Chapter 8: Money from Later
Jack Walsh: "How much is here?"
Jonathan Mardukas: "Neighborhood of three hundred thousand."
Jack Walsh: "That's a, that's a... very respectable neighborhood.”
– Midnight Run (1988)
It may surprise you at this point that I don’t think all debt is bad. Debt can be useful. Again, back to our human capital example: your lifetime earnings are a finite amount. When you borrow, you use some of your future earnings today. For this privilege you pay a higher price (through interest payments). When does this make sense? It can make sense if what you buy goes up in value (appreciates) rather than down (depreciates). It can make sense if what you buy increases your future earnings. It can make sense when there is no alternative. And it can make sense when you want to spend money on an opportunity that might not come by again.
Buying a Home
Owning their own home is one of the biggest goals for many people. Plunking down cash for a place is out of reach for most, so this is one instance where borrowing is the only option. If you’re fortunate, a house will also increase in value. But a lot depends on your specific situation, and it’s rarely a financial slam-dunk. Here we’re going to just focus on some features of mortgages that are important to understand.
Say we have a $300,000 home in our sights. Nowadays, some first-time homeowners can make a down payment of as little as 3%. Pay just $9,000 and borrow $291,000. (There would also be several thousand more in “closing costs,” which pay for attorneys, appraisals, taxes, title insurance and such.)
Home equity is the amount of the house that is included in your net worth: the value of the home minus the outstanding mortgage balance. At the beginning, equity is equal to the down payment, in this case, $9,000.
Let’s look at a 30-year mortgage with an APR of 3.88% (from our earlier table). The mortgage payment in this case comes to just over $1,369 a month. For the first payment, $941 of this will be interest. [14] The remaining $428 will reduce the loan balance, so equity increases to $9,428. Every month, equity increases a little more, slower at the beginning, faster later on, until it the loan is paid off. After five years, assuming the house has the same value, equity is $37,311, an increase of $28,311. Here is what the path over thirty years looks like:
Your home equity changes as you pay off the loan but also as the value of the home changes. Here is the path for a hypothetical home whose value changed with average home prices from 1990 to 2020: [14a]
Home prices increased nicely overall, but there was a period of five years between 2006 and 2011 where they fell. It took another five years to get back to the level of 2006. Home price appreciation is not guaranteed.
Reducing Interest Costs
Back to our mortgage loan. What’s the total you have to pay back? Adding up all the payments comes to $492,920, of which $201,920 is interest.
You can reduce this interest cost in four ways:
Borrow less. Banks used to require a down payment of at least 20% of the house price. In our example, if you put down $60,000 (20% of $300,000) and borrow $240,000 the smaller loan reduces total interest paid by more than $35,000. You also avoid paying premiums for private mortgage insurance every month, which is usually required for down payments less than 20%. Borrowing less may require saving for a few extra years before taking the plunge on a home purchase.
Choose a shorter term. The rate on a 15-year mortgage is usually lower than on a 30-year mortgage. With the 3.22% rate from our table, your payment will be higher ($2,041 in this case) but you will save over $125,000 in interest.
Pay more than the required payment. Even if you can’t afford the higher payment of a 15-year mortgage, always make sure that you are allowed to pay back your mortgage faster than planned. Mortgages should not have any prepayment penalties. If you send in more than the required payment, banks will usually apply this to the principal. For example, if you pay an extra $100 each month, the 30-year mortgage will be paid off about 3½ years earlier and save over $27,000 in interest.
Find a lower interest rate. With mortgages, even a small difference in the APR can make a big difference. In our example, finding an APR just a quarter of a percent lower saves $15,000 in interest. A mortgage is the kind of big decision for which doing research and negotiating make a difference.
Ready to borrow? As you shop around for a good rate you may find yourself talking to different types of companies that arrange for or “originate” mortgages. These include mortgage bankers, mortgage lenders, or mortgage brokers, among others. Lenders and bankers put up the money to lend to you; brokers are middlemen who work for a fee representing several lenders. Always remember that these companies do not work for you. They get paid more if you borrow more, which means they may try to focus just on the size of the payment and push you toward a larger loan. When shopping around, compare local bank and broker interest rates with online services such as Bankrate.com.Always focus on the APR of the loan which will include any up-front interest charges known as points. One point is equal to 1% of the loan paid up front.
Once your mortgage is in place, you may interact with a different mortgage servicer than the bank who made the loan. It is not unusual for a mortgage to switch servicers several times over its lifetime, but this will not affect the payments you owe.
Going to College
With crazy-high tuition costs, does it even still make sense to go? Most researchers who have looked at the issue have concluded yes. [15] The overarching reason is that you can expect significantly higher income with a college degree. Taking on some debt to afford college can make sense, but take on too much and the advantage may disappear. [16]
While this is generally true it may or may not be true for you. Just because somebody is willing to lend you money does not mean you should take it. The degree you pursue matters. So does your age, the income you can expect after graduation, and the earnings you give up while in school.
Student loans get pretty complicated. Do your research, starting with the government’s website at https://studentaid.ed.gov/sa/. Here are a few important points to keep in mind.
Student loans fall into two general categories: federal and private. With federal debt you are borrowing from the government, whereas with private loans you are borrowing from a bank.
How much is safe to borrow? There’s no single right answer, but a common guideline is not to exceed the annual income you expect to earn after graduation. That’s in the $45,000 to $60,000 range for most undergraduates, which will take $475 to $640 a month for ten years to pay back at a 5% APR. If you already have other debt, that needs to be factored in. A large debt load can affect all aspects of life. People with more student debt tend to wait longer to marry or buy a home and they tend to be more likely to take a job outside their chosen field. [18]
Standard federal student loans are paid back over ten years. At a 4.53% interest rate for undergraduates, for every $10,000 you borrow you pay back a total of approximately $12,453. As with all debt, you save interest if you can pay back the loan more quickly.
A benefit of federal student loans is that they allow a variety of repayment plans. These plans can stretch out your payments or lower your payments early on but will cost more overall than the 10-year plan. Also, if you are having trouble repaying federal loans, you may be able to temporarily stop making payments. This is known as forbearance. It’s important to understand that if you are approved for forbearance your loan balance will increase by the amount of interest you did not pay. It may be better to opt for an income-driven repayment plan, which means that, if your income is low, you may have a zero required payment without adding more interest to your loan. [18a]
There are some risks to dealing with the government. It’s a giant bureaucracy and there is nobody you can appeal to. Miss a loan payment and risk joining the one-in-ten borrowers who are delinquent on their payments. Worse, you could end up in default of a loan. Default has a number of consequences, all of them bad. [19] Ultimately, if you don’t pay up, the government will garnish you wages. And I don’t mean garnish with parsley, I mean literally remove the money from your bank account. With the government, you owe debt until you pay it off or until it is forgiven.
Private student loans require even more vigilance. Now you are dealing with lenders who want to make money off you. Your first question should be: Why do I need a private loan? If the answer is because you’ve reached the limit on federal loans, think carefully before proceeding and adding to your debt burden. Also, it’s critical to read the loan documents carefully and understand all the major provisions, which can differ a lot from one bank to another. Ask for help if you don’t.
Family Matters
When it comes to student debt, family finances almost always come into play. It’s natural for parents to want to help their children go to college, and the system pushes them to do it. Federal Parent PLUS loans are specifically designed for parents to help pay their kids’ college expenses. They are easy to get and, unlike loans taken out by students, have no set maximum amount that can be borrowed. When it comes to private loans, lenders often require parents as co-signers to get the best rates.
The upshot is that parents can end up with a lot of their children's student debt—often more than the students themselves. Parents end up saving less, with potential implications for their own financial security. An open conversation about the family's financial resources can put everyone on the same page, even if it is difficult to broach the subject.
Dealing with an Emergency
Sometimes we borrow because we have to—a medical emergency, a relative in need, a major home repair. Faced with an emergency we should be clear-eyed and say: I am prepared to sacrifice my future income for this.
If you have to borrow for an emergency, look for the lowest interest rate. You may be tempted by the convenience of a credit card, but it is an expensive convenience. Explore other options. For medical bills contact the provider and negotiate (see Chapter 23 for more tips.) For larger acquisitions or repairs, see if you can spread out the payments. Remember, money is money (it’s fungible). You can try to negotiate payments on other bills, for example by talking to your mortgage servicer or utility company, and then use the freed-up money toward the emergency expense. If you have a 401(k), you can consider borrowing from it (see callout). Perhaps borrowing from family or a friend are an option, but be sensitive to the impact owing money can have on relationships.
My Precious
Debt can be okay when a) you can afford to make the payments and b) you have made a clear-eyed decision to sacrifice future income for something special today. What qualifies? That is up to the individual. Say you are an avid mountain climber and want to splurge on a Himalayan climbing expedition. Go ahead. If you wait and save until you can pay cash you may miss the opportunity. Or maybe you’re an aspiring actor and have an opportunity to audition for an excellent movie part. Go ahead and borrow to pay the airfare.
This advice is a little dangerous. Instant gratification is a big draw. For example, I’d suggest that borrowing to go on a luxury vacation doesn’t make sense, even if though it may give you some pleasure. Ask yourself, “Can I still get this or do this in x months or years if I save up the money.” If the answer is yes, save up and postpone the satisfaction. It will be all the sweeter when you can pay cash.
The point is, borrowing thoughtfully and with a clear commitment to subsequently tighten your belt until the debt is paid off, can absolutely work. Unfortunately, it’s all too easy to tell ourselves that we will be disciplined and then fail to follow through. That’s where we get into trouble.
Refinancing
Say you have a student loan or a mortgage with a fixed interest rate. You notice that interest rates on new loans are now much lower. Someone taking out a loan today is getting a better deal than you did. This situation has become common, because since the 1980s there has been a steady downward trend in interest rates:
No surprise then that it has become common for borrowers to refinance their debt—i.e., take out a new loan to pay off the old one and get the lower interest rate.
How do you know whether refinancing makes sense?
The answer depends on individual circumstances. It is easy to get tricked into thinking you are saving money just because you can reduce your monthly loan payments. Lenders push “savings” from lower payments very aggressively because they make money each time you take out a new loan. But not so fast. Often a big part of the lower payment is from extending the debt (recall the “size of payment ploy” from the previous chapter). You can end up with a lower monthly payment and still pay more interest over time because you pay for longer.
The only way to figure out whether to refinance is to crunch some numbers. There are a lot of moving parts, so the answer is not always clear. You can access this worksheet to try out different scenarios.
Refinancing a mortgage often involves new closing costs (fees for attorneys, taxes, and the like). That means the savings from a lower interest rate must be at least large enough for long enough to cover those costs.
Refinancing is most likely to be beneficial if one or more of the following is true:
You have a large remaining balance; interest savings on a smaller balance may not be significant enough.
You plan to keep the home for several more years; if you sell in a year or two the monthly savings won’t add up to much.
The new interest rate is least 1% lower than your current rate.
You can eliminate the cost of private mortgage insurance (PMI) because the home has increased in value.
Your credit score has improved a lot.
You have an adjustable-rate mortgage and would like to lock in a low fixed rate.
It can be tempting to do a “cash-out” mortgage refinancing—one where you take out a larger loan than your current balance without increasing your monthly payment. This is the size-of-payment ploy working in the other direction. By extending your loan and paying a lower interest rate you can borrow more. Look at a cash-out refinancing as two loans: (1) The first refinances your existing mortgage balance; this makes sense if you can save on interest. (2) The other is entirely new debt. Whether this makes sense depends on what you do with the money.
If you are thinking of refinancing your student loans, be sure to do your homework. Federal loans can only be refinanced with private loans and it is a one-way street. Once you have moved to private loans there is no way back; you lose the flexibility of federal loans or access to any relief that the government might make available. (Federal loan consolidation is not refinancing and doesn’t save you any money.)
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