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Debt Reduction

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Changes to Student Loans Coming July 1

by Flexo on June 15, 2009

in Debt Reduction

While it’s great to avoid debt whenever possible, if you have to deal with federal student loans, including Stafford and PLUS loans, you might qualify for some better deals starting July 1.

Interest rates will be at the lowest rates in years. If you can consolidate, lock in rates after July 1. They will be at the lowest levels since the inception of the federal student loan program. The interest rate for graduates who are in a grace period is 2.00%.

Former students now in the process of repaying their variable rate federal student loans will be able to lock in a rate of 2.50%. Parents who have taken PLUS loans will be able to consolidate at 3.38%.

There aren’t many places to find cheaper money than this, but there are a few of limitations:

  • Former students who have already consolidated are not eligible for these low rates.
  • These rates are only valid for loans originated before July 1, 2006.
  • Borrowers who are still in school do not qualify for consolidation.

There is more good news.

Income-based repayment. If a borrower is not earning enough to make monthly payments, they can apply for income-based repayment. The lender can extend the life of the loan and lower your payments to 15% of your income.

Student loan forgiveness. Borrowers who work for non-profit companies or the government will qualify for student loan forgiveness. After 120 payments (ten years), the government will write off any balance remaining on the loan. Student loan forgiveness applies to people who do not work for the public sector as well if they are repaying on an income-based repayment plan. In this case, 25 years of payments are necessary before the remainder of the loan will be forgiven, but will be considered income for tax purposes.

Rates for new student loans. Subsidized Stafford student loans will sport a new interest rate of 5.6% if the first disbursement is taken between July 1, 2009 and June 30, 2010. This is the second of four annual interest rate drops for new loans.

Increased Pell Grant scholarship maximum. Low and middle-income families might qualify for a Pell Grant scholarship. The maximum a student might receive from this federal program will increase on July 1 to $5,350.

These programs can save families thousands of dollars throughout the life of the repayment.

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When Going Into Debt is Worthwhile

by Flexo on June 10, 2009

in Debt Reduction

On a macro level, debt was a force behind the incredible economic expansion over the past two centuries, and the availability of debt at the family level played a role as well. Despite all that debt has brought society, many financial gurus and authors vilify debt and explicitly call the idea of borrowing money “evil.” Typical mass-produced financial advice often calls for avoiding debt as much as possible. Is this a realistic goal in economically developed nations in the twenty-first century?

For some, it is. There is no doubt that there are many ways families can survive and thrive while avoiding the need to borrow money at all. Avoidance of all debt can be a struggle for most families, particularly in today’s United States. Are the sacrifices worth the effort?

To join in this discussion, you must accept that debt is not evil. All forms of money are tools to simplify the exchange of goods and services. As tools are objects with no inner consciousness, they can neither be good nor evil, as these words indicate a nature of intentions. Intentions require a sophisticated neural network, something lacking as much in money as it is lacking in a doorknob.

If you’re still with me and you agree that borrowing money is not an evil concept, you might also agree that the tool of debt could possibly be used for both wise and unwise decisions, designed by the active neural networks in human beings (the tool-wielders).

From a pure numerical viewpoint

Even though amounts and values of money are normally symbolized by numbers, money is never solely about digits on a ledger. If it were, there would be only one reason to go into debt: an opportunity to use someone else’s money to earn more money than what is borrowed — a sure thing. If I offered you $10,000 without interest with the only caveat that you repay me slowly each month and in full by the end of twelve months, it would be wise to accept the offer, invest the $10,000 in a safe investment like a high-yield savings account, pay me back, and keep the interest you’ve earned for yourself without much effort.

This is what credit cards have been offering, though less frequently recently, with 0% balance transfer offers, or so they’d like you to believe. If you look deeper, there are usually some risks:

  • The credit card companies might drop the promotion.
  • If you fail to make a payment in time, even if your check arrives on someone’s desk one minute too late, you will owe interest to the credit card.
  • The bank might lower the interest rate you are earning in the savings account to a point where the exercise is not worthwhile.
  • Your credit score will decrease due to an increased utilization ratio, forcing you to pay more for new loans or mortgages.

The numbers are trickier when you question whether to take on debt at a higher interest rate with the possibility of earning more from a riskier investment, like stocks. Here you have to weigh the probability of not earning more than the interest you will be charged for borrowing the money.

In the end it is a judgment call. You could devise complex algorithms to help you to decide whether to borrow money at one rate for the possibility of earning a higher return on an investment, but anything can happen.

Debt for education

University of Delaware Campus

One of the most prominent rationalizations for accepting debt for education, like student loans, is from the purely mathematical viewpoint. People who go to college earn more throughout their lifetime than people who do not. The numbers show that in many cases, money spent for college, including interest payments lasting ten years after graduation, are worthwhile thanks to increased career opportunities and salaries. On average, an individual with a Bachelor’s degree will earn twice as much as an individual with only a high school diploma, though the statistics will differ depending on the field of study and the career.

Thus, it often makes mathematical sense to enter into debt to obtain a Bachelor’s degree, if necessary. There are ways to avoid education debt, such as having parents who have earned and saved enough money to fully fund the education, choosing a free or less expensive school, obtaining grants or scholarships, or even working. When these options fail, the possibility remains that choosing to attend and graduate from a certain college and accruing debt will be a better decision than not earning the degree at all.

Student loans can generally be found with low interest rates or with a portion of the interest being subsidized by the government because it is in society’s best interest to produce a well-educated workforce and thinkforce.

Your career’s start-up expenses

When a new company is formed with a visionary idea, there are often required start-up expenses. These include finding real estate for an office or storefront, furnishing the office or acquiring inventory, hiring employees and paying them salaries, and spreading the word about the new business. I like to compare this process with a recently-graduated student entering a career. Unless the business has received help from investors (who often require that they become part owners), these start-up companies rely on loans.

Similarly, in some cases new employees can be excused for using debt to put them in a competitive position for starting their careers. Dressing appropriately and presenting a professional appearance requires expenditures for which a newly-minted graduate may not be financially prepared. (This is one reason I suggested the gift of clothing or gift cards for recent graduates.) Attending networking events, sending out resumes and traveling to interviews are all start-up expenses that must be financed in order to land the right job.

That first job is an important indicator of the remainder of your career, particularly if you remain in the same career path your entire life (as fewer people do). The better placed and paid you are in your first job, the higher your income will be throughout your career.

If necessary, a moderate amount of debt at the point you start your career will provide the opportunities to place you in a better position for future earning.

Owning a house

McMansion

Thanks to the prevalence and availability of debt, consumers have reached higher and higher beyond their means. In the 1960s, median house prices were about 2.5 times the median annual household salary and at the height of the housing market in the early part of this century, the multiple was around 5 (source). Saving to pay for a house with cash could take years or even decades.

During the height of the housing frenzy, many families were willing to take on debt using the above numerical viewpoint. House prices seemed to go up without fail, and the prospect of earning more by leveraging a house purchase with debt seemed to make financial sense. Unfortunately, the underlying assumption that real estate prices always increase proved to be incorrect and many families were hurt due to over-leverage.

But that doesn’t mean that it’s never wise to buy a house with help from a loan. Buying a home should not be a purely financial decision. Families often want to create a stable home environment, and settling down in a location with the intent to stay for several decades is a key component of that idea. Furthermore, families with children want to ensure that the free public education offers a quality experience, and regions known for excellent education, in high demand, will often be more expensive.

A mortgage, while a decades-long debt sentence, is not evil. It makes sense for families to live in the best location they desire if they can afford the debt payments.

When else is debt worthwhile?

If you accept debt into your life, there are sacrifices you will need to make. You will also need to accept other sacrifices if you refuse to enter debt. It comes down to personal choice. Is it crazy to be willing to accept debt, as long as it is affordable and well-purposed? Or do you agree with idea that money is a non-intentioned tool, to be used in whatever situation logically calls for it? Are there any other instances where it can be a smart decision to take on debt?

Photo credits: mathplourde, snapped_up

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Majority of Bankruptcies Due to Medical Bills

by Flexo on June 4, 2009

in Debt Reduction

Not only are most personal bankruptcies due to medical bills beyond the ability of the consumer to pay, but most of the households declaring bankruptcy for this reason do so despite having health insurance coverage.

Researchers from Harvard Law School, Harvard Medical School, and Ohio University reported 60 percent of personal bankruptcies in the United States involved medical bills, an increase of 50 percent over the past six years. Furthermore, seventy-five percent of those bankruptcies were claimed despite having health insurance, intended to cover medical expenses and prevent unaffordable bills.

The researchers indicated that only 29 percent of those who declared bankruptcy explicitly cite medical bills as the cause, but the 60 percent figure includes households with medical bills totaling more than 10 percent of family income.

Health insurance appears to be useless when it is most needed. Twenty-five percent of insurance companies cancel coverage immediately when an individual covered suffers a disabling illness. Within a year, another twenty-five percent of insurers cancel coverage.

Even with medical coverage, here are the average bills, out of pocket, for some of the most expensive conditions:

  • Multiple sclerosis: $34,167
  • Diabetes: $26,971
  • Injuries: $25,096
  • Stroke: $23,380
  • Heart disease: $21,955

The study was funded by the Robert Wood Johnson Foundation and will appear in the August edition of the American Journal of Medicine.

Medical bills underlie 60 percent of U.S. bankruptcies: study, Reuters, June 4, 2009

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Pros and Cons of Interest-Only Mortgage Payments

by Flexo on June 3, 2009

in Debt Reduction

Yesterday, Consumerism Commentary reader Ryan suggested I write about interest-only mortgages.

There is no such thing as an “interest-only mortgage.” Wouldn’t that be nice, though, to have a mortgage that did not require you to pay any principal back to the lender? Unfortunately, when you become a borrower, your lender will insist upon receiving interest payments as well as principal at some point. What does exist, however, is an interest-only payment option for mortgages. The interest-only payment option can apply to adjustable-rate mortgages and fixed-rate mortgages alike. The purpose is to allow borrowers to reduce monthly payments for a period of time. Rather than a monthly payment of $1,200, in which $600 goes to interest and $600 goes to the principal, the monthly payment would only be $600.

The lower monthly payments during the interest-only period are good for households with irregular income such as commission payments less frequent than monthly, or households with unpredictable income, like that of a business owner who is expecting low income while the business is in a period of growth.

Interest-only payment options also allow borrowers to “afford” a more expensive home. This can be important for an executive who needs to entertain clients at home and its appearance is crucial to career success, but there could be a strong desire to use the lower payments to buy a home beyond the means of the borrower.

This is a dangerous prospect, especially in an environment where we can’t be sure whether the value of the house will rise in the short term. While making interest-only payments, the borrower is not building equity in the house. if the borrower is not building equity, the concept is similar to renting, particularly if home values are stagnant or decline. The amount you owe on the mortgage will never decrease. Even worse, some interest-only payments don’t cover the full amount of interest due each month. The excess, non-paid interest would then be tacked onto the principal, causing the borrower to owe more in principal than the home was worth when purchased.

When house values are declining, like they have been in many areas of the United States, this problem is compounded. Not only does the borrower owe the full purchased value of the house while making the interest-only payments, but the house’s declining values means the borrower will quickly owe more than the home is worth. Then, if it is sold, the borrower could owe more money to the lender than he received in the sale.

Interest-only payment options don’t last forever. After the interest-only period ends, the lender will expect the borrower to start paying back the principal. This can result in a significant increase in the number written on the checks sent to the lender. If the income hasn’t increased as expected or if the business has not moved past the “growth” stage, the new payment — a larger payment than you would have had throughout the life of the mortgage if the interest-only option was not selected — might be unaffordable.

The Federal Reserve Board has a helpful comparison chart outlining the differences in payments you might expect if you choose an interest-only payment option, reproduced below. Notice how low the equity is in the last column, identifying borrowers who opt for the interest-only method.

Interest-only mortgage payment comparison

Do you have or have you had an interest-only payment option on a mortgage? Please share your experiences or opinions.

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Debt Reduction Methods and Philosophies: Snowball, Avalanche and More

by Flexo on May 29, 2009

in Debt Reduction

When someone who has accumulated debt across a number of credit cards embarks on the journey to rid himself or herself of this debt, and when that person is generating enough monthly income to cover all expenses and the minimum payments due on all cards with additional funds left over, there are two main philosophies describing the best way to achieve this goal. Although all approaches are good, there is no question where I stand on this issue.

I suggest following the path that affords the opportunity to get rid of debt as quickly and as cheaply as possible. This method has many names, but I’ve called it the Debt Avalanche in the past. The opposing viewpoint, popularized by author and guru Dave Ramsey, suggests paying off debt in such a way that it might take more time and be more expensive but offers “quick wins” which help some people gain encouragement and momentum at the earliest stages of the process. And there are, of course, many points of view that present a compromise between these two extremes.

The snowball approach to debt reduction

By ordering your credit card debts from lowest balance to highest balance and paying the minimums to all except the first on the list each month, you will pay off your first debt sooner than by following any other method. If you need encouragement to continue your journey as you pay off debt, you can celebrate after your first credit card has a zero balance.

Not everyone requires this type of extra motivation for paying off debt. Additionally, even those who need extra motivation may not suffer by choosing a cheaper and quicker method of paying off debt. The “quick win” of paying off the first debt could come just as quickly by using the Debt Avalanche. But even if the first payoff doesn’t come as quickly, you can redefine your first milestone to allow yourself helpful celebrations as explained in the next section.

J.D. Roth from Get Rich Slowly has seen success with the Debt Snowball approach, as have many others. It is the most widely marketed philosophy.

For an illustration of the monthly process of sending minimum payments to all credit cards except the one on top, regardless of how the debts are ordered, see this visualization from No Credit Needed.

snowball3

One major problem I have with the above snowball approach is that your largest balance may be significantly more expensive than your smallest balance. Today it is not difficult to find a default interest rate on a credit card north of 30%. There is no way in good conscience I could recommend holding off on eliminating a debt this expensive in favor of paying off a small balance with a 7.9% interest rate. The same goes for payday loans, whose fees can border on usurious if interpreted as interest rates.

The avalanche approach to debt reduction

There is no question that anyone who follows this alternate approach to its conclusion will have emerged from debt sooner and by paying the least amount of interest possible. Some people argue that it is not as likely for someone to follow the Debt Avalanche through, but there are no data to support this. By ordering your credit card debts from the most expensive (highest interest rate) to the least expensive and paying the minimum each month to all cards except the first on the list, you reduce your interest payments quicker.

Since this is a mathematical approach, critics say it doesn’t take into account the emotions that come into play when dealing with money. It is true that emotions — your feelings about money — play an important role in financial decisions, and although this is a mathematical approach, how you feel about money still is represented in this method.

  • If you follow the Debt Avalanche method, you can feel good knowing that you’ve made a sound decision and will spend less money than others who take a different approach.
  • You can motivate yourself throughout by creating your own milestones for achievement, including paying off your first credit card, paying off $1,000 (or some other meaningful amount), or consistently reducing debt for six months (or some other meaningful time frame).
  • Your emotions may be the cause of your debt in the first place. While they obviously cannot be eliminated, learning to focus on the best mathematical approach for certain financial decisions can improve your overall relationship with money.
snowball4

I outlined the details of the Debt Avalanche last year. Trent from The Simple Dollar also likes the Debt Avalanche approach and Five Cent Nickel explains how Dave Ramsey is bad at math.

Other approaches to debt reduction

The hybrid approach. Somewhere between a snowball and an avalanche lives this hybrid. The concept here is simple. Order the credit cards from highest interest rate to lowest, like the Debt Avalanche, but move the card with the lowest balance to the top. This will provide a “quick win” if necessary but could still save significant money and time when compared to the Debt Snowball approach.

Pay the most annoying debts off first. This approach plays directly into the human psyche. The urge to eliminate a persistent itch is strong enough to motivate anyone to scratch, just ask any kid with chicken pox. Stephanie from Poorer Than You is a fan of this approach. This works well when you include debts other than credit cards. If you have a personal loan from a family member, I usually suggest paying that debt off the quickest while paying minimums to your credit card to help retain good will within close relationships.

Baker from Man vs. Debt says the same thing slightly differently: Pay off the debt with the highest emotional impact first. The argument here is simple. For some people the debts with the highest emotional impact are simply the debts with the highest interest rate, while others have a different psychological composition requiring alternate focus. You can’t go wrong by this approach which if continued will help you feel better quicker.

So what is the “right” answer?

It is easy to say, “Do what works for you,” and allow the debtor to come to his or her own conclusions. This can be a dangerous approach as it invites people to skip the consideration of all the options. Many people I’ve talked to who have successfully eliminated debt by using the Debt Snowball method not only found themselves back in debt after some time but did not realize that they could have saved hundreds of dollars and been out of debt sooner just by ranking their credit cards in a different order. They simply followed a guru’s advice without any critical thinking. Not only did they not learn to approach money from a more stable viewpoint but they paid extra money in the form of credit card interest for this “feature.”

Would they have succeeded if they were simply presented the idea that they could save money on their debt reduction journey by following a more mathematical approach? It’s certainly possible.

There is no approach that does not have some sort of merit. Getting out of debt in any way possible is better than not getting out of debt at all. All that I ask is that the details, including the total cost and time differences, are fully explained before a method is prescribed for someone else.

Here’s a calculator that will help inform anyone in debt about the timing and bottom-line differences between the various approaches to eliminating debt. In some cases, the cost of one method over the others will be striking.

An informed decision is the best type of decision. With a full understanding of the differences and is familiar with their own psychological tendencies, someone with debt can make an intelligent choice that is right for the individual or family.

Photo credits: House of Sims, Joe Shlabotnik

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Suze Orman Says Stop Paying Off Debt

by Flexo on April 27, 2009

in Debt Reduction

Recently, famous finance guru Suze Orman, who usually doles out sensible advice even if in an disrespectful manner, has advised the public to stop paying off credit card debt any faster than minimum payments allow in order to shore up a savings account that could last eight months in an income emergency. According to this recent advice, the economy has changed in such a way that interest payments on debt are small prices to pay for the disaster of a personal recession.

It’s fair to say that Orman has a valid point for some. For example, this advice should be directed to a person whose income depends on a job from which he or she might be soon laid off, if that job is in an industry in which it will be difficult to find a new job, and if he or she won’t settle for a lesser job in while searching for a full replacement. But that describes only a small sample of the population. Orman is painting the picture with too broad a brush.

Liz Pulliam Weston recently pointed out this disagreement with Suze Orman. Weston points out that paying only the minimum to credit cards identifies you as a risky customer. Risky customers are punished by credit card issuers with increased rates and lowered credit limits, in some cases, without advance notice. Besides the direct effect of less available credit and higher interest payments, these actions have an unfortunate downstream effect. It is likely that this will result in a lower credit score.

Again unfortunately, much of modern society relies on a credit score. Your credit is checked when you apply for a loan or mortgage. But it is also checked when insurance companies determine your rates. Auto insurers have found that low credit scores, or credit risk in general, correlates to a risk of dangerous driving. Therefore the insurers feel justified in charging customers with lower credit scores higher premiums for the same coverage. Some employers check credit reports and scores to determine whether hiring you may present an undue risk to the company. And landlords check credit reports and scores when deciding whether you are fit to lease an apartment.

It’s very difficult to function in modern society without a credit history, and a good credit score and clean report goes a long way to make sure you can operate and navigate through life smoothly. Suze Orman’s advice might put that at risk in exchange for an oversize emergency fund in an environment in which the interest you can earn on savings is very low. It could take years to build up eight months’ worth of expenses in cash reserves, and paying only the minimum towards credit cards during that time will prolong and increase the cost of debt. If the minimum payments don’t even cover the amount of new interest charged, by following Suze Orman’s advice, you would be condemning yourself to a life controlled by debt and the credit card companies.

Suze Orman’s advice might be sensible for some people, but it’s important to think about the consequences of all but abandoning the elimination of debt. Where do you stand on Suze Orman’s advice to forgo debt repayment in favor of an eight-month emergency fund?

A Change in Credit Card Strategy, Suze Orman, March 1, 2009
Bad advice from Suze Orman, Liz Pulliam Weston, MSN Money, April 23, 2009

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42 comments

Number One Frugality Tip: Don’t Be a Woman

by Flexo on April 2, 2009

in Debt Reduction

I will admit that the title of this post is a bit inflammatory. I should specify that the more accurate number one frugality tip should be “Don’t be a woman (or a man, but in our society, mostly a woman) obsessed with beauty.” Newsweek illustrates this by breaking down the cost of female beauty maintenance over a lifetime in a recent article, linked below.

According to the study, the average “modern diva” will spend over $200,000 on hair alone. Add in the expenses for maintaining a beautiful face, body, hands and feet, and the average lifetime expense climbs to almost $450,000.

The Newsweek editors go into further detail by splitting the expense by age group. The graphic below shows how much a woman will spend throughout her “tweens”.

Now, I don’t judge. If you have the money to spend, spend it. But it’s better to be conscious about these costs than to let them go by without thinking about them.

The Newsweek study doesn’t go far enough, however. While they’ve provided details about the expenses, they haven’t studied the effect that spending money on beauty will have on a woman’s income or other levels of success. For example, one theoretical possibility is that a lifetime expense of $450,000 for conforming yourself to what the rest of the world considers “beautiful” will result in a lifetime increase of income of $1,000,000. If that is the case, it would be hard to argue than the price of beauty was not well spent.

Tween's Expenses for Beauty

And in real life, return on investment (ROI) is measured in other ways than money. If for whatever reason, spending money to fit into a certain category makes a person happier, and she can’t find happiness by any other means, how can you argue against spending the money if it is available? If the money is not available, and our diva relies on debt to finance vanity, the true cost out of the pocket could be much greater.

According to the survey’s methodolody, invasive procedures like breast implants and liposuction were not considered in the totals. You can view the raw data here or view the Newsweek story that offers a browsable interface.

Any divas out there? Can you cut back on spending on beauty or is it a justified expense?

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12 comments

Passing 100,000 Miles on My Honda Civic

by Flexo on March 30, 2009

in Debt Reduction

A few months short of five years ago, I purchased a new 2004 Honda Civic to replace a failing older model that had not been in my care. Today, this “new” car is passing 100,000 miles on the odometer, and it’s still running great. While I occasionally find my mind wandering towards the purchase of something sportier, at this time, I plan on sticking with the Civic until maintenance costs more than the car is worth. I hope to stretch ownership for another 100,000 miles.

Here are the expenses I’ve put into the car so far:

Accessories $745
Insurance $9,894
Interest on Auto Loan $413
Fuel $7,042
Parking $302
Registration $239
Service $3,208
Tolls $3,645

The main accessory I purchased was a lower-end GPS device, which was ultimately stolen from the car while it was parked for the weekend in a particularly bad parking space in Queens, New York. I never replaced the device. The next most expensive accessory was a replacement stereo that fully integrated with my iPod. The service category includes regularly scheduled maintenance as well as a slew of oil changes. It also includes my $500 deductible after a “minor” accident, a tire replacement after one was punctured and unrepairable, and a couple of traffic tickets.

I paid off my non-industry auto loan with an interest rate of 2% somewhat quicker to keep my total interest expense down to $413. Also, according to edmunds.com, my car has depreciated a total of $7,580 since it was purchased.

Many of the expenses should be controlled better, and it may be time to re-evaluate my insurance coverage.

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