Beating Broke

Personal Finance from the Broke Perspective

Reducing Your Debt: Much Better than a Snowballs Chance

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Credit card debt, mortgage loan, car payments, tuition…all of these add up to your debt and debt means stress in any economic environment. Like a lot of folks, you probably haven’t defaulted on your debt but it’s hard to keep up on and while there are a lot of plans to pay down cards by paying a little extra each month, it doesn’t move quickly. Paying the minimum payment on those debts doesn’t get you anywhere.  It’s time to stop sending the minimum payment to your debts… sort of.

Get the Debt Snowball Rolling

Snowball
credit: ff137 on flickr

I’ve written before about using a snowball plan for pay-down. You can read one of my favorites here: Debt Avalanche, Correct?  If you aren’t familiar with how the debt snowball works, here’s a run-down. Add up all the extra you pay on your debt and apply it to your smallest credit card. Keep paying that extra to the card and your payments are going to start making a big difference faster than you would believe. Once that card is paid off, apply that extra and the payment you regularly made and apply it to the next largest loan or card. Here comes the hard part; as you pay off credit cards, cut them up. You don’t have to cancel immediately, and possibly shouldn’t for credit score reasons, but once your debt to income ratio is more manageable you may want to consider it. The goal is to quit being eaten by small payments and start making big payments.

Stop Paying So Much Interest

Step number two is adding an extra payment per year to your mortgage loans. This shaves 10 years from your mortgage through the elimination of interest. There are two ways to do this. Your mortgage lender probably has some type of offer available that lets you pay every two weeks instead of a monthly mortgage. Because of the various five week months, this effectively creates a 13th payment for the year, but once you commit you might struggle to get back to a monthly payment.

To stay in control of the extra payment you could simply mail an extra payment at some point in the year with bonus money, but a more comfortable way is to take your payment, divide by 12 and add that amount to your monthly payment. It’s a much more painless proposition that still adds up to an extra payment and ultimately gets more money paying toward your principal. Caution: This is only appropriate if you plan to stay in your home or if you have an equity goal in mind. If you are trying to sell your home, this may not be the wisest option.

The same is true of car payments. If after the credit card and personal loan debt is paid, you may be tempted to pay off your car. If you do not plan to buy another and are hoping to be payment free, this will absolutely work as rapidly for a car payment as for credit cards, loans and your mortgage; however, if you are considering a trade-in, keep the extra money you would spend on your car payment and start putting it to work for you in an IRA!

Your Primary Home is NOT an Investment

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Home or Investment?Your primary home is not an investment in the normal sense of the word.  Dictionary.com defines Investment thusly*: “the investing of money or capital in order to gain profitable returns, as interest, income, or appreciation in value.”  Some of you will argue that you buy your house because it will appreciate in value.  But, to fit the definition, you must have bought it specifically for that purpose.  And in the case of a primary residence, that isn’t true.

When you bought (or buy) your primary residence, you’re looking for a home.  You’re looking for a place to call your own where the money that you spend on it goes towards your ownership of the home.  Sure, it may show some returns by way of appreciation of value, but those are locked into the house until you sell.  And, truthfully, you probably don’t care about that unless you sell, so if you plan on living in the house (the definition of primary residence) it makes little difference what the house is worth as long as it provides a home for your family.

So, don’t be fooled into looking for a good “investment” when you buy a house.  Look for an affordable home that will provide for your shelter needs.  When (if) you sell the house, it gets converted into an investment and you will have hopefully made some money, but when you’re looking for a home, pick the one that will fit your needs. Not the one that shows the most potential for return.  That’s what second homes and rental properties are for.

*I know that thusly isn’t really a word.  I blame it all on Alton Brown.

Photo Credit: svilen001 @ sxc.hu

Buying a House: How Much Can You Buy

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This post on behalf of Emortgage Calculator

One of the more important parts of buying a house, is not over spending on the house that you plan on buying.  Despite all the headlines during the recent real estate boom and crash, people are still trying to buy much more house than they can reasonably afford.  When they do that, any little setback can be a disaster to their housing situation.  Think about it; if you’re already stretching to pay the mortgage, and you lose your job or have some other major expense, will you still be able to pay the mortgage next month?  Probably not.   And that’s where the trouble begins.

door keyMany will say that you shouldn’t buy a house where the mortgage payment accounts for more than 40% of your income.  Some will include the escrow and utilities into that equation, some do not.  Being the frugal fellow that I am, I suggest you shoot for a far smaller number than that.  If you want to truly be able to afford your house, the mortgage payment, including escrow (but not utilities), shouldn’t exceed 25% of your income.  If you really think about it, do you really want to pay any more than one quarter of your income on just your house?  How will you afford anything else, let alone pay down debt?

There are several ways that you can estimate how much house you can buy.  Your lender will tell you how much you can buy and still qualify for the loan, but that’s a terrible way to go about it.  They are only interested in completing the loan, not whether you can pay for it for 30 years.  Many of the real estate websites will have a loan calculator on their sites as well, which can give you a pretty close estimate.  If you’re in the UK, the Emortgage Calculator can help you estimate those costs.  Most calculators will ask you a few simple questions.  How much is the house worth (value), how much will you borrow (loan total), how long will you borrow it (Term), and at what interest rate (Rate).  Using those numbers, the calculator will amortize the loan, and return the estimated monthly payment on the mortgage.  Use that number, plus an estimated escrow amount (roughly 20-25% of the payment amount makes it a safe estimate), and you’ve got a number that you can use to determine if the house is too much house for you.  Then, you can continue on with shopping for a house.

A few other notes.  Yes, an “interest only” loan gives you a much smaller payment amount and may seem like a good way to get into a house that you otherwise couldn’t afford.  But, you’re only paying interest for that period.  When the interest only period ends, so does your affordable payment amount.  Then, you’re stuck with a much larger payment, and all of the principle of the loan.  Same goes for an “ARM”, or “Adjustable Rate Mortgage”.  The payment is nice and low before the first adjustment period, but when that adjustment happens, the payment can go up by a good amount.  Avoid both and stick with the conventional 15 or 30 year mortgages.  You’ll be glad you did.

photo credit: woodleywonderworks