PLANNING ON BORROWING MONEY?

PLANNING ON BORROWING MONEY? Statistics show that at the beginning of 1950 American consumers had a total outstanding debt of a little over 19 billion dollars. By the end of 2006, that number has grown to almost 2.4 trillion dollars. Consumer credit is the largest economic engine in the creation of wealth in our economy. Lack of education in this area has also led to record numbers of bankruptcies, foreclosures, and delinquencies. This is the easiest time in history to get that mortgage for your dream home, take out a vehicle loan for the car or truck you can’t live without, or take a signature loan to pay for some unexpected expense in your life. Don’t do it until you know exactly what you are getting into, and what the costs will be down the road. Educate yourself in the terminology, know what you are signing. Mention balloon mortgages or mortgage points and most eyelids will begin to droop, but these terms will have a huge impact on your life when you buy your house or take out a loan. Here is an overview of the most common things you should know about different kinds of credit. The concepts are not difficult and you will become empowered as you begin to learn them.

MORTGAGES Thirty years ago there was only one type of home mortgage a buyer could get. Today’s market is teaming with new strategies for financing a home. Keep in mind that the mortgage company, realtor, and mortgage broker do no necessarily have your best interest at heart. Their job is to sell you a home as quickly as possible. That is where their income comes from. Should you get your financing through a mortgage broker or go directly to a bank or other lender? Mortgage brokers (MBs) are a middle man between the borrower and the lender. They can shop around for the lender with the lowest rates, and find lenders who will offer the best terms for a given credit situation. For some, it is a good idea to go through a mortgage broker. For those with credit problems, they can often find better financing terms than the consumer could alone. If you do go through a mortgage broker, ask that they disclose their fees up front. There are actually two types of mortgage brokers, and understanding the difference between them will help you locate a reputable one.

An Up-front Mortgage Broker (UMB) discloses their fees to customers in advance and in writing, and disclose the wholesale prices (rates and points ) none passed through from lenders. Customers of UMBs pay the broker’s fee plus wholesale loan prices.

A Conventional Mortgage Broker (MB) quotes a retail price to the customer, and usually only reveals their markup in required disclosures after the application process. What are points and how do they affect my mortgage?

Points are a type of fee paid by the consumer to the mortgage lender. Each point is 1% of the value of the mortgage. For example, on a $150,000 mortgage one point would equal $1500 paid at closing to the lender. There are actually two types of points. Origination points are used by lenders to recover the cost of the loan origination (processing of the loan). Discount points are used to “buy” a lower interest rate (also known as a “buy down”). A general rule of thumb is that 1 point on a fixed rate mortgage will buy the interest rate down by .25%, and on an adjustable rate mortgage by .375%. Points can generally be negotiated with the lender. This is an important consideration as you begin to draw up a strategy in the purchase of your home. Do you want to pay a higher closing cost in exchange for better terms on your mortgage? This would depend on several factors. First, how much cash do you have available? Another consideration is length of time you plan on staying in your home before selling. Let’s take a hypothetical couple, Bob and Kathy, who are planning to buy their first home. They know they will be staying there for about five years before selling and buying a bigger home. Their mortgage lender is offering them an $80,000 thirty-year fixed rate mortgage at 6.75%, with no points. This will place their monthly payment at $518.88. If, however, they take two “buy down” points on the loan, their interest rate will be 6.25% with a monthly payment of 492.57. This will save them $26.31 per month, or $1578.60 over the five years they plan on staying in the house. HOWEVER, two points on this mortgage will cost them $1600 at closing, a little more than they would actually save. Bob and Kathy figure out rather quickly that they are better off not taking the discount points. Let’s take another couple, on the other hand, who know they will be staying in the same home for the thirty year life of the mortgage. The lower interest rate would save this couple $9471.60. It would make a lot more sense for this couple to take the $1600 “buy down” at closing. You can see why points are an important consideration when taking out a mortgage. Now let’s look at some different types of mortgages.

Fixed-Rate Mortgage (FRM) Very simply, this is a mortgage with an interest rate which is fixed through the life of the loan. The interest rate is set at closing and will never change. Adjustable Rate Mortgage (ARM) With this type of mortgage your payments will vary over time. Typically, there is an initial period of time after closing in which the interest rate is fixed (1 year, 2 years, 3 years, etc.), and then there is an incremental adjustment made every so often. How often the interest rate can change on an ARM, and by how much each time, is determined in the mortgage contract at closing. This will usually be every 6 months or a year, and the amount of each adjustment is tied to an index specified in the mortgage contract. There are a few circumstances in which it is advantageous to get an ARM over a fixed-rate mortgage. If interest rates are high and expected to drop over time, your payments will probably drop with each adjustment. If you are planning to live in the home for a short length of time, your initial fixed rate period may be lower than what you would get with a straight fixed-rate. Do your research and shop around for the best mortgage.

A balloon mortgage is one which becomes due in full at a predetermined time, usually 5, 10, or 15 years. It is set up like a traditional 30-year fixed -rate mortgage, usually has a lower interest rate, but when the loan comes to term the outstanding balance must be paid in full. With proper planning this can be done either by refinancing or selling the home.

80/20 Mortgage. This strategy is offered by many lenders as an option to finance the home with no money down. It entails taking out two mortgages on the home, a primary (80% of the financing) and a secondary mortgage (the remaining 20%). Often the second mortgage is offered as a balloon mortgage and it usually has a higher interest rate than the primary. Advantages to the consumer are that no down payment is required (just closing costs), and this strategy keeps the purchaser from having to pay PMI (Private Mortgage Insurance. PMI is required on all mortgages in which 20% equity is not owned in the home. It is added into the mortgage payment each month. With the 80/20, since 20% is financed separately, the consumer can get around having to pay this. The downside of the 80/20 is that there is no equity in the home. Interest Only Mortgages. This type of mortgage allows you to pay interest only (without paying down the principal) for a fixed length of time, usually 5 to 10 years. It is usually financed at a slightly higher interest rate than a standard mortgage. It is an option to consider for some who have a variable income and who are disciplined enough to make payments on the principal when they can. It may also be considered by some who plan to remain in a home for only a few years and expect the housing market to rise in that area over that period of time. This is a risky mortgage and is not for everyone. After the interest only period is over, the unpaid principal is added into the monthly payments over the rest of the life of the mortgage. This makes the mortgage payment much higher at that time than a conventional mortgage would have been, unless principal was paid during the initial phase.

VEHICLE LOANS Vehicle loans are easily available even for those with bad credit. Since the borrower is using the vehicle as collateral, lenders can offer better interest rates than on an unsecured loan. Your interest rate will usually depend on your credit score and the length of the loan can vary anywhere up to five or six years. Most dealerships, used and new, offer financing through banks and lenders they are already set up with, and the application process is easy. This may not always be your best avenue for financing. Try several different lenders to find the best interest rate. Credit unions usually offer the best terms. When deciding how long to finance for consider not only your budget but also the expected depreciation of the vehicle you are financing. If you finance the vehicle for five years instead of three, there is a greater risk that you will be upside down on your loan through most of its life. This means you will owe more than the vehicle is worth. This is especially true of new vehicles, which on average lose 25% to 35% of their value in the first year. Also think about the total interest you are paying on a vehicle. If you take out a 3-year loan on a $10,000 vehicle at 7.5% your total interest paid by the end of the loan will be $1198.16. If you take out that same loan for five years you will have paid $2022.80 in interest. Simple calculators can easily be found on the internet for planning your purchase. What about 0% interest financing? 0% interest or “same as cash”, these offers usually come from new vehicle dealerships trying to entice buyers who ordinarily would not buy a new vehicle. If you are in the market for a new vehicle anyway, and your credit score supports it, these offers are better than interest loans. If you ordinarily would not buy new, however, the no interest deal does not change the fact that the vehicle will lose anywhere from 7% to 12% of its value as soon as you drive it off the lot. That is definitely not the “same as cash”. Should you trade in your old vehicle? The fact is you are not going to get nearly the blue book or street value of the vehicle on trade-in. You would do much better selling the vehicle yourself, then using that money as a down payment. Some do not like the hassle, however, and prefer the convenience and ease of doing a trade-in. Keep in mind, however, you do not EVER want to trade in a vehicle that is already upside down on a loan. That just rolls a financial problem you already have into a bigger financial problem. If you are already under terms on your vehicle that seem unreasonable or unmanageable, you can always go back and refinance later. The best strategy when buying a new vehicle is to go into the dealership with the budget already done, knowing what you are willing and able to pay. Then do not accept any terms that take you over that budget.

SIGNATURE LOANS A signature loan, also known as an unsecured loan, is one which is unsecured by any collateral. It is borrowed simply on a signature. These are riskier for the lender, therefore the interest rate is usually higher than that of a vehicle loan. The borrower’s credit score is scrutinized much more carefully here, and banks typically will not lend to customers below a certain score. Signature loans are generally offered ranging from a few hundred to a few thousand dollars with interest rates of between 12% and 22%. Most lenders will work with the borrower in determining the length of the loan. Many banking institutions advertise Christmas loans, back to school loans, and other specialty loans which all fall into the signature loan category. These can often be had at special interest rates. Another type of signature loan is called a passbook loan. These are special loans which are designed for nothing more than to build the customer’s credit. This loan is actually secured by a savings account which is frozen until the loan is repaid. The most common form of unsecured loan is the credit card. Aside from payday loans, discussed in the next section, credit cards generally have the highest interest rate of any type of lending. With the low minimum payment and ease of getting a wallet full of credit cards, many consumers charge their way into tens of thousands of debt before they realize what they have done. They have gone into debt without a plan, and there is no easy plan for getting back out. Paying minimum on a high limit card generally takes about twenty years to pay off. Before “charging it” be sure you can afford to pay the balance off in a reasonable amount of time. Stay aware of the fact that any unsecured loan is debt for which you probably have no matching asset. It simply brings your net worth down.

PAYDAY LOANS The payday loan establishment is the most controversial and maligned segment of the lending industry. There are two reasons for this. One, the interest rates are so high on these types of loans, averaging an APR (annual percentage rate) of 400%. Two, there is no credit check done before issuing the loan, so it is very easy to get this type of short-term financing. Since those with bad credit often have a history of bad debt management, they easily get themselves into bad financial messes with payday loans. Most states have now put caps on the amount of fees payday lenders can charge but the APR is still going to be in the triple digits. What are payday loans? Payday loans are also known as cash advances, deferred deposits, and payroll advances. The borrower gives the lender a check which has been post-dated, usually until his or her next payday in the amount they are borrowing plus the lender’s fee. The payday lender then cashes the check on that date. Most payday lenders will allow the customer to continue rolling over the loan to the next payday by repaying the fee every time. Generally the lender only requires proof of steady income and a couple of bank statements showing an account in good standing. Many cash advance services are also available online and the required information is faxed. The loan limit with most of these companies is $300 to $600, although a few will loan as much as $1000. The fees charged range from $25 to $35 for every $100 borrowed. What are the benefits of getting a payday loan? They are easy to get approved and a fast means of getting cash before payday in an emergency. If no other options are available they can be a good tool to use in the event of a one-time expense such as a medical emergency or vehicle repair. Before getting this type of loan, be sure to have a plan for paying off the loan in the shortest length of time possible! Bad planning or no planning are the quickest way to get yourself into a mess with this type of loan. Let’s say your car breaks down and you need to borrow $300 to fix it immediately. You write a check for $375 to a payday lender but realize that the extra $75 fee will keep you from having the funds to repay on your next payday. Therefore you return and write another check for $75 to roll it over. If this goes on for three pay periods you have now paid the lender $225 for a $300 loan that you still owe! It is a trap many unprepared consumers fall into with this type of lending. What if you decide to take out a payday loan? The first thing is to make sure you have no other options. Payday loans should only be used as a last resort. If you do feel you have to take out the loan, find out what fees are going to be charged by your lender and know exactly when they are going to cash it. Also make sure they have an option available to roll the loan over. You do not want to take that option but need it as a back-door in case something happens before payday. Only if you know you can repay the loan in a reasonable amount of time (no more than two pay periods) and trust the lender should you take the loan. Borrowing money is an essential part of the American way of life. It allows us to enjoy many of the things we would not otherwise be able to afford. Whether it is a new home, a car, or quick relief from one-time emergencies manageable debt is the way we enjoy the fruits of our civilization long before we could otherwise afford them. The key to managing your debt wisely is planning and education. Before taking out a loan of any kind know how and when you are going to repay it. Also, read your loan documents carefully and educate yourself on the terminology

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