Conserving Money by Controlling It
A major pitfall in any financial plan is the temptation to spend more than you can afford, especially when credit is so easy to get. Because many credit-card issuers target college students and recent graduates with tempting offers appealing to the desire for financial independence, it is important that you arm yourself with a solid understanding of the financial costs entailed by credit cards. The same lessons apply equally to other loans, such as home mortgages, cars, and student financial aid.
Credit Cards: Keys to Satisfaction or Financial Handcuffs?
Although some credit cards don’t charge annual fees, all of them charge interest on unpaid (outstanding) balances. Figure AIII.6 reprints part of a page from Bankrate.com’s credit-card calculator at www.bankrate.com/
Figure AIII.6
Paying off Credit-Card Debt
If you pay only the monthly minimum, it will take you 115 months—more than 9 1/2 years—to pay off your credit-card debt. During this time you will pay $2,096.70 in interest, almost half again the principal balance! Repayment takes so long because you are making only the MPD, which decreases with each monthly payment.
Save Your Money: Lower Interest Rates and Faster Payments
Figure AIII.6 confirms two principles for saving money that you can apply when borrowing from any source, not just credit cards: Look for lower interest rates and make faster repayments.
Seeking Lower Interest Rates
Look again at Figure AIII.6 and compare the cost of borrowing $5,000 at 18 percent with the cost of borrowing it at 9 percent. If you assume the same 5-percent minimum monthly payment, a 9-percent APR will save you $1,232.14 in interest during the repayment period—a nearly 59 percent savings.
Making Faster Payments
Because money has a time value, lenders charge borrowers according to the length of time for which they borrow it. In general, longer lending periods increase the cost, and shorter periods are cheaper. Using Figure AIII.6, compare the costs of the 5-percent MPD with the faster 10-percent MPD. The faster schedule cuts the repayment period from 115 to 55 months and, at 18 percent APR, reduces interest costs by $1,222.84. Combining both faster repayment and the lower interest rate cuts your total interest cost to $450.30—a savings of $1,695.07 over the amount you’d pay if you made slower repayments at the higher rate.
Declining Asset Value: A Borrower’s Regret
Financially speaking, nothing’s more disappointing than buying an expensive item and then discovering that it’s not worth what you paid. For example, if you buy a $5,000 used car with a credit card at 18 percent APR and make only the MPD, as in the preceding example, you’ll end up spending a total of $7,407.50 over 9 1/2 years. By that time, however, the car you bought will be worth less than $1,000. Some of this loss in asset value can be avoided through realistic planning and spending—by knowing and staying within your financial means.
Financial Commitments of Home Ownership
Deciding whether to rent or buy a home involves a variety of considerations, including life stage, family needs, career, financial situation, and preferred lifestyle. If you decide to buy, you have to ask yourself what you can afford, and that requires asking yourself questions about your personal financial condition and your capacity for borrowing. Figure AIII.7 summarizes the key considerations in deciding whether to rent or buy.
Figure AIII.7
To Buy or Not to Buy
How Much House Can You Afford?
Buying a home is the biggest investment that most people make. Unfortunately, many make the mistake of buying a house that they can’t afford, resulting in unnecessary stress and even devastating financial loss. This happened on a massive scale in the housing downfall that began in 2007 and has still not fully ended. The seeds for destruction sprouted during the years 2000–2007 when millions of optimistic home buyers borrowed beyond their means by getting larger loans than they could afford. With the rising demand for home ownership, housing prices became inflated and borrowers responded by seeking unrealistically larger loans. They implicitly assumed that market prices would continue to rise indefinitely, thereby providing a profitable investment. Borrowers were aided by lenders using loose credit standards, unlike the more conservative time-proven standards that will be presented here, leading to unrealistic repayment requirements. By 2007 the housing market was oversold and the U.S. economy entered a severe recession. With rising unemployment, borrowers were unable to meet monthly payments, especially when interest rates (and thus payments) on loans increased. Consequently, housing vacancies increased and property values plummeted. Borrowers lost their homes and the equity they had built up in them. The depressed housing market did not begin to revive until 2014.
In addition to loan payments, the typical demands of ownership, time and other resources for maintaining and improving a home tend to cut into the money left over for recreation, eating out, taking vacations, and so on. You can reduce the financial pressure by calculating in advance a realistic price range—one that not only lets you buy a house but also lets you live a reasonably pleasant life once you’re in it.
Most people need a loan to buy a house, apartment, or condominium. A mortgage loan is secured by the property—the home—being purchased. Because the size of a loan depends on the cost of the property, both borrowers and lenders want to know whether the buyer can afford the house he or she wants. To determine how much you can afford, one time-tested (though somewhat conservative) rule recommends keeping the price below 2 1/2 times your annual income. If your income is $48,000, look for a house priced below $120,000.
Any such calculation, however, will give you only a rough estimate of what you can afford. You should also consider how much money you have for a down payment and how much you can borrow. Lending institutions want to determine a buyer’s borrowing capacity, the borrower’s ability to meet the recurring costs of buying and owning.
PITI
Every month, the homeowner must pay principal (pay back some of the borrowed money), along with interest, taxes, and homeowner’s insurance, or PITI, for short. As Figure AIII.8 shows, the size of principal and interest payments depends on (1) the mortgage amount, (2) the length of the mortgage loan, and (3) the interest rate.
Figure AIII.8
Monthly Payments on a $10,000 Loan
In evaluating loan applications, lenders use PITI calculations to estimate the buyer’s ability to meet monthly payments. To determine how much someone is likely to lend you, calculate 28 percent of your gross monthly income (that is, before taxes and other deductions). If your PITI costs don’t exceed that figure, your loan application probably will receive favorable consideration. With a monthly gross income of $4,000, for example, your PITI costs shouldn’t exceed $1,120 (28 percent of $4,000). Additional calculations show a house price of $162,382 is the most this borrower can afford. Figure AIII.9 gives a sample calculation, and you should be able to make step-by-step computations by plugging your own numbers into the worksheet.
Figure AIII.9
Worksheet for PITI Calculations
Other Debt
In evaluating financial capacity, lenders also look at any additional outstanding debt, such as loans and credit-card bills. They will generally accept indebtedness (including PITI) up to 36 percent of gross income. Because PITI itself can be up to 28 percent, you might be allowed as little as 8 percent in other long-term debt. With your $4,000 monthly gross income, your total debt should be less than $1,440 ($1,120 for PITI and $320 for other debt). If your total debt exceeds $1,440, you may have to settle for a smaller loan than the one you calculated with the PITI method.
Finally, lenders will also take into account the “quality” of the debt. For instance, suppose you have purchased a car that seems appropriate for your income level and you have a monthly payment of $300 for another 3 years on your car loan. A mortgage lender might not weight that as negatively as multiple high-interest credit card accounts with the same combined monthly payments. Why? The car loan would generally be considered a reasonable financial decision whereas the credit card debt would reflect poor financial decisions. Websites such as http:/