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Debt, Bad Debt -
Tips to Managing Your FinancesBy Julie Vincent of CityBrokers Most people doggedly pursue low mortgage interest rates but, with few exceptions, these same people are carrying extremely high credit card interest. What many people pay in credit card interest over their lifetime equals the down payment on a new house! There are good reasons for having credit sources but it is critical to know how credit works and how to make it work for you. It is also important to understand the difference between good and bad credit. Here’s a simple description: mortgage = accruing equity= good debt; credit card debt = depreciating goods = bad debt. Good credit is related to increasing value; a mortgage for example. Bad credit relates to things that depreciate. Any non-appreciating item purchased with credit should be paid for as quickly as possible. Some feel a mortgage should be paid down as fast as possible - good practice when you have no other debt - however, usually, credit card interest is far higher than mortgage interest. Always pay off high cost credit first. According to Canada Mortgage and Housing ( www.cmhc.ca ), your home’s value will likely increase this year and for perhaps five more. If your mortgage interest is in the 5% - 6% range, you will see an annual net gain because the asset’s value is increasing. Things bought with credit cards do not increase in value. If you’re not paying off credit cards monthly, you’re losing income equal to the interest you’re paying on your non-growth stuff. There is no upside to paying interest. Yes, have a credit card but never treat credit as an extension of your salary. Credit lets you temporarily delay payment for purchases but temporarily does not mean putting off payment until the cost of the item has increased 100% and its value has decreased to nothing. Eliminating Debt - Most people have too much credit and too much debt. Thanks to effective product marketing, the lines between “I need it” and “I want it” are greatly blurred in our culture. Know the difference. We all need a place to live, food and clothing but not a 10-room home, a closet full of designer clothes and filet mignon every night. Most people need a vehicle, but few need a HumVee. Once wants and needs are defined, it is easier to manage finances. To better balance debts, get rid of unneeded credit. Cancel cards if you have more than three and lower borrowing limits on your remaining cards. You’ve probably noticed that your credit limit increases occasionally. Credit card companies love people who use their cards regularly and make regular payments but never pay their cards off because they provide huge interest revenue for those lenders. Another way of managing debt is to consolidate it. High monthly payments on several credit cards usually make it impossible to pay off debt. Consolidating debt into one low interest payment can make a huge difference in what goes out of your pocket each month. Here’s a scenario: a working couple has a home worth $300,000 with a mortgage balance of $110,000. Their mortgage payment is about $1200 a month. They also have five credit cards with a total balance owing of $50,000. They pay $1500 a month in minimum payments. Let’s assume this couple’s mortgage interest rate is 5.25% and their average credit card rate (bank and store cards) is 22.96%. Their average interest rate (cards and mortgage) is about 14%. This couple can consolidate their debt in a variety of ways. For instance, they can replace their mortgage and all their debt with a home equity line of credit or they can leave the mortgage in place and consolidate their credit card debt into a home equity line of credit in addition to their mortgage. Secured lines typically carry an at-prime rate and have an interest-only minimum payment requirement. In the first scenario, this couple replaces their entire debt – mortgage and credit cards – with a line of credit secured against their home. Most institutions will lend up to 75% of a home’s appraised value, less any mortgage owing. In this scenario, with a home worth $300,000, there is $225,000 of available equity in their home. This couple owes in total $160,000. If they replace their mortgage and all their debt with an at-prime line of credit, their required minimum monthly payment on $160,000 will be approximately $700. They are currently paying out $2200 a month. If they make principle and interest payments of $1500 a month, they will effectively pay down their debt and free up $700 for investments and savings. In the second scenario, the couple keeps their mortgage in place, and adds a secured line of credit of $50,000, which pays out all their credit cards. It works like this: the available equity in the home is $225,000 less the mortgage balance of $110,000. This leaves $115,000 of equity they can borrow against. By consolidating their credit card debt into a secured line, they reduce the cost of their credit to prime rate from an average of 22.96% - a potential drop of 17%! Their mortgage payment remains unchanged but the required minimum payment on their other debt is about $220. Yes, that’s right: $220. By making monthly payments of $1000, they will rapidly pay down the debt and will free up $500 a month to invest or save. The Bottom Line - There are good reasons to have credit cards – convenience included. But that convenience is costly if you’re paying high interest on your cards. Credit cards provide temporary access to funds but are not an unlimited supply of free cash. Carrying balances at high interest eats into your hard earned salary. Julie is mortgage specialist with six years experience & 20 years business development, marketing & public relations experience. Her specialty is new buyers. Contact Julie any time at 403.287.2740. |