Debt Handling - What’s the Right Amount of Debt?
By Debt Handler | August 26, 2007
No ‘one-size-fits-all’ recommendation is possible when considering the right amount of debt to assume. But that doesn’t mean there are no good guidelines at all.
Naturally, credit card companies and other lenders are happy to make available as much money as they think their borrowers will repay. They take risks, but those are calculated risks. They look at default rates, current interest rates and carefully review credit history when they make loans. Borrowers can benefit by following some aspects of their strategy.
Before taking out new credit, consider the odds that you will have to default on repayment. Don’t factor in to your decision the possibility of deliberately defaulting or filing bankruptcy. You’ll find the consequences are rarely worth it and that should be reserved as a very last resort.
You can factor in expected increases in income - banks and other business do - but you should be very sure you’re actually going to receive it. A promised raise or hoped for income from a stock sale is far from guaranteed money.
Look at current interest rates and make a prediction about where they are headed, businesses do. That’s a very difficult thing to be confident about, but general trends are not random. Look at bonds, futures and other indicators. If 6% bond option prices are going down, many pros are betting interest rates will rise to above that in the future. These represent the bets of professionals about the future direction of inflation and interest rates.
Look at your own credit history the same way a bank would. Try to see it from their perspective. Would you loan yourself $10,000 at 7% for 48 months? Avoid rationalizing late payments or defaults. You may have had a legitimate reason, or you may not yet have developed the resources (inner and financial) to repay all your debts on time.
Consider your total income and expenses realistically. You may badly want a new car, but can you afford an extra $500 per month without sacrificing essentials while still meeting your current obligations? Be honest with yourself.
No one can decide for you whether it’s worth assuming an ongoing $200 per month credit card payment at 12% in order to have an item you’ve been longing for. You may value having the item today more than you value the extra money it will cost you over what you save by saving for it.
But you should at least think about it. Impulse buying is the most common way credit card users get in over their heads, financially speaking. Project the possibility that if you wait (and saved for, say, a year) you will have both the item and something else you can purchase with the money you would have paid in interest.
Evading the fact, if it is a fact, that you can’t really afford the payments is the surest way to get into financial trouble. That kind of trouble can take months or years to get out of. Think long term, be realistic, and you’ll be able to decide what is the right amount of debt for you.
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Debt Handling - Consider Tax Implications In Your Debt Calculations
By Debt Handler | August 24, 2007
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When analyzing financing options or debt handling issues many people neglect to include the tax implications of one strategy over another. Including tax implications in your scenarios can become very complicated. It’s always handy to have a computer program that will help you. But even without that there are a few simple guidelines to keep in mind.
In the U.S., the biggest tax write-off for many individuals is the interest paid on a property loan. Since they represent large debts, paid over many years, the interest is (for several years) the overwhelming majority of the total monthly payment. As a result, much of that interest paid can offset taxable income.
But there are other tax issues involved with other forms of debt that should be factored into planning.
Taking out a home equity loan used to be primarily for the purpose of making improvements to the property. Many people these days use that money for a much wider variety of goals. A HELOC (Home Equity Line of Credit) can be used to finance just about anything - an auto purchase, repayment of credit card debt… you name it.
One advantage of this type of debt is precisely the tax benefit. Just as with a primary loan, interest on a second mortgage or a HELOC is tax deductible. So, even when the interest rate is the same as a credit card (and they are often lower), the net result can be beneficial.
The only way to know for sure in your circumstances is to do the calculations. Online loan calculators are readily available that will help you do just that. Run through several scenarios to decide the effect in your case.
It’s possible to obtain a loan to pay for large medical costs. Some people pay for such things with a credit card, which is possibly the most expensive way to finance the debt. Sometimes that’s necessary; no ‘one-size-fits-all’ recommendation is possible.
Since much of the interest on such loans, and sometimes the medical expenses themselves, is tax deductible it can be worthwhile to finance the costs that way.
Interest on or amount paid to student loans, too, is tax deductible up to a point. Your circumstances will vary from another’s. Tax filing software is probably your best bet for calculating the pros and cons in your individual case. As you answer the ‘interview questions’ you can put in the amounts and follow the tutorial to determine the impact.
Whatever the example, whenever you are considering assuming debt - especially for large amounts - taking the time to evaluate the tax implications can save you substantial amounts of money. That can easily be worth a couple of extra hours of research, especially since you’ll be able to use that knowledge time and time again.
Topics: Debt Handling Tips | 3 Comments »
Debt Handling - Student Loans
By Debt Handler | August 22, 2007
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Few areas of credit are as complicated today as that of student loans. There are many types, with lots of terms, complicated conditions, and fine print. But studying those options is important in order to make the best long-term choice for education funding.
One of the most common options is a Stafford loan. Hundreds of thousands of students have used these as a means of partially financing their education and they do have some positive aspects.
The Stafford loan has no pre-payment penalty - you can pay off any remaining balance any time. There’s no credit check performed, so almost everyone will qualify. There are no payments required while the student is taking courses, provided they maintain at least a half-time status. And, after leaving school there’s a six-month grace period during which no payments are required.
But there are limits on the amount that can be borrowed in one year. Also, though Stafford rates often look attractive relative to ordinary loans, they contain additional charges that can make the cost of borrowing higher. Up to 3% in fees (including a 2% Federal ‘origination fee’ and a 1% Federal default fee) can be applied.
Further, there are plans in which the repayment is made over a 10-year period. That may sound attractive given the relatively low monthly payment it typically entails ($116 per month in the following example). But the amount of interest accumulated on a 7% loan of $10,000 (and most students borrow more) over 10 years is: $3,933. That’s over 39% of the original amount paid in interest. Definitely, not cheap money.
Though it may involve beginning repayment immediately, many parents attempting to help finance their son or daughter’s education will find it worthwhile to investigate other alternatives. Even students should make an effort to look for other routes, including a combination of grants, scholarships, and conventional loans repaid with money earned from part-time work.
Savings plans, of course, are one of the best options to investigate and the sooner they’re started in the child’s life the better. The risk with all such plans is that inflation, financial crises, and other unpredictable elements can cause that investment to be worth very little by the time it is needed.
Investigate options - tax-free municipal bonds, inflation-adjusted hedge funds, and others, for example - that can help offset those effects.
Regrettably, there is no easy way to finance today’s high cost of education. But doing the necessary homework to investigate all options will save all concerned time and headache in the long run.
Topics: Loans | No Comments »
Debt Handling - Secured vs Unsecured Loans
By Debt Handler | August 20, 2007
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Both lender and borrower are faced at the outset with a basic decision - to obtain a loan that is either secured or unsecured. But, what does that mean, and what are the pros and cons of each for either party?
A secured loan is one in which the money borrowed is guaranteed to be repaid or some asset will be forfeited. The most common example is a home loan. The borrower agrees to repay on the terms of the contract, and if he or she defaults, the lender can legally claim the home as compensation.
In theory, that means that if you miss a payment on the home loan, the lender has the legal right to foreclose and sell the property. In practice, that never happens. Among other reasons, lenders know that reclaiming a house is a long, unpleasant chore and they would be left with the necessity to sell the home to recoup the money.
No lender is going to do that for such a small misstep as missing a single payment. Even if the borrower lags by several months, at most the lender will typically send a series of firm letters demanding payment before taking any other action. Even in an active seller’s market lenders have many more important things to do and don’t want to undertake the effort of removing a homeowner and selling a house.
Nevertheless, it’s wise to realize that the lender has this right. How important or not that right is can be judged by recognizing that even with an unsecured loan, creditors have the legal right to seize assets like salary, stocks and property. This requires only undertaking a relatively simple and inexpensive legal procedure to declare the borrower in default.
But, legal procedures are only RELATIVELY simple and inexpensive - and lenders will almost always try to work out a repayment option before taking that step.
There are other differences between secured and unsecured loans that borrowers should be aware of. Since the money in an unsecured loan is not, in theory, backed by the right to seize the asset in case of default, the interest rates on them are usually higher.
The lender in that case is taking a larger risk, and they are compensated by charging higher interest. That covers losses from defaults (which are higher on unsecured loans) and is one way to change borrowers incentives. Most people will try much harder to meet a debt that is tied to their home than for an unsecured loan.
So, there are pros and cons for both borrower and lender to obtaining one type of loan versus the other. As a borrower, you may find it necessary to incur a higher rate of interest if you don’t have a home, bonds or other assets to offer as collateral. Or, you may simply want not to put those at risk.
Only you can decide in your particular circumstances whether the advantages outweigh the risks and costs.
Topics: Loans | 1 Comment »
Debt Handling - Mortgage Refinance - Is It Right For You?
By Debt Handler | August 18, 2007
There are several interlocking reasons to consider refinancing your mortgage. When rates are low, you can lower your monthly payment and/or the total amount of interest you will pay over the life of the loan. You may also want to take out some equity to finance home improvement projects or pay off other debts.
But as a method of adjusting debt it has some drawbacks that should be considered before making that big step.
One drawback is what was just alluded to: it’s a big step. Refinancing your current mortgage loan involves most of the steps required to take out the loan in the first place. You’ll need current income statements, past tax filings and an array of other documentation. You’ll (usually) be filling out a lot of paperwork, and sometimes paying additional fees.
All that takes time and can cost you a substantial sum of money before the process is complete. You’ll want to be sure to run some realistic calculations before making a final decision. Online calculators to help you do that are readily available.
One reason some consider making the effort, though, is almost always a poor one: to pay off credit card and other high interest debt. There are many ways to offload that debt without going through the pain of refinancing your primary mortgage loan.
If you have reasonable credit and some equity, you can get a second mortgage or a homeowner’s equity line of credit (HELOC). The rate may be slightly higher, but you will find the effort is considerably less. It also protects you in case of financial reverses. Provided you continue to make the primary payments, if you slide for a while on the secondary you are unlikely to be at risk of losing your home.
The second reason is more fundamental. Rather than continuing to seek a way out of debt by borrowing yet more money, you should first make serious efforts to reduce your dependence on borrowing. Some readjustment of current debt may be a good plan - if you can achieve a lower total outstanding debt, a lower interest rate or negotiate relief from some of the payments.
But borrowing more only adds to your long term problem. This should be a last resort, not the first thing you think of as a way out of your debt problem.
Debt consolidation often leads to merely reshuffling your debt, sometimes adding more interest and making your situation worse. But, if it’s coupled with a payment plan that does in fact gradually reduce the burden, while making it possible to meet your obligations, it can be a good plan.
In the end, the only way to know for sure is to objectively examine all your outstanding obligations and research the different plans available. Some combination of debt forgiveness, lowered monthly payment(s) and reduced interest payments is the ideal you should shoot for.
Don’t surrender your home in order to deal with a short term problem that can be fixed by other methods.
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