When to Offer Unsolicited Advice



Image credit: iqoncept / 123RF Stock Photo

 

A close family member (let’s call him “B”) mentioned that he recently opened a new credit card through his bank.  He already had a Discover card, but thought that he should have something more widely accepted as some retailers do not take Discover.  This approach seemed logical, until B said this: “The bank gave me a $7,500 credit line.  And, there is a promotional 0% APR for the first 12 months.”  He seemed excited by the high credit line and the promotional interest-free period, but I was concerned.  This family member is very bright.  In most situations, he’s practical and has plenty of common sense. However, I worry that he may be setting a dangerous financial precedent if he starts to rely on credit.  Here are some background details that cause me to worry:

*B and his wife are 24-year old newlyweds.  He financed the engagement ring.   According to the jeweler’s website, loans are interest-free if paid in full within 12 months.  If the loan is not paid in full within 12 months, interest accrues from the purchase date at an APR of 29.99% (oh boy...)  I don't know whether he paid off the loan within 12 months, but I sincerely hope he did.  That’s a super high interest rate.  The ring is quite lovely, by the way.  But I just don’t think it’s a good idea to buy a ring unless you can afford to pay for it in cash. 

*B and his wife just finished Master’s degrees.  While in graduate school, they both had part-time positions as graduate assistants/researchers, but never held full-time jobs.   I estimate that B and his wife each earned $15,000-$18,000 a year as researchers.   Given these modest incomes...

*I don’t believe B has much in savings.  I could be wrong, but I doubt he would have financed the engagement ring if he’d had the cash to spend. 

*B will start medical school in a few weeks.  Over the next four years, he will take out six figures in loans.   

*B’s wife is currently seeking employment (until recently, he had been deciding between a few medical schools.  The medical schools were in different locations, and B’s wife waited to apply for jobs until he had decided on a medical school)

*A $7,500 credit line?!!!  Someone can get themselves into a lot of trouble with a $7,500 credit line, especially if he/she does not have a source of income. 

 

I have an uneasy feeling that B and his wife may get in over their heads with this new credit card.  I inwardly cringed during this conversation because I would hate to see B and his wife make a financial mistake that could haunt them for years.  Perhaps I am being paranoid and should give them more credit (bad pun, I know).  They’re adults and are capable of making their own decisions.  When B told me about the new credit card, I decided not to offer him any advice.  We were in a social setting with his parents and I didn’t think it was an appropriate moment to climb onto my soap box.  I had to resist the urge to tell B what I really thought: 1) Credit cards should be used as if they are debit cards; only make the purchase if you could afford to buy it in cash, 2) Pay off that balance in full, every month, even if there is an interest-free period.  It’s not as though you could leverage credit to your benefit in this scenario, so you’re better off paying your bills, and 3) a $7,500 credit line for an unemployed person seems like predatory lending on the part of the bank.  Be very, very careful whenever you use that credit.  The bank is counting on you NOT being able to pay your balance after 12 months, at which point they’ll slam you with a very high interest rate.

I wanted to say all those things.  Really, I did.  But I thought this might sound too preachy and judgmental.  B was simply making conversation.  He hadn’t asked my opinion, so I didn’t feel it was my place to offer advice, especially with his parents standing nearby.  Instead, I said, “Wow -- $7,500?  That’s higher than my credit line!”  I am hoping that my comment will put his high credit line in perspective.  His parents are both financially savvy, so I imagine that they taught him about credit cards when he was younger.  If not, I’m hoping they will warn him after hearing this worrisome conversation.

 

So, friends, here’s my question: Have you ever offered unsolicited financial advice to a friend or family member?  If so, how was it received?  Do you think I should have said something more forceful in this situation?                

Why Interest Rates Matter

Alexander Hamilton, first U.S. Treasury Secretary

If you know nothing else about Alexander Hamilton, you probably know that he was killed in a duel with Aaron Burr (remember this "Got Milk" commercial?).  But did you also know that he was the first United States Secretary of the Treasury?  Two of his major fiscal policies included creation of the U.S. Mint and a central bank for the emerging nation.  Although the “First Bank of the United States” later became defunct, I think it would be fair to say that Alexander Hamilton was responsible for building much of the financial structure that still exists in the United States government.  Another fun fact: Hamilton was considered quite handsome in his day.  Personally, I think he resembles Mel Gibson – nothing wrong with that. 

Anyway, on to the real content of this post: interest rates

After a March meeting of the Federal Open Market Committee (FOMC), the Federal Reserve released a statement regarding its anticipated treatment of interest rates.   The statement was vague, but the Fed announced its intention to keep interest rates low for the immediate future.  The Fed also specified several benchmarks that it will use in order to determine the appropriate time to discontinue its current “easy money” policies.  As I understand it, so long as inflation does not increase significantly, the Fed will wait for unemployment to dip below 6.5% before it considers raising interest rates.  The Fed projects that interest rates will remain low throughout 2013 and 2014, but these low rates will not continue indefinitely.  I will be thrilled once unemployment percentages return to a more manageable level.  In this most recent recession, several loved ones were victim to layoffs that lasted anywhere from two months to six years, and I know their experience was not unique. 

However, as aspiring home owners, we wish that interest rates wouldn’t increase as a result of the economic rebound.  Since Mr. W. and I would like to buy a house within the next 3-4 years, we’re very interested in interest rates.  These predictions have led me to ask: Precisely when will interest rates rise?  How much will they rise? What are interest rates going to look like in 2016 and 2017? And most importantly to us, How will interest rates affect the cost of purchasing a home?

Unfortunately, I can’t answer the first three questions.  If you happen to own a crystal ball, feel free to share your economic forecasts with those of us non-magical folks.  Thanks.

The fact of the matter is that lower interest rates decrease the incentive to have a large down payment.  I've been wondering whether it would be better to take advantage of current borrowing conditions (ie, buying sooner) or save as much as possible for a down payment (ie, buying later).   

Although I can’t predict the future, I can estimate how interest rates will impact the cost of purchasing a home.  I’m a bit of a numbers geek, so I spent some time crunching numbers and playing around with various mortgage scenarios.  In the analysis that follows, I’ve concentrated primarily on the total cost of the down payment, principal, interest, and PMI (if applicable).  I’ve assumed a 30-year mortgage since it is the most common choice.   I’ve also assumed purchasing a $350,000 home because this will probably be a good ballpark when Mr. W and I start looking for a starter home: two- or three- bedroom, one-bath single family home that is in a good school district, but needs a bit of TLC. 

This is what I learned: Interest rates matter.  Truly, they do.  In fact, getting a low interest rate could save more money than having a hefty down payment.  That conclusion is a bit scary, for two reasons: 1) it flies in the face of traditional wisdom that you should only buy a home once you have saved at least 20% for a down payment, and 2) we have control over how much we save, but we can’t control interest rates (unless you’re the chair of the Federal Reserve, which I’m not).

PLAN A
In a perfect world, we could buy a home with a low interest rate and standard down payment.  Let’s take a look at this “perfect world” scenario.     

 

In this perfect world, let’s suppose we buy a $350,000 home with 20% down and a 3.5% interest rate.  In my analysis, this is Plan A/Option 1.  This means that our loan amount is $280,000, for which we’ll have a monthly mortgage payment of $1,257.  Over the life of the mortgage, we will pay $172,637 in interest.  The total cost to buy the home is $522,637.  At 3.5% interest, it costs us $.617 to borrow a dollar (this is the “interest/principal ratio”). 

Now, let’s suppose that interest rates start to increase.  Plan A/Option 2.  At 4%, it would cost us $551,235 to buy that same $350,000 home.   The cost to borrow a dollar at 4% increases to $.719.  Now let’s consider Plan A/Option 4.  At 5% interest, it would cost us $611,116 to buy a $350,000 home, and the cost to borrow a dollar would be $.933.  That’s not a pretty picture.   Obviously, the best option is to buy the home at 3.5% interest.  No big surprise there.   

Unfortunately, life isn’t perfect.  We don’t currently have $70,000 saved for a down payment and there aren’t many houses around here that are less than $350,000.  So let’s move on to another scenario, “Plan B”.  

PLAN B

In this group of scenarios I’ve assumed that, for every year we wait to buy a home, we save an additional 5% towards the down payment.  I’ve also assumed that interest rates increase by approximately .5% on an annual basis. 

 

 

 

 

In Plan B/Option 1, we put 10% down and are able to get a 3.5% interest rate.  Since we didn’t have 20% for a down payment, we must pay PMI of $142/month for the first 6.9 years of our mortgage*.  The monthly mortgage payment, before PMI, is $1,414.  Including PMI, the total cost to buy our home would be $555,954.  We'd pay just under $12,000 in PMI.  The cost to borrow a dollar (interest plus PMI, divided by loan principal) is $.654.  That’s not so bad, right?

Now, let’s suppose that we wait until we have 20% for a down payment, by which time interest rates have increased to 4.5%.  This is Plan B/Option 3.  We wouldn’t have to pay PMI in this scenario, which is great.  However, the total cost to buy our home would be $580,739.  The cost to borrow a dollar would be $.82.  Even though we put twice as much down on the house, and we didn't pay PMI, we would still end up spending almost $25,000 more to buy the same home.  And that's just the difference of 3.5% versus 4.5% interest.  And now let’s suppose we decide to really pinch our pennies and are able to put 30% down on the home.  Plan B/Option 5.  It takes us two years to save the extra cash, by which time interest is a not-so-nice 5.5%.  We would be paying $605,790 to buy a $350,000 home, and the cost to borrow a dollar would be a whopping $1.04.  You mean I have to pay more in interest than I’ve borrowed?! Yikes.  Somehow that feels like highway robbery.   Paying PMI is often stigmatized, but in this scenario it might be the best option. 

You might look at Plan B and wonder, “J.W, do you actually expect to get a 3.5% interest rate if you’re only putting 10% down?  Isn’t that wishful thinking?”  Perhaps.  I think it would depend on our credit scores as well as our debt-to-income ratio.  In both of these categories, I believe Mr. W and I would qualify for a low rate from lenders…but I could be wrong.  And you might also wonder whether interest rates would really increase at .5% per year.   Maybe that’s too steep an increase, although it wasn’t so long ago that mortgage rates were 4.75% (I remember when my parents refinanced their house from 5.375% to 4.75%.  I think that was in 2010).  Both of these would be fair criticisms, so let’s look at a third set of scenarios, “Plan C.”

PLAN C

In “Plan C,” I’ve assumed that we would qualify for a 3.75% loan if we were to put 10% down on a house.  As with “Plan B”, I’ve assumed that for every year we wait to buy a home we can save an additional 5% towards the down payment.  I’ve also assumed that interest rates only increase by .25% per year.    

 

In Plan C/Option 1, we buy the same $350,000 house with 10% down and a 3.75% loan.  Much as in Plan B/Option 1, we pay PMI of $142/month for 7.2 years*.  Our monthly mortgage payments are $1,459 before PMI.  Including PMI, the total cost to buy the house is $572,420, and the cost to borrow a dollar would be $.706.  If we delay buying a home until we have 20% interest, we would no longer pay PMI, but interest rates would be 4.25%.   This is Plan C/Option 3.  The total cost to buy the home would be $565,875, and the cost to borrow a dollar would be $ .771.  In this scenario, we can see why having a larger down payment is financially beneficial.  Now, let’s suppose we wait two years longer and are able to squirrel away enough for a 30% down payment.  Plan C/Option 5.  Interest rates are now 4.75%.  The total cost to buy the home would be $565,093, and the cost to borrow a dollar is $.878.  In terms of total cost, this is incredibly similar to Plan C/Option 3.  Plan C is intriguing because there is such a small difference in cost between Options 1-5. 

Of course, there are several additional financial considerations to purchasing a home that should be taken into account.  To keep this post from becoming even longer (are your eyes glazing over, yet?), I'll share those considerations in another post.  

All in all, this exercise didn’t leave us with any “Ah-ha!” moments.  We still don’t know exactly when it will be the right time to buy a home.   What we did learn was that it’s expensive to borrow money.   We now understand why some folks insist on paying cash for their homes.  We also learned that we should pay attention to interest rates.  For now, we’re not rushing into buying a home.  For several reasons, we know that now is not the right time for us.  But depending what happens with interest rates, the right time could be sooner than the 3-4 year goal we laid out in our plan.  Until then, we’ll continue to save for a home in the hopes of being ready to buy when we decide the time is right.

For those who are saving towards a home, would you ever consider putting less than 20% down? 



*Explanation on PMI calculation: For purposes of these calculations, PMI is included until 23% equity is established.  Lenders are required to remove PMI once 22% equity is established and if all mortgage payments have been made on schedule.  However, the process to remove PMI from the mortgage requires an appraisal and may take several months, so 23% equity has been used in this analysis.  PMI calculations assume that the home value remains consistent with the purchase price. 

**Disclosure: As a reminder, I'm not a financial advisor or CFP.  I've also never worked in the mortgage or loan industry.  The content of this blog is not intended to be used as financial advice, but is simply my perspective on what will work best for my household.

Topics in Personal Finance: Why We Still Have a Car Loan

Mr. W. and I currently have a car loan with a $10,000 balance.  I know that most personal finance gurus would advise paying down that loan ASAP to avoid interest charges.  We could pay off the loan in its entirety, but we've decided not to do so.  Here are some background details that explain our decision: 

In August of 2012, we bought Mr. W.'s used Honda Civic.  At $16,000 and less than 20,000 miles, it was a great deal.  When we bought the car, our wedding was just six weeks away.  We hadn't planned to buy a car until after the wedding, but Mr. W. was in an accident that made his previous car un-drivable (no one was injured, thank goodness).  We tried to share a car for a few weeks, but this doubled his already-too-long commute.  Mr. W. clearly needed a new car. 

Other than assorted wedding-related deposits, the car was our first major joint expense.  We had the funds to pay cash for the car, our wedding, and our honeymoon.  However, we decided to put 20% down on the car and finance the rest.  Between the wedding and honeymoon, 2012 was shaping up to be a very expensive year.  Now we were buying a car, as well.   

Before buying the Civic, Mr. W. and I agreed that we should maintain a certain level of savings.  We just didn't feel comfortable draining our savings completely.  Marriage would bring a lot of firsts for us: first time we lived together, first time we combined our finances, first time we had to share closet space and a bathroom.  On top of all those changes, we didn't want to stretch ourselves too thin financially. 

At the time, $12,000 seemed like a reasonable amount of cash to have on hand.  We ensured that after making the down payment on the car and paying for all wedding/honeymoon expenses, we would still have $12,000.  Since getting married, we've increased our savings goal to $25,000.  This amount would cover our fixed living expenses for approximately one year. 

Why did we determine to save a year's worth of expenses?  Why not just six or nine months?  Mr. W. and I both work in relatively specific industries.  If either -- or both -- of us were to lose our jobs, it could take some time before we found another position.  Given the uncertain job market, we decided to prioritize increasing our nest egg rather than paying down our car loan ASAP.  We make the monthly payments, but we're not trying to pay off the car until we've built our nest egg.  To us, the peace of mind is worth the 4.6% interest rate.

How do you feel about car loans?  Unwise, or a necessary evil?