yr mortgage & liquidity

I originate very few 15 year mortgages. The reason? I believe that cash is king. Given that mortgage rates are at historical low levels I would rather see my clients take out a 30 year amortizing mortgage and invest the difference instead of potentially creating a cash-trap with a 15 year loan. Here’s an article that was published in the Wall Street Journal that places a 30-year mortgage at the top of the list for “surviving a cash crunch”:

Take Seven Steps
So You Survive
A Cash Crunch
By BRETT ARENDS
April 12, 2008

No one wants to get caught in a cash crunch. Look at what happened to Bear Stearns.

Investors can’t go running to the Fed.

Sometimes all it can take is a surprise bill, or a sudden loss of a job, to put your family’s liquidity in peril. And these are treacherous times. The economy is rocky. Employers are cutting jobs. And some investments — including home values — are turning wobbly just when you may need them most.

The Federal Reserve, alas, isn’t going to bail you out if you get hit by a liquidity crisis.

So where can you turn? If you’re worried, check out your emergency lines of credit now, before there’s a crisis.

Here are the seven habits of highly liquid people.

1. Refinance your mortgage over 30 years. Just switching your remaining debt from, say, a 20-year schedule will slash your monthly outflows by nearly a fifth. Borrowing against your home is the cheapest form of consumer debt.

2. Set up a home-equity line of credit. They’re usually cheap to arrange, and you can draw on it when you need it. Right now, rates are as low as 5.25%.

3. Get a free float from a new credit card. Some still offer zero-percent interest on balances transferred from your current card. As always with the credit-card sharks: Watch out or they’ll find a way to sock you with fees anyway.

4. Get your money back early from the IRS. Most Americans prepay too much tax, and the average refund is nearly $2,500. File a new W-4 with your employer to cut your monthly withholding. You have to estimate your likely bill in good faith. If you end up prepaying too little, you can make it up by Dec. 31. If you don’t, you will have to pay 7% or so in penalties. The rate fluctuates, but it’s a lot cheaper than an unsecured loan.

5. Set up unsecured financing sources now, while you don’t need them. Ask your bank for an overdraft facility, of course. And apply for some emergency credit cards. Yes, the rates are usurious, so don’t use them unless you have to. But someday you may have to.

6. Check out how to borrow from your 401(k) retirement plan. Most plans allow this, though the rules vary. The limits are often 50% of your balance, up to $50,000. It can take anywhere from a few days to a few weeks to get the money. Note: You may end up paying taxes, plus a 10% penalty, if you don’t repay the money when you leave your employer, or within a specified period. It is usually five years. Check the rules ahead of time.

7. And, most obvious: Start saving. Most middle-class families can save thousands a year just by paring back on discretionary bills. This is a good time to slash those bills to the bone.

Q & A with Merrill Economist

In this weekend’s Barron’s there was an article that featured a Q & A with Merrill Lynch Chief Economist David Rosenburg. He is credited with calling the current economic slowdown far before anyone else and makes interesting predictions about American Households’ spending patterns in the future:

Here is a excerpt from the article:

Q: Will we notice profound changes in the nature of the U.S. economy when the business cycle rebounds?

A: Profound, profound, profound. Frugality is going to be a source of pride. It’s no different than how in 1972 you saw a lot of Lincolns and Cadillac Sevilles in the dealer lots. Three years later you were in the crusher. We’re going to be as a consuming nation, trading down, getting smaller, focusing on savings, repairing our balance sheets. Take a look at the median age of the boomer, they’re only within 10, 12 years of retiring. I think that’s going to have a big impact on savings, and the choices of savings in that process, a focus on less risk, and more on income and safe dividends.

Q: Will I be able to get the access to credit I need to buy the gadgets I want?

A: It will all come down to your creditworthiness. I think that lots of things are going to be changing. Our attitude toward debt is already in the process of shifting. For lack of a more exciting term, we’re going to learn to live within our means a lot more than we did in the past 20 years. I think we will ultimately come out of this a lot stronger. We bloated up on debt in years of over-consumption. And we’ve suffered from a coronary, and we’re going through the bypass surgery now. Inevitably we will be healthier. But we will have to follow the doctor’s orders and have a healthier diet.

Thinking about refi’ing? Read this first….

The purpose of this article is to give consumers a guide for determining whether or not a proposed refinance makes financial sense for them. Through my interactions with many of my clients over the years I’ve found that much of the population is left confused when evaluating mortgage refinance options. I hope that I can shed some light through this article so that you can make better decisions about your own situation.

Because evaluating proposed refinance options is often confusing and overwhelming, many “rules” have been created over the years in an attempt to simplify the formula. Among the most common of these is the “1% rule” in which loan holders are to refinance ONLY if they can lock a rate 1% below their existing mortgage rate. Although I applaud the simplicity of such a rule I do not think it is effective in helping people make wise financial decisions.

The truth of the matter is that every single household’s situation is different and therefore there is no blanket rule that can apply to all people. We may advise two households differently even though they have the exact same mortgage balance and the exact same interest rate evaluating the exact same refinance proposals because each has different objectives.

So how do you decide whether or not a proposed refinance makes sense for you? Here is a methodology that we use with our clients:

The first step is to identify what your objectives are.

For most people the biggest consideration in deciding whether or not to refinance is cost. If they can replace their existing loan with a lower cost option then the refinance makes sense for them. For these people we’d like to remind them that costs can be expressed in a variety of ways such as closing costs, interest costs, opportunity costs, etc.

For other people the monthly payment or loan program may be their biggest consideration. For example, maybe someone is anticipating going back to school and wants to refinance into an interest-only loan to reduce their monthly payments. Or, maybe a person has an adjustable rate mortgage (ARM) that is scheduled to adjust in the coming months and they think that it would be a good time to lock in a fixed rate. These considerations may not be motivated by cost in the near term but instead by lifestyle changes.

The bottom line is that the objectives can vary depending on the person and the circumstance. It’s important that a person identifies what is important to them and communicates it to their mortgage professional.

The second step is to evaluate your options.

Once your mortgage professional understands what you’re after, they should be able to provide you with multiple refinance options based on those objectives. This is where the art of evaluation comes into play.

At the heart of evaluating a refinance proposal is a cost-benefit analysis. As a consumer you must weigh the cost associated with the refinance (as measured by the closing costs) against the proposed benefit (your objectives).

If your objective is anything other than cost the evaluation is much more subjective in nature. You will have decide if the closing costs you’ll incur for refinancing is worth whatever benefit you are seeking.

If cost is of most importance, then the cost-benefit analysis is relatively easy to complete. With this analysis we’ll evaluate the proposed cost of the refinance, in terms of closing costs, and weigh it against the proposed interest savings over time.

The cost-benefit analysis looks like this:

Proposed closing costs ($)/ Proposed Interest Savings ($ per month) = break even period: # of months in which it would take to recoup the closing costs and begin saving money

Once a person has calculated the length of time it would take for them to recoup their closing costs they can then decide if they expect to hold the loan long enough in order to experience significant savings.

In order to make sense of this concept lets evaluate a hypothetical situation:

Johnny Homeowner bought his home in January of 2006. At that time he took out a 30 year fixed rate mortgage @ 6.50% which he’s made standard payments on ever since. As of March of 2008 his loan balance is $296,067 and his monthly principal and interest (P & I) payment is $1,871.

He is currently evaluating a refinance proposal which would replace his existing mortgage with a new 30 year fixed rate mortgage @ 5.875%. The closing costs associated with the refinance are $3,000 which he has decided to include in the new loan so that he doesn’t have to pay them out of pocket. The new monthly payment would be $1,769 which represents a savings of $102.

Here is the analysis for him:

$3,000 (closing costs) / $102 (monthly interest savings)= 29 months.

What the analysis suggests is that he would have to maintain this mortgage for 29 months in order to recoup the initial closing costs he paid for the refinance. From that point forward he’s in better shape than he would have been had he not refinanced. So, for him to evaluate whether or not this makes sense he’d probably want to feel confident in the fact that he’ll have this loan for at least 30 more months.

The last step is to make your decision.

Since everyone is different there is no right or wrong answer when it comes to refinancing. We can help you best understand the implications of refinancing but ultimately it’s up to you to decide whether or not you should do so.

Typically we try to provide our clients with little to no closing cost refinance options because we believe there is less risk of making a bad decision when the break-even period is relatively soon. The tradeoff in that the borrower may not be locking an interest rate that is as low as they could get if they were willing to incur more costs.

If you decide that the refinance terms are not good enough to justify the cost then be sure and communicate that to your mortgage professional. Often times they can keep a lookout for you so that if/ when the opportunity does present itself they can pro-actively let you know.

In summary, deciding whether or not to refinance can be a difficult decision. In order to make sense out of it we’d first encourage you to identify what your motivation for refinancing is. Second, communicate that to your mortgage professional and have them work up some options for you to review. Evaluate these options using a cost-benefit analysis to decide whether or not the proposed benefit outweighs the cost of the loan. Finally, remember that there is no right or wrong answer. If you think that it makes sense then go for it and if not be sure to inform your mortgage professional what it is you’re looking for so that they can keep an eye out for you.

No-Closing Cost refinances- How do they work?

For most of our clients, the idea of a “no closing cost” (NCC) refinance seems too good to be true. We think that these loans are great tools for helping our clients save money; but it is critical that our clients understand how they work. The purpose of this posting is to explain how we can offer NCC refinances and how we use them to help our clients manage their mortgages most effectively.

The first thing to understand when it comes to NCC refinances is how they are even possible. As a mortgage lender, there are two ways in which we can generate revenue for our work in originating a new mortgage. The first and most common way is by charging an origination fee to our clients, also known as “points”. Some lenders charge a 1% point in addition to standard closing costs (lender, appraiser, title/ escrow, etc.).

The second way we can generate revenue is by selling the servicing rights of a loan we originate. In other words, lenders are willing to pay us a fee in exchange for the stream of payments that our clients pay as a part of their mortgage obligation. NCC refinances become possible when we can use the revenue from the sale of the servicing rights to cover all of the closing costs that our client would normally incur.

So what is the tradeoff? The tradeoff is that in order to generate enough revenue to make a NCC refinance feasible, we have to assign a premium to the interest rate above what a borrower could lock in if they were willing to pay their own closing costs.

As an example, here is list of available 30 year fixed rates with the associated closing costs:

4.75% w/ $3,500 closing costs + 1% point ($3,500)= $7,000 closing costs

5.00% w/ $3,500 closing costs

5.25% w/ $0 closing costs (in fact there is a $3,500 lender credit that is used to offset the $3,500 in costs)

For most of our clients it can be difficult to justify the standard closing costs associated with a refinance because the fixed rate being offered is only modestly better than their current situation. For example, for a client who has a current fixed rate of 5.50% the 4.75% would only create approximately $3,000 in annual interest savings & the 5.00% option only about half that. A borrower would need to hold the mortgage for over 3 years in order to save enough interest to recoup the closing costs associated with these options. For most people the “break-even” period is simply too far away to make the proposed refinance attractive.

However, this person could take advantage of our NCC refinance option @ 5.25% and immediately begin saving approximately ~$800 per year. This amount would not change their life but the fact that they incurred $0 closing costs to obtain the new rate would make it beneficial to them from day 1.

Here are some FAQ’s we’re commonly asked about NCC refinances:

Should we wait to see if rates go lower?

The best part about NCC refinances is that typically we can continue to provide them. If a borrower took advantage of the aforementioned 5.25% option and rates continued to decrease over the following months we could always provide another NCC refinance in the future. Since there is no cost to them there is no drawback in doing it multiple times, even within a short time period. We call this the “ratchet effect” because we effectively “ratchet” your mortgage rate lower as long as it makes sense but the rate will never move higher from the fixed point.

Will we have to bring any cash into closing?

It is likely that you’ll have to bring some money into closing. The amount will vary on a case-by-case basis but lenders will essentially collect what equals to one mortgage payment because by refinancing you’ll skip your next one. For example, if you closed the NCC refinance on June 15th you’d be responsible for the interest on your current loan from the date of your last payment (June 1st) to the 15th (when the loan would be paid off). You would also be responsible for the interest that will accrue on the new mortgage from the close date, to the last day of the month (June 15th –June 30th). You WOULD NOT have to make a mortgage payment on July 1st.

Depending on whether or not you pay your real estate taxes & homeowner’s insurance with your monthly mortgage payment, the lender may also need to collect funds to re-establish a tax/ insurance reserve account. Often times these amounts can be included in your new loan amount so that you don’t have to fund this with cash out of your pocket. Keep in mind that when you pay-off your existing mortgage the lender will refund any amount that you currently have on deposit with them and therefore this amount that is collected is effectively a “wash”.

If you pay your real estate taxes and homeowner’s insurance separate from your mortgage payment then the lender may require that your current homeowner’s insurance be renewed (if it set to be renewed within the next few months) or any outstanding real estate tax liens be paid (depending on the time of year).

Will my loan amount change?

Some of our clients have asked us if when talking about a NCC refinance we are simply referring to “rolling” the cost of the loan into the new loan amount. We are not. This is truly a NO CLOSING COST refinance. If you’re comfortable paying your equivalent of one mortgage payment at closing and possibly any collected taxes and insurance then we can keep your loan amount exactly the same.

Does my 30-year term on my mortgage start over again?

It is true that with the new mortgage your term will start over again (there are some exceptions). However, if paying off your mortgage is most important to you then it would still be in your best interest to complete a NCC refinance. This is because if you used the monthly payment savings that you’ll get from the refinance to pay additional principal each month you’ll pay off your principal quicker than your current mortgage with a higher interest rate.

Are NCC refinances available to everyone?

NCC refinances are tougher to offer for borrowers who have loan amounts < $250,000.

Good article in the WSJ…

A Fate Worse Than Debt:
Are You a Walking Junk Bond?
By JONATHAN CLEMENTS
March 19, 2008;

Banks are shaky. Bonds are suffering cuts in their credit ratings. Even bond insurers are hurting. Next up for a downgrade: people.

As the economy sputters and the housing market slumps, folks are struggling to pay their bills, and growing numbers are seeing their credit scores tumble. The result: Among Americans with credit histories, maybe a fifth are now akin to walking junk bonds, with lenders viewing them suspiciously and offering them credit only at steep rates.

Here is a look at what’s happening — and how you can avoid junk-bond status.

Unraveling Fast. To get a handle on the state of U.S. consumers, I turned to Equifax, the Atlanta-based credit bureau.

For every consumer with a credit history, the firm calculates an “Equifax risk score,” which ranges from 280 to 850. The average credit-risk score for U.S. consumers climbed fairly steadily for much of this decade, in part because many Americans used home equity to keep their credit-card debt under control.

But over the past year, the average score has slipped slightly. More notably, there has been a 7% increase in consumers in the bottom category, those scoring below 580. These folks now account for 17% of the consumers tracked by Equifax.

“I think it’s directly related to the subprime consumers who are behind on their mortgages,” says Myra Hart, a senior vice president with Equifax. “They’re late on their mortgages or even going into foreclosure.”

As the economy slows, she says most consumers will maintain decent credit scores because they will hang on to their jobs. But among those unlucky enough to get laid off, we could see a further jump in rock-bottom credit scores as these folks struggle to pay their bills.

Indeed, for the unemployed, things could unravel fast. Ms. Hart notes that debt-service payments have jumped 39% over the past five years, outstripping the 25% rise in disposable income. On top of that, the annual savings rate this decade has ranged between a meager 0.4% and 2.4%, which suggests families don’t have much of a financial cushion to fall back on.

Dodging Disaster. Don’t want to end up as a subprime consumer? To maintain a top-notch credit score, the standard advice is to pay your bills promptly, avoid applying for credit too often and use only a small percentage of your available credit lines.

Such strategies are important — but they aren’t exactly a prescription for savvy money management. Instead, what you really need to do is shun the sort of foolishness that can put your family in peril. To that end, stick with these two guidelines:

Cap your core living expenses at half of your pretax income. We’re talking here about things like groceries, car payments, mortgage or rent, utilities, student-loan payments and insurance premiums.

That will leave the other half of your income for savings, income taxes and fun stuff like vacations and eating out. If you lose your job, these other expenses should shrink sharply — and you can live on half of your old income, says Michael Maloon, a financial planner in San Ramon, Calif.

“The key is to have enough savings to cover a minimum of six months of those core living expenses,” he says. “Me and my clients, we don’t take any risk. That money goes into a money-market fund.”

Don’t be short-term clever and long-term foolish. Since the early 1990s, there has been a gradual collapse in financial discipline, as Americans quit saving, spent home equity and, more recently, started raiding their 401(k) plans.

All this has been excused as perfectly rational. Not saving was okay, people believed, because stocks and homes were rising in value. Tapping home equity made sense because rates were low and the interest was usually tax-deductible. Taking a 401(k) loan was fine because you pay interest to yourself.

Indeed, with enough of these clever strategies, you could wreck your financial future. What if you lose your job, get hit with unexpected medical bills or decide you want to retire? Trust me: Things could be mighty rough if you haven’t saved, your home is fully mortgaged and you’ve drained your 401(k).

Prepay your mortgage versus invest the difference?

There was a great article in Consumer Reports that was sent to me recently by a colleague. Consumer reports ran some hypothetical scenarios where a person had the option of either investing or prepaying their mortgage by $100 per month. The results? You’re better off investing the money in the long-run. Check out their article here:
http://www.consumerreports.org/cro/money/credit-loan/prepaying-your-mortgage-3-08/overview/prepay-mortgage-ov.htm?resultPageIndex=1&resultIndex=1&searchTerm=your%20mortgage