10 Pivotal Financial Questions (& Their Answers) by Kent Smetters Table of Contents 1. Should I Lease or Buy a Car? 2. How Do I Consolidate Personal Debt? 3. Should I Refinance my Home? 4. How Do I Build my Credit Score 5. Should I Rent or Buy a Home? 6. Should I choose an adjustable rate mortgage or fixed rate mortgage? 7. Should I Refinance my Home? 8. How Much House Can I Afford? 9. How Much Car Can I Afford? 10. How Do I Create a Home Budget?
1. Should I Lease or Buy a Car? While there are some cities in the US where owning a car isn t essential to getting around, most people find the need to have a vehicle for transportation. Sitting through an episode of your favorite television show will expose you to at least a few car commercials with offers for either leasing or buying. Once you have done your due diligence to research what type of car is right for you, the decision to lease or buy shouldn t be taken lightly. If you decide to purchase a car, you will most likely need to take out a vehicle loan, which typically runs from 4 to 6 years. As with most loans, you will have need to have a down payment. Your payments will be calculated based on your down payment and interest rate (in which you credit score will be a factor). Once you pay your vehicle loan off, the car is yours and you can continue to drive it without the monthly payment weighing on your budget and you can sell your car. Owning a car will also tend to save on insurance premiums. Leasing a car is essentially borrowing a car from the dealership for a certain period of time. When you lease a car it usually doesn t require a down payment and if it does, it s relatively small. Lease payments also tend to be relatively smaller than a payment would be towards owning the same car. However, lease payments do not go towards your ownership of a vehicle. As long as you are driving leased cars, you will have a payment. Leased vehicles usually come with a yearly mileage limit typically 12,000 15,000 miles a year and a monetary penalty for every mile driven over the agreed upon limit. A close inspection is usually done upon the return of the vehicle. A penalty may be assessed for stains, wear and tear, or other cosmetic imperfections beyond normal wear and tear. The decision whether to purchase or lease is a complicated one. As Consumer Reports notes, The financial workings of leasing are so confusing that people don t realize that leasing invariably costs more than an equivalent loan. And even if they did, the extra cost is difficult to calculate. Similarly, according to Bankrate.com, experts say buying and keeping a new car for the long term is usually the better deal. But why might you lease? First, do you plan to keep the car for 3 years or less? Second, are you planning to drive fewer than 12,000 15,000 miles per year (depending on the lease agreement)? Third, will you be able to avoid minor damage or cosmetic defects? (Any parent knows that spills happen when you re carting around small children!) If you answer yes to ALL of these questions, then are you usually better off leasing otherwise, purchase. However, even if leasing seems appealing, really ask yourself why you feel the need to change your car so frequently. Is having the newest car really worth it? Another reason for leasing is if you are a small business owners. You can sometimes reap the reward of tax deductions for lease payments if the vehicle is primarily used for business. As with any commitment, be sure you diligently research your options and shop around for the best prices, contract terms and interest rates to save yourself money. Be sure to read ANY 1
(lease or sale) contract closely, watching out for any fine print and noting any parameters that you need to abide by to avoid any surprises in the future. Happy driving! Citations http://www.forbes.com/sites/jimgorzelany/2013/03/14/cars that can last for 250000 miles/ http://www.consumerreports.org/cro/2012/12/buying vs leasing basics/index.htm http://www.bankrate.com/finance/auto/should i lease my next car 2.aspx 2
2. How Do I Consolidate Personal Debt? When struggling with debt, one of the first steps to getting your finances in order is to make a list of the balances, monthly payments and interest rates for each of your debts. This step creates a visual picture that is overwhelming and shocking. In another article, we discuss strategies for paying down this debt with our existing cash flow [link to article, Which debts should i pay off first? ] It might also be tempting to consolidate your debt in an attempt to pay them off quicker and for less money. But, as with any major financial decision, debt consolidation requires that you make an educated decision that is best for you. Debt consolidation isn t really helping you pay off your debt; it s simply putting it all into one location, with one (hopefully lower) payment. One option for homeowners who are interested in debt consolidation is to use a home equity line of credit to pay off personal loans, credit cards, or vehicle loans. With current low interest rates, this may seem like an appealing option. However, it is also risky, because your home is now collateral for the bills you re paying off. If you fall into default on these payments, you could lose your home. Bankrate.com offers this calculator to help with deciding if using your home s equity is worth it. Borrowing from your 401(k) is also another tempting option. However, even if your 401(k) plan allows you to borrow, if you ever switch or lose your job, you typically must repay the entire loan within 30 to 60 days. You likely won t have that money if you used it to pay off other debts. Moreover, it is challenging to replenish your 401(k) because the government caps how much you can contribute each year. So this type of borrowing risks your retirement. Another option is a debt consolidation loan, which is offered by most banks and some private companies. But this option frequently ends up being laden with fees and hidden costs that will end up costing you more in the long run. Relative to non bank institutions, banks tend to have a lower interest rates and be more upfront with loan terms. Just as with any loan, you will be paying interest on the borrowed money and this loan will probably extend the repayment length of your debt. If you have several credit cards to pay off, you might also be lured into transferring all of your credit cards to a single card with a lower interest rate. Credit card companies often advertise zero percent interest rate balance transfers. These offers are meant to entice you. But in reality, to qualify for a zero percent rate, you have to have an excellent credit score, which probably means very little credit card debt in the first place. Moreover, these credit cards often have additional one time charges that undo their value. Make sure to check the fine print. While debt consolidation may seem like an easy way out of debt, it is simply a bandaid to a much larger problem. Just as it s important to GET out of debt, it is just as important to develop a plan to STAY out of debt. Creating and sticking to a strict budget will help you avoid digging into a deeper hole of debt. 3
Citations http://credit.about.com/od/debtmanagementsolutions/a/waystoconsolidatedebt.htm 4
3. Should I Refinance my Home? With interest rates at historic lows, many homeowners are choosing to refinance to lower their interest rate. Lowering your interest rate will help you save money on your loan, lower your payments and possibly allow you to pay off your debt sooner. You can use an online calculator to see your possible savings. However, refinancing your mortgage is not as clear cut as the TV advertisements may make it sound. While the allure of saving money on your loan may cause you to run to your nearest mortgage lender, it is important to remember that a refinance can be as stressful as the first time you applied for the initial mortgage on your home. In order to ensure the lowest interest rate, you want to make sure your credit score is as high as possible. Secondly, when refinancing your loan, you will have to pay closing costs again, which can add up quickly and negate any savings. Out of pocket costs such as a home appraisal, lawyer fees and application fees soon may negate the savings of the lower interest rate. Another reason that a homeowner may decide to refinance is to use the equity in their home to complete a large home project or to consolidate debt. This type of refinance is called a cash out refinance because you take out more money than you owe on your home in order, leaving you with extra money in your pocket. A cash out refinance is beneficial for those homeowners who are looking to complete a project that would add significant value to their home or to consolidate their other debts to pay them off faster with a lower interest rate. But taking out extra money to do upgrade a home is risky, because you could end up owing more to the bank than your upgrade is worth. So you should be very confident of the project. If you use the extra money to pay off other debts, you could end up losing your house if you fail pay off your new, larger mortgage. In contrast, many states have homestead rules that protect some house equity from creditors for non housing debt. When sitting down to make the decision on whether or not a mortgage refinance is right for you, it is important to know the facts about both your current and future loan. A simple chart will make comparison simple. Factoring in the closing costs and the down payment required for the refinance is essential to see if refinance is worth it. Can you afford to put the money down? How much will you be saving on a monthly basis? Current Loan Refinance Loan Payoff (existing mortgage) Down payment Closing costs 5
Interest rate Years until paid off Monthly Payment In many cases, a refinance does not cover the additional fees unless you plan to be in your house for several years. For example, if your new down payment and closing costs total $5,000, but you only save $100 in Monthly Payment, then you need to be in your office for at least another 50 months, just to recoup those fixed costs. But refinancing can be a money saver if done under the right conditions. Citations http://www.freddiemac.com/finance/pdf/refireport2014q4.pdf 6
4. How Do I Build my Credit Score If you have ever applied for credit whether it be a credit card, loan, or mortgage you have probably heard the term credit score. Your credit score is a number between 300 and 850 the higher the number the better the score. Your credit score is what lender s base their lending terms on when you apply for credit. Your credit score is based on the following factors: Payment History (35%) Amounts owed (30%) Length of credit history (15%) New credit (10%) Types of credit used (10%) As you can see, payment history is the mostly heavily weighted number in the score, so be sure you are making payments ON TIME and paying at least the minimum. Lenders will also look at the amount you owe, versus the amount of credit you have. The length of your credit history and the new credit you have applied for will also be weighed. Lastly, the type of credit you are using (student loan, mortgages, credit cards) will be assessed to create your score. Credit cards with revolving debt impact your score the greatest and credit cards that carry more than 35% of their limit with weight heavily on your score. When you are looking to buy a home, it is important to first build your credit score in order to obtain the best rate interest rate on your mortgage. A credit score can also help in obtain better homeowner's insurance rates. It is strongly advised to check your credit score once a year. There are several websites such as creditkarma.com, freecreditreport.com and credit.com, in which you can check your credit score. Additionally, many banks and credit unions offer their members one yearly credit report, free of charge. The best way to maintain a high credit score is to make sure your bills are paid on time and in full, whenever possible. Delinquent payments will cause your credit score to plummet. Additionally, a credit score reports how much of your possible credit is currently being utilized. You will want to keep your debt ratio down in order to reap the rewards of a high credit score. If you're trying to rebuild your credit score, there is hope! Although negative information can remain on your credit report for up to 7 years, you can begin to raise your credit score. First, be sure all of your accounts are current. Contact the companies that you have delinquent accounts with and establish a plan to correct them. If possible, pay off these accounts and keep the card with a zero balance. You also want to avoid applying for new credit while you are trying to rebuild your score, as a percentage of a credit score is calculated by the number of new accounts opened. Another tip when building your credit score is to watch your report closelymake sure the accounts listed on it all belong to you and are reflecting accurate information. If 7
you detect any inaccuracies, be sure to contact the three major credit reporting companies immediately. Equifax 1 800 685 1111 (Fraud Hotline: 1 888 766 0008) Trans Union 1 800 916 8800 (Fraud Hotline: 1 800 680 7289) Experian 1 888 397 3742 (Fraud Hotline: 1 888 397 3742) 8
5. Should I Rent or Buy a Home? Finding a home can be a long and arduous process. A person must decided whether renting or buying a home is the right choice for them. Although there is no set answer, there are several factors to take into account before you make your final decision. First, have you saved enough for a home down payment? With banks requiring anywhere between 5% 20% of the total home cost as down payment and the average price of a home in America being $341,000 that means you would have to have between $17,000 and $68,000 to put down on a home. Down payment requirements vary from bank to bank and your credit score will weigh heavily on them. Renting often only requires a security deposit of one to two months rent when signing a lease agreement. Second, have you considered whether you can afford the ongoing expenses from a home ownership versus renting? Depending on where you live, your monthly rent might be smaller or larger than a mortgage payment. But when calculating your monthly expenses from homeownership, don t forget taxes. You receive a tax deduction for the interest paid on the mortgage, but you also might owe property taxes. Include both. And, don t forget the upkeep costs associated with home ownership that are required to maintain the house s value. For the average home built before 1990, budget an additional $75 dollars per month for maintenance. For homes built after 1990, budget an additional $50 per month. Third, how long do you plan on staying in the residence? If you have a job that requires moving often, it typically doesn t make financial sense to purchase a home. Not only is your house resale price riskier over shorter periods of time, you often have to pay transfer taxes and other closing costs when you buy or even sell. Typically, renting is the better option if you plan to be in the house for less than five years. But, if you plan to stay in your home for at least five years, buying a home is a good option for building equity, assuming that the house price will likely at least maintain its value over time. Fourth, lifestyle can greatly impact your decision to rent vs. buy. Often, rentals have strict rules regarding pets and offer less square footage. Also, rentals typically have rules on decorating and the number of people allowed to live in a rented property. Owning allows you to have more free reign over these decisions. Renting may be a great way to get your feet wet for living on your own, creating a monthly budget and independence. But renting does not always make financial sense. It is important to take a step back, and look at all aspects of your life before making a decision. Citations https://www.census.gov/construction/nrs/pdf/uspricemon.pdf http://www.irs.gov/publications/p530/ar02.html http://www.nahb.org/generic.aspx?sectionid=734&genericcontentid=35389&channelid=311 9
6. Should I choose an a djustable-rate mortgage or fixed-rate mortgage? When researching and shopping for a mortgage, one major factor is the interest rate of the loan. The interest is basically the percentage of the borrowed money you must pay each year on the outstanding balance in return for the bank allowing you to borrow the money. There are two types of mortgages: a fixed rate mortgage and an adjustable rate mortgage. Being a knowledgeable consumer will allow you to save money in the long run. A fixed rate mortgage is one that comes with an interest rate that will remain the same throughout the life of the loan. This type of loan allows the homeowner to rest comfortably, knowing that their monthly payment will remain the same, regardless of any fluctuations in the economy that cause interest rates to rise. These mortgages are simple to understand. Also, with interest rates at historic lows, using a fixed rate mortgage to lock in a rate ensures that you will have an inflation hedge since your house value may rise with inflation but your fixed payment does not. An online calculator can help you estimate the monthly payment. An adjustable rate mortgage, otherwise known as an ARM, is a mortgage whose interest rate fluctuates based on the economy. Typically, ARMs are cheaper in the beginning, allowing people to purchase more expensive homes than they could with a fixed rate mortgage. But these mortgages adjust with interest rates, so your payment could rise or fall with interest rates. ARM mortgages are also difficult to understand and their terms are often confusing to an average homebuyer. Why might you choose an ARM despite the risks? If you re only planning on staying in a home for less than five years, then an ARM would make sense because the first few years of the payment are less expensive. Plus, a short term stay in a home would mean that you would probably be moving before the interest rate adjusts. However, it s important to calculate what your payment would be if interest rates rise sharply. Would you still be able to afford the payment with a significant increase? If you answered no to either question, then go with a fixed rate. 10
7. Should I Refinance my Home? With interest rates at historic lows, many homeowners are choosing to refinance to lower their interest rate. Lowering your interest rate will help you save money on your loan, lower your payments and possibly allow you to pay off your debt sooner. You can use an online calculator to see your possible savings. However, refinancing your mortgage is not as clear cut as the TV advertisements may make it sound. While the allure of saving money on your loan may cause you to run to your nearest mortgage lender, it is important to remember that a refinance can be as stressful as the first time you applied for the initial mortgage on your home. In order to ensure the lowest interest rate, you want to make sure your credit score is as high as possible. Secondly, when refinancing your loan, you will have to pay closing costs again, which can add up quickly and negate any savings. Out of pocket costs such as a home appraisal, lawyer fees and application fees soon may negate the savings of the lower interest rate. Another reason that a homeowner may decide to refinance is to use the equity in their home to complete a large home project or to consolidate debt. This type of refinance is called a cash out refinance because you take out more money than you owe on your home in order, leaving you with extra money in your pocket. A cash out refinance is beneficial for those homeowners who are looking to complete a project that would add significant value to their home or to consolidate their other debts to pay them off faster with a lower interest rate. But taking out extra money to do upgrade a home is risky, because you could end up owing more to the bank than your upgrade is worth. So you should be very confident of the project. If you use the extra money to pay off other debts, you could end up losing your house if you fail pay off your new, larger mortgage. In contrast, many states have homestead rules that protect some house equity from creditors for non housing debt. When sitting down to make the decision on whether or not a mortgage refinance is right for you, it is important to know the facts about both your current and future loan. A simple chart will make comparison simple. Factoring in the closing costs and the down payment required for the refinance is essential to see if refinance is worth it. Can you afford to put the money down? How much will you be saving on a monthly basis? Current Loan Refinance Loan Payoff (existing mortgage) Down payment Closing costs 11
Interest rate Years until paid off Monthly Payment In many cases, a refinance does not cover the additional fees unless you plan to be in your house for several years. For example, if your new down payment and closing costs total $5,000, but you only save $100 in Monthly Payment, then you need to be in your office for at least another 50 months, just to recoup those fixed costs. But refinancing can be a money saver if done under the right conditions. Citations http://www.freddiemac.com/finance/pdf/refireport2014q4.pdf 12
8. How Much House Can I Afford? A home tends to be on the of the biggest investments made. So when you are wondering which home to buy, it is important to know how much you can afford. It is often said that you should buy a home that is no more than two and a half times your base annual salary. However, it is imperative that you don t use that general rule without taking your financial and personal resources into account. Many people end up struggling to meet the financial demands of home ownership. But by doing some calculations in advance, you can be assured that your home will be a source of pleasure and memories and not a poor investment. You can use one of the many calculators online to estimate what your mortgage payment would be each month. Some of the calculators (links are provided below) will tell you how much home you can afford based on your salary, while others will estimate what your monthly payment would be. Both of these numbers are totals that you need to be both familiar and comfortable with. It is important to remember to include your Personal Mortgage Insurance (if your down payment is less than 20%), which can add upwards of $250 to your monthly payment. You also need to include your insurance payment. Obtaining quotes from several insurance companies will give you an estimate on what your payment will be. While some people choose to pay their insurance twice a year, others opt to pay the premium on a monthly basis. Some mortgage companies will even add this into your payment for you. Once you have your base payment, you will need to figure out what your taxes will be on the home you are looking to buy. Most home listings give you a general idea of what the taxes are, however it is extremely important to confirm that figure with the tax assessor. The tax figure may include exemptions or discounts that the previous owners qualified for that a new owner may not. Taxes are usually paid to the mortgage company and kept in an escrow account, the mortgage company then will pay the taxes on the property from that account. Once you have an accurate number for the annual taxes, you should divide that number by 12 (months) and add that to your monthly housing payment. It is also important to Now that you have a general idea (remember that interest rates and credit scores may make your payment fluctuate), it it time to look at the rest of your budget. Listing your monthly payments and expenses, along with the estimated mortgage payment will help you visualize if you can, in fact, afford the home you are looking at. You want to be sure that the home you re purchasing will still allow you to make your payments and meet other financial obligations that you have. Once you own your home, is important to create a home budget (link to previous article) to keep track of and stay on to your budget. Citations http://www.bankrate.com/calculators/mortgages/new house calculator.aspx http://www.bankrate.com/calculators/mortgages/new house calculator.aspx 13
9. How Much Car Can I Afford? Automobiles are often seen as a status symbol and if you believe all of the advertisements that seen to be everywhere, you can drive the top of the vehicle for a minimum monthly payment. With incentives like low payments and zero interest, it is often easy to forget that you need to analyze how much you can truly afford before driving off of the sales lot. In order to decide how much you can afford on a car payment, you first should look at how much money you have to put down. Try to put at least 20% down on a vehicle purchase. While this might seem like a lot of money to put down, it will help you in three ways: it lower your interest rates, lower the amount of money borrowed that will affect your credit score, and also keep your payments lower. Saving up the 20% may seem daunting, but it is the first step in being able to set a the goal of purchasing a realistic vehicle. Next, you should look at your household gross (before taxes) monthly income. Your car payments should be no more than 10% of your monthly income. Keeping your car payments as close as possible to 10% will help your monthly budget stay on track. You also should not finance the car for more than four years. Car dealers will often offer to extend car loans for up to seven years to make a vehicle seem more affordable however, vehicles depreciate and with a loan longer than four years, you will soon owe a significant amount more than your car is worth. With these simple steps in mind, it is also important to remember that car sales is a competitive field, as are loans. When shopping for a car, remember to compare prices and offers from several dealers. Also, shop around different banks for loans: don t just take the deal offered by the car dealer. Likewise, shop around for car insurance quotes. By paring some keen negotiation skills with a budget conscious price range, you will soon be driving a car that is well within your means. 14
10. How Do I Create a Home Budget? Creating a home budget is essential for keeping your finances and sanity in check. In order to create a functional budget, you have to be honest with yourself about the amount of money coming in and out keeping a log of money spent is a good way to see where your money is going. The first step of creating your household budget is to list all of the household income. One can do this with a simple notebook and pen, a computer program such as Excel, or an online budgeting tool that can be found by a simple keyword search. Be sure to account for all sources of income including, job salary, an unemployment or government benefits, alimony, child support, etc. Once you have all of your income sources listed, add them up! The second step of creating your budget is to add up all of your expenses. This is the area that tends to be a true realization to people seeing all of your expenses written out in front of you can be a true eye opener. It is important to remember all of your expensesmortgage/rent, car payments, all utility payments, food, entertainment, etc. In addition to these obvious expenses, it is ideal to also list your smaller purchases spending $3 a day on that coffee you grab on the way to work? That s $15 a week, $60 a month, or $720 a year! Being honest with yourself will help you to create a true picture of your financial situation. Once you have all of your expenses listed, find the sum of them. Take the sum of your expenses and subtract that from your monthly income. Hopefully, your income is a lot more than your expenses. Another necessity for any home budget is an emergency fund. When you re taking care of a home, things break, appliances age, roofs leak and the unexpected can occur, well when you don t expect it. It is important to keep an emergency fund for these occurrences. While there are several theories on the amount one s emergency fund (ranging from a total of three months worth of expenses to a year s worth), starting with a small, obtainable goal is a smart decision. Once you have your monthly expenses subtracted from your income, you will see how much money you have left over. One should take a percentage of this money and put it into an emergency account, which is kept separate from you re spending money, but that will accessible when it is needed. While earning more than you spend is usually the goal, many people realize that their earnings do not always support their spending habits, but by seeing your spending tendencies on paper, it will help you figure out where to save money. Many utilities (cell phone, cable, internet), along with insurance (both home and auto) are competitively priced and by simply making phone calls to these companies to compare prices, one can save several hundred dollars per year. Lastly, another budgeting tip that works well for a lot of people is to use cash and avoid debit and credit cards. Using cash tends to make you more aware of what you re spending, instead of mindlessly swiping a card for daily incidentals. While creating an honest and true household budget can be a scary task, tackling it will help you realize your financial state and hopefully change it for the better. Citations 15
http://www.freddiemac.com/homeownership/pdf/monthly_budget.pdf http://www.bankrate.com/finance/financial literacy/secrets to creating a budget 1.aspx 16