Debt Part 1 - Mortgage & Credit Cards

Debt

Depending on what you’ve heard before, debt can sound from benign to absolutely horrifying. Two of the greatest economic collapses in modern history, the Great Depression and the Great Recession, were both triggered by bad debt. As such, people like Dave Ramsey consider debt like a plague to be avoided at all costs. However, we believe that through understanding what it is and how it works, we can help alleviate some of those concerns and have debt work in your favor.

Debt in its simplest terms is a process of lending and borrowing. You’ve probably been in debt countless times without even realizing it. For example, if you’ve ever had a friend foot the bill for you at a restaurant so you can pay them back later, a debt was created the moment your friend paid for you and closed when you Venmoed them your share. The same thing with keeping an open tab at a bar, you owe the bar a debt until you get ready to leave and pay your tab.

Those are harmless instances of debt that occur in our day-to-day lives that make our lives better and more convenient. Of course, these are not what come to mind when we think about debt, so let’s discuss some more important types of borrowings:

• Mortgage

• Student Loans

• Personal Loans

• Credit Card Debt

Mortgage

Probably the largest debt for most people, this is money you borrow to buy a house, condo, apartment, etc. If you want to buy a $500,000 house but only have $100,000, you can ask a bank to borrow the remaining $400,000. In this instance, you’ve put 20% as your downpayment ($100,000 divided by $500,000) and will pay interest on the $400,000 loan. There are broadly two types of interests to choose from:

• Fixed Rate - where the interest rate over the life of the mortgage stays the same

• Adjustable Rate - where the interest rate moves up and down with the general economy

Avoiding a mortgage is near impossible for most people. If your goal is to own your own living place but do not have hundreds of thousands or millions in cash, you have no choice but to get a mortgage. Because this type of debt is so unavoidable, we want to spend a bit more time discussing what types of mortgages are considered safe, which are risky, and which should be avoided.

• Fixed-Rate: 30 or 15-year mortgages, generally considered the safest option. Since the interest rate is fixed, you won’t be in for any nasty surprises. Your monthly payments are always the same amount, and as long as you continue to pay every month, there shouldn't be any mortgage-related danger of losing your home.

• FHA loan: this is a subset of the fixed-rate category, where the government makes a promise to your bank that if you can’t pay, Uncle Sam will. As a result, it requires a much lower downpayment, as low as 3.5% in some cases ($17,500 for a $500,000 house).

• The government offers this program to incentivize first-time homeownership. You must live in the home for 2 out of the first 5 years after purchase to prove it is your primary residence. It also requires you to pay for MIP (mortgage insurance protection) just in case you fail to pay, and the cost typically runs around 0.5% - 1% of your total loan amount ($2,500-$5,000 on a $500,000 loan) per year.

• Adjustable-rate mortgages: also known as variable-rate mortgages or tracker mortgages, are considered far riskier since the interest rate you pay on the loan moves up or down periodically based on the prevailing interest rate of the broader economy.

Variable-rate mortgages are complex by nature and can become a burden to your financial health for many reasons, for example:

• Interest rate rises - if you bought the house when rates were low but see a jump in interest rate a few years into your mortgage, your monthly payments and total loan amount can easily exceed your expectations. In some cases, the payments may even overwhelm your ability to pay, forcing you into foreclosure.

• Negative amortization - a fancy word to mean the amount you owe to the bank increases rather than decreases. This happens when your monthly payment is less than the monthly interest charge. As stupid as that sounds, some mortgages allow for this payment structure, and some unethical salespeople use this “low monthly payment” as a way to attract less informed consumers.

• Teaser rate - you know when a company offers you a “3 months free trial” before charging you a much higher price after the 3 months are over? A lot of variable-rate mortgages give you a super low rate for the first couple of years to draw you in before charging you a much higher rate for the remainder of the mortgage.

Between 2007 - 2009, the world experienced one of the worst economic downturns. The Great Recession was fueled by garbage variable-rate mortgages. When negative amortization kicked in and the teaser rates ended, a ton of people suddenly found that their interest rate spiking beyond their financial capacity to repay. Lots of people realized that the amount they owed on the mortgage was more than the value of their house!

So many people had these crappy mortgages that when they all started going into default, it crippled the global economy.

A fixed 30 or 15 years mortgage on the other hand, is a much safer choice for almost everyone due to the lower risk built into it compared to a variable rate mortgage.

Let’s say the broader economy interest rate is around 3%, so you take out a 30 years mortgage, and because you have good credit (more on this later) you get a fixed 4% interest rate for $400,000.

In this case, banks are contractually and legally not allowed to charge you a dollar more than $1,910 per month, even if the broader economic rate jumps to 30% a year later. This is an incredible piece of protection for your financial well-being as you are impervious to sudden economic shifts beyond your control. On the other hand, if the broader economic interest rate drops to 0.3%, you can refinance at 2.5%, locking in an even lower rate for your mortgage.

With a fixed rate mortgage, fluctuations in the broader economic interest rate are often your friend; with a variable rate mortgage, they are often your enemy.

Credit Card Debt

Avoid this.

Ahem, sorry. What we meant to say is…

AVOID THIS LIKE THE PLAGUE!

The average rate for credit cards is 17.98%. Remember our previous discussion looking at the dangers of a negative ROI? Let’s say you spend $5,000 on an impulse purchase and put it on your credit card, which has a minimum monthly payment of 4% or $200 (4% * $5,000). What happens if you only pay the minimum payment every month?

In this scenario, that $5,000 debt ends up taking you 133 months, or 11 years, to pay off. Since you are paying $200 per month, it means you are paying back a total of $26,600! For a $5,000 purchase!

Paying off a high-interest rate debt (17.98%!) with just the minimum payment is like pushing a snowball up Mount Everest. It’s not impossible, but it will take a big toll on you. The high-interest rate is constantly growing the loan amount at a compounding pace, eating away at your wallet.

Please note: we urge you to avoid credit card debt, not credit cards.

It’s okay to pay for things with a credit card, after all, who doesn’t love those sweet sweet cashbacks and reward points? Just make sure, make very sure you NEVER buy anything you can’t afford with a credit card.

In other words: if you can’t pay for something with cash, don’t put it on a credit card. Make sure you pay off the full amount to avoid being charged interest, set up autopay, AND set a monthly alarm for yourself to double-check. Mismanaged credit card debt will wreak havoc on your financial health.

"But what if I need to buy it?"

If it’s essential but you really don’t have the cash, then get a personal loan for it. An interest rate on a loan will be significantly less than that of a credit card.

Side Note: there is a rumor online that you should keep a small balance unpaid each month because that is somehow good for your credit score. This is just a rumor, and there are no shortages of people with 800+ credit scores who always pay off their full balances. It will only cost you interest payments with nothing good to show for.

Up Next…

Nima just told me that I’m rambling now, so in Debt - Part 2 we will look at both student loans and personal loans, their pros and cons, and how to handle them properly…