Ins and Outs of Debt

When you hear "debt," you don't think it's a good thing. And most of the time you are right. Too much debt can cause you real trouble. But there are also times you will want to use debt wisely. Buying a house or a car involves getting into debt, but in a way that can prove you are a responsible adult who can handle your money.

Getting Out of Debt

The Big Picture

Debt is tricky. If you are heading for trouble, fix your current problem first, then plan to stay out of future trouble.

To keep your head above water, you will have to increase your income or cut back on your expenses.

Watch your credit cards for signs of increasing debt and signs of trouble.

How can you tell when you are under financial stress? Getting in over your head? If bill collectors are calling, you are in financial trouble. But what if you are simply having difficulty stretching your paycheck to pay monthly bills? Answering yes to any one of the following questions could indicate financial stress:

  1. Do you routinely spend more than you earn?
  2. Are you forced to make day-to-day purchases on credit?
  3. Are you able to make only the minimum payments on monthly credit card debts?
  4. If you lost your job, would you have difficulty paying next month's bills?

Three basic steps to get out of financial trouble:

1. Fixing the Current Situation
To fix your climbing debt, you have to make more money or cut expenses. Because making more money is not an option for most people, you must reduce your current expenses. Consider these steps:

2. Fix Your Credit
If you have creditors demanding payments, deal with them realistically. Contact your creditors and let them know you're having difficulty making your payments. If you have had a temporary financial setback, explain it. Try to work out a payment schedule with your creditors. Most are willing to work with you and will appreciate your honesty, but they will want regular payments.

The Fair Debt Collection Practices Law prohibits a debt collector from telling anyone but your attorney how much you owe, harassing or threatening you, using false statements, giving false information about you to anyone, and misrepresenting the legal status of your debts. Under federal debt-collection laws, creditors cannot seize most government assistance and can only garnish a portion of wages to collect debts.

For more information, see related topics: Credit Reports, Bankruptcy

3. Stay Out of Trouble
The most important aspect is to know what financial condition you are in now and how you got that way. Then, as you make changes, you should keep going back to see how things are progressing. One of the most important tools for doing this is creating and following a set monthly budget.

Getting a Handle on Credit Cards
Re-establishing good credit starts by paying off current debt. Close unused credit cards and voluntarily lower your credit line to limit the total debt you can get into. As you pay off certain debts, close the accounts and make sure each company sends you a confirmation.

Ideally, you should carry one or two bank credit cards (according to www.myfico.com, the average household in America has nine credit cards) and no more than three cards. When creditors look at your credit file, they want to see that you can handle more than one credit account at a time. You can do that by using a card and paying off the amount in full each month.

Creditors frown on applicants who have many open credit lines. Keeping cards open that you don't use may lead to denied credit. Rejected credit applications are kept in your file. Too many don't give a good picture of you.

A credit report that shows voluntarily closed accounts looks a lot better to your creditors than those that have been involuntarily closed. Review your credit report to verify that all of your actions are being processed.

Using Credit to Re-establish Credit
Regular payments on credit cards creates a strong credit history. If you have a credit card, use it every month—make small purchases and pay them off to avoid interest charges. If you don't have a credit card, apply for one. If your application is rejected, try to find a cosigner or apply for a secured card—covered by pre-payments into a savings account.

It takes about two years to rebuild your credit so that you won't be turned down for a major credit card or loan. Even people who have declared bankruptcy can generally apply for a mortgage with two years of re-established credit. Approval depends on the amount of re-established credit as compared to the severity of the credit delinquencies.

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When Debt Works for You

The Big Picture

A home is a basic necessity. But should you buy or rent? There are advantages and disadvantages to both.

Renting is a good short-term answer to housing, but short-term places still need to be in an acceptable location.

How much can you afford to spend on rent? A worksheet helps you figure it out.

What should you look for in a rental property? Create a list that works for you.

What rights do you have? What rights does your landlord have? Interviewing a landlord requires some preparation.

What to look for in a rental contract.

Debt isn't always a bad thing. There are times in life when you will want to own a house, and take advantage of the tax breaks a house offers. Credit cards, when used wisely, can be useful in establishing credit and showing you are a responsible consumer.

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Selling Your House

The Big Picture

Reasons for selling a house, from foreclosure to making a profit.

What you can do to make your house attractive to sellers.

Advantages and disadvantages to selling on your own and using a real estate agent.

Understanding agreements, from a real estate agent's listing agreement to a buyer's offer, contingencies and inspections.

What to expect at closing.

Sometimes the decision to sell a home is a simple one. You have been transferred to a different part of the country. You may be experiencing a change in marital status. Maybe your farmily is growing and you need more space.

Maybe home values in your area have risen and you want to sell for a profit. If you are a seller in a seller's market, this strategy is a good idea, even if you haven't been living in your house for a long time.

Should you find a new home first, before putting your house on the market? This will depend on the housing market in your region. If you know your home will sell quickly, wait until you have a ratified contract on the home you want to buy before listing your current home.

What if you are facing foreclosure?
Before you take action, talk with a local housing or credit counselor. There may be strategies you can use to work with your lender to avoid foreclosure and get back on track with your mortgage payments.

Prepare to sell your home without spending too much.
Once you decide to sell your home, look around and decide on improvements that will get a better purchase price. Your real estate agent can make objective suggestions; listen to them. Here are some things you can do without spending too much money.

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Mortgage Basics

The Big Picture

What a mortgage is and what a lender looks for before offering you a mortgage.

The difference between fixed-rate and adjustable-rate mortgages and balloon payments.

Other kind of mortgages and how to compare what they offer. Fees, rates and payment dates all make a difference.

Mortgage Basics
A mortgage is a loan used to buy real estate. The mortgage is actually a lien—a legal claim—on the home or property that secures the promise to repay the debt. Mortgages have two components: principal and interest. You can get a mortgage from a bank, a credit union, a mortgage company or sometimes even a seller (or other private party) to buy or refinance a home.

Before you need a mortgage, it's smart to understand enough about them to let you pick the bets rates and type of mortgage. Knowing exactly how much you will be spending on your mortgage each month will help you separate the amount you qualify for from the amount you can realistically afford.

You don't need to know about every mortgage product in the industry. Get an overview of the basics, then do some research at the library, on the Internet or ask questions of experts—your real estate agent, loan officer or mortgage broker. You may want to meet with a local housing counselor or take advantage of the expertise of a good buyer's real estate agent. Here is some information to start with.

Mortgage Categories
There are two categories of mortgages that nearly all lenders can offer: government-backed mortgages and conventional mortgages. Government-backed mortgages are insured by the Federal Housing Administration (FHA) under the Department of Housing and Urban Development. Government-backed loans are for borrowers who need lower down payments or have lower incomes. These are geared toward first-time home buyers and can be very useful.

Conventional mortgages are either privately insured through private mortgage insurance companies or not insured at all. They are ideal for buyers with larger down payments. If you have a limited income or limited down payment, you still may qualify for a conventional mortgage. Be sure to ask when you are meeting with lenders.

There are different types of mortgages to consider as well.

What's in a Mortgage?
Nearly all mortgage loans have monthly payments that are due at the beginning of every month. Some loans have bi-weekly options. Included in each payment are principal and interest. The amount borrowed is the principal. The interest is an amount calculated using the rate (percentage) that you must pay for the privilege of borrowing. Your mortgage payment is divided into paying off your principal and your interest. This process is called amortization. In the first years of your mortgage, almost all the money will go to interest, allowing you a bigger income tax break.

How Long a Loan?
Most loans are amortized over 30 years, but there are 5-, 10-, 15-, 20- and 25-year terms as well. The longer the term, the lower the payment; but the longer the term, the more interest you will pay.

Refinance your mortgage.
Homeowners can consolidate their short-term debts by refinancing their homes. A lower mortgage rate and a rising value of your house means you can take out cash when you refinance and pay off your bills. The lower mortgage rate also lowers your monthly payments substantially. Refinancing does spread the payment of the short-term debt over a longer period of time, but with a lower rate, it might be worth it.

The problem with consolidating debt into one loan? You may feel free to start spending more on credit cards. If you are using your home as collateral, be clear on how you are going to change your spending habits. The only way to stay out of debt is to control it.

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Types of Mortgages

Fixed-Rate Mortgages (FRM)
The benefit of a fixed rate mortgage is that the rate of interest remains the same for the life of the loan.

Adjustable-Rate Mortgages (ARM)
In an adjustable-rate mortgage, the interest rate can move up or down to match current market interest rates. There is usually an introductory discounted rate, lower than fixed rates. Depending on the type of ARM, the first adjustment period can last for a period of one, three, five, seven, or 10 years before a change in rates occurs. Most ARMs adjust every year until the loan is fully paid. When you consider an adjustable rate mortgage, be certain you know how much the rate can go up in the first adjustment, how much the rate can go up over the life of the loan, and whether it can be converted to an FRM.

Interest-Only Mortgages
In an interest-only mortgage, the borrower only pays interest (plus property taxes and homeowners insurance) on the loan. This usually results in a lower monthly mortgage payment. The borrower does have the ability to pay extra toward the principle.

Balloon Loans
Balloon loans are either not amortized or partially amortized short-term loans that become due in a period of usually three, five, seven, 10 or 15 years in one large payment. In most cases the payment is based on a 30-year loan and has an attractive discounted rate similar to ARM rates. The main difference between an ARM and a balloon loan is that an ARM becomes due at the shortened maturity date. In some cases a balloon loan may have an interest-only payment that may keep the payment lower than an amortized loan. Keep your eye on the date, and avoid a huge payment by converting before the balloon payment comes due.

First-Time Buyer Programs
Many lenders offer affordable mortgage choices geared toward the first-time home buyer. These choices clear the obstacles that made purchasing a home difficult in the past. First-time buyer programs can help borrowers who have not saved a lot of money for the down payment and closing costs, have a poor credit history or no history at all, have quite a bit of long-term debt, or have an unstable income.

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Second Mortgages or Equity Loans

The Big Picture

Restructuring debt can be improve your financial situation.

The difference between a second mortgage, an equity loan and a home equity line of credit.

How to avoid foreclosure.

Second mortgages or equity loans can serve several purposes. You can renovate your house, pay off debt or even refinance to take out an education loan.

If your debt is eating up a big percentage of your income, you may need some debt restructuring. One way to restructure and consolidate debt is to take out a second mortgage—or home equity loan—on your home. Applying for a home equity loan is much easier than the process you underwent in applying for your original mortgage. To qualify for a home equity loan, your credit must be in good standing and you must be able to document your income. Beware of zero- or no-equity loans, which enable you to borrow up to 125 percent of your home's value. Such loans have higher interest rates and tighter qualifying standards.
There are two main types of second mortgages:

  1. Home equity loans
  2. Home equity lines of credit

Home Equity Loans
A home equity loan is a lump-sum loan and is generally amortized like most first mortgage loans. The difference is that the home equity loan is a second loan against your home behind the first mortgage that you already have. The closing costs for a second mortgage are lower than closing costs on a first mortgage loan. The rates on home equity loans are fixed rates that are slightly higher than fixed rates on first mortgages.

Home equity lines of credit (HELOC)
A line of equity is similar to a home equity loan. There are some differences that make a difference:

Both loan types can be effective in reducing your overall debt. Another benefit of a second mortgage or home equity loan is that you can deduct this interest on your taxes. However, don't be too quick to decide that this is the best solution for you. You probably don't want to deplete all of the equity in your home just to reduce your monthly bills. Be careful if the combination of both the second mortgage and your first mortgage goes beyond 90 or 95 percent of the value of your home. You don't want to be in a position where the sale of your house does not cover the debt that you owe plus real estate fees.

Remember, if you cannot make your second mortgage or home equity loan payments, you could end up losing your home.

When is a Good Time To Refinance?
The old rule of thumb was that you should refinance only if the rate is at least one percent lower than your current rate; but in these times of "no- or low-cost" refinance loans, you may decide that refinancing is in your best interest. If you are halfway through your mortgage term, it's probably not in your favor to refinance because you are now paying more in principle than interest.

Why should you refinance? Let's take an example: Say that you purchased your $150,000 home three years ago with a 30-year mortgage at 7.5 percent annual percentage rate (also including $2,000 per year in property taxes and $400 per year in homeowners insurance). Your monthly payment would equal $1,249:

Now, consider refinancing the $145,382 principle balance today at 6.0 percent annual percentage rate for 30 years, the monthly payment would go down to $1,072:

If you stayed in your home for the next 30 years, you would save over $50,000 in interest payments. In this example you have extended your loan term an extra three years; you may use all (or part) of the monthly savings to pay down the principle; doing so would reduce your time-frame on paying the loan.

You do not necessarily need to refinance with a 30-year mortgage loan; you can refinance with a 15-, 20-, or 25-year loan. The interest rate on a 15-year loan is usually 0.5 percent less than a 30-year loan, and the 20- and 25-year loans about the same as a 30-year. But, you would be shortening your time in paying the loan.

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