Instead of saving, consumers have been refinancing or borrowing against their home equity and using credit cards as cash. But with home values decreasing and foreclosures increasing, debt no longer looks like the solution to consumers' money problems. Lenders are becoming more stringent in their lending criteria, while consumers are now faced with the reality that it is dangerous to live beyond your means. It's now time for everyone to return to the basics about debt. Consider the following strategies as it relates to your mortgage debt and credit card debt:
Not so long ago, it was common to buy a home with no money down and an exotic mortgage that kept your initial mortgage payments to a minimum -- perhaps the mortgage was amortized over a very long period, the first few years of the mortgage had a very low interest rate, or only interest payments were required. You often didn't even have to prove your income to qualify for the loan. What a difference a year makes. With home values declining and mortgage foreclosures on the rise, mortgage lenders are returning to the basics.
If you are looking for a mortgage now, expect to make a substantial down payment, prove your ability to pay the mortgage, and have a good credit rating for the best deals. And forget exotic mortgages.
Don't get complacent if you already have a mortgage. Work aggressively to reduce your debt so that when you do sell, you won't owe more than your home is worth. However, there are tax advantages to this type of debt, so you probably want to make sure your other debts are paid off before tackling your mortgage debt.
Interest rates on mortgages and home-equity loans are typically lower than other consumer loan options. Also, interest paid on up to $1,000,000 of mortgage debt and $100,000 of home-equity debt is deductible on your tax return. These two factors usually make the after-tax cost of a mortgage or home-equity loan much lower than consumer debt.
Some strategies to consider for your mortgage debt include:
• Evaluate refinancing options. If interest rates have decreased since you obtained your mortgage, even by just 1/2%, take a look at refinancing options. If your credit score has improved dramatically since you obtained your mortgage, you may be able to negotiate a lower interest rate. Also, if your original loan was a jumbo loan (over $417,000 in 2008) and is now under that amount, you may qualify for a lower rate.
• Eliminate private mortgage insurance (PMI). If your down payment was less than 20% of your home's purchase price, you are probably paying PMI, which typically runs between .25% and 1.25% of your total mortgage amount. Once your home equity exceeds 20%, you don't have to purchase PMI. With housing values decreasing in much of the country, this may be harder to do. You will probably need an independent appraisal before your lender will cancel the PMI. While this may cost a few hundred dollars, you could eliminate several years of PMI costs, making it well worth the cost.
• Determine whether to pay down your mortgage debt. The after-tax cost of mortgage debt is typically fairly low. However, if your income exceeds $159,950 ($79,975 for married taxpayers filing separately) in 2008, your itemized deductions are reduced by up to 80%. Thus, those with high incomes may find that mortgage interest does not provide much tax benefit. Individuals approaching retirement age may want to pay down their mortgage debt so they can enter retirement debt free. In all cases, however, you should compare your after-tax cost of mortgage debt to the after-tax return earned on investments before deciding whether to pay down your mortgage. If you decide to accelerate payments, make sure your lender allows additional principal payments without penalty.
Credit Card Debt
It's difficult to find anything good to say about credit card debt. Interest rates are typically high and not tax deductible. If you only make the minimum payments on the balance, it can take years to pay off the debt. Your goal should be to pay off, as quickly as possible, all credit card debt. Some strategies to consider include:
• Put your credit cards away until all your balances are paid in full. If you are really committed to paying down those balances, you don't want to add to the problem by continuing to increase the balance. Pay cash or don't purchase the item.
• Pay the balances in order of most expensive to least expensive. Make a list of all your credit card balances and the interest rates charged on each. Add up your minimum payments and then determine how much more you can budget to help pay down those debts. Use these additional funds to pay off the debt with the highest nondeductible interest rate. Once that debt is paid in full, start paying the debt with the next highest interest rate, continuing until all the balances are paid.
• Look for a lower-interest-rate credit card. You may find an offer that contains a teaser rate that is only available for a limited time. You can transfer balances from your high-interest-rate cards to the lower rate card and then pay off the balance as aggressively as possible. Before getting the new card, make sure to review all details. The low rate may only apply to new purchases or to transferred balances. You're looking for a card that will apply the low rate to transferred balances. Also, check if there are any balance-transfer fees. Once the teaser rate is over, either find another low-rate card or call the company to request a lower rate on that card.
• Consider using a home-equity loan to pay off your consumer debts. Home-equity loans typically carry lower interest rates than other consumer debt, usually prime rate or 1% to 2% over prime rate, and as long as the balance does not exceed $100,000, interest paid on home-equity loans is deductible on your tax return as an itemized deduction. Keep in mind that you are taking equity out of your home when you do this. This may be a good tradeoff if you use the funds to reduce higher cost debt. However, if you just run your credit card balances up again, you will still have the consumer debt plus less equity in your home. You may find it harder to get a home-equity loan than it was in the recent past. Now, lenders are likely to require a loan-to-value ratio of at least 90%, a high credit score of at least 680, and a full appraisal of your home. Some homeowners with home-equity lines of credit are being notified by the lenders that the line has been reduced or frozen.