Archive for the 'Scenario' Category

17
Mar

Would You Refinance Your Debt at 7% Interest?

By David 0 Comments
Categories: Debt Repayment and Scenario

I believe I have the golden opportunity, here. For once, my financial aid finally went through for school, and while I wasn’t approved for “free money” like grants or need-based scholarships, I was approved for federal stafford loans. Not only does this mean I can go back to school in summer, but it also means I will have an extra $3000-8000 to work with, if I so choose. Here’s the deal; most of that is in unsubsidized stafford loans. This means the loans sit there, gaining interest, until I enter repayment. This means a higher initial principal, but I don’t have to worry about high interest rates. However, when you compare that to credit cards, astronomical rates, and generally feeling like a ruined man, I think there is only one path forward.

I’m going to pay off my credit card debt with student loans.

Here’s my train of thought. I pay $300 per month in credit card minimums, normally about $500-600 per month as I can. At this rate, it might only take me a year to finish paying everything off, assuming I can find ways to add to that snowball. So over a year, I’m not really paying a ton in interest rates if I continue this method, but I’m still paying about an extra $1k in interest over that period. And as I learned when I lost my job, nothing is permanent. At any moment something could sweep by and ruin my whole plan. If that happens, I don’t want to be stuck with high interest rates. Enter the student loan. If I still put $500 or more per month toward that loan, it will take me between 11-13 months to pay off the debt, only a few less than my current method. However, the money I pay each month goes largely to principal, and if something happens to wreck my plan (losing a job), I’m not even in repayment yet! Not only will I be able to pay off this loan, but it should free me up to be able to pay off more than this student loan by the time I graduate. Meaning I graduate owing less in student loans than I already do right now.

I think it’s the smart move to make. If my future was certain, I’d just continue my current plan and get it paid off. However, I know with my job comes a direct pay increase once I get my degree, so I can count on making more money when I actually enter repayment. If something does go wrong, it’s effectively like hitting a pause button; I’m no worse off for it. With regular credit cards, they are not too keen on giving you free money. The best case scenario is that I pay off my debt even earlier, and the worst case scenario is that I freeze my debt where it currently is.

Some side benefits are peace of mind, likely a giant leap in credit score, the knowledge that if something happens to my situation I’ll be ok, and the ability to start putting money towards solid investments greater than 7% return (peer to peer lending comes to mind). I can’t think of any downside to this plan. Granted, I technically can’t use student loans to cover debt repayment, but I can use them for food and rent, and then rebudget that money to pay off the credit cards. The net result is that by August, I will have no debt at an interest rate above 6.8%! You can’t touch that type of refinancing with a ten-foot sub-prime pole!

Can anyone foresee any problems with this arrangement?

01
Aug

When it Makes Sense to Consolidate

By David 4 Comments
Categories: Debt Repayment and Scenario

My roommate is in a similar position to me, but without quite as much credit card debt. He is faced with about $3,000 in credit card debt, and about $14,000 left on a car note. He looked at his situation, and is really not able to put more money each month toward the credit card debt. He has enough for minimums plus maybe a little bit extra. His credit cards are around 22-24% APR, and his car note is around 7-7.5%. He has four years left on his car, and by paying minimums about a century left to pay the credit card debt off.

He has been looking into consolidation lately, and visited Wells Fargo, who denied him a consolidation loan for the credit card debt. They said to come back and refinance the car along with it, and they could probably do something. So after estimating that a 4-year refinanced note for $19,000 (to pay off cards, car, and establish an emergency fund to keep from using cards again) at 10% would be about the same monthly payment he’s already making now. While he’s taking a bit of a hit on the car portion, it enables him to eliminate all credit card debt faster than he can pying minimums. I agreed it might be good to look into, so he went to Wells Fargo again.

It didn’t go well, to make a long story short. The best they could offer is $19,000 at 22% interest for 5-6 years. Obviously he could see it made no sense at all to do this and left right away. However, when I had a chance to use some calculators, I’m actually glad they didn’t give him the deal I’d estimated. Just goes to show your head can be a bit tricky, and you should always verify a scenario using actual math.

Adding the numbers for long term cost, he will have paid $8,000 or so on those credit cards, and about $16,000 on the car, for a total of $24,000. Even if he got the consolidation at 10%, he’d still be paying about $23,500 towards his total debt. In this situation, it might not make sense at all to consolidate. Since the primary portion of his debt is lower interest, it would be better for him to keep finding other ways to pay off the credit card debt sooner. I am going to advise him to try to get his interest rates lowered (he has made good payments for awhile, so that will help his standing). Luckily, in just a month his FICO score improved about 30 points, so that can’t hurt either. I will also advise him to try to pay even $25 per month extra on his cards. If he can even pay just $25 extra per month, he’ll have it paid off in 3 years. If he can pay an extra $55/month, it would shorten it to right over 2 years, and he’ll only pay a total of around $4,200, which is a much better deal than if he were able to consolidate.

I learned a few lessons from this, which I hope will keep me from making the mistake of consolidating when it doesn’t make sense.

1. Never consolidate upwards. The fact that $14,000 at ~7.5% would be moved upwards at all is a pretty good indicator it would never work. You almost always lose money this way. While adding the car enabled him to get a loan at all, even at a low interest rate of 10%, it does not make sense. I imagine raising the rate only works when the low interest debt is a tenth or so of your total debt, or at least less than a quarter.

2. Credit Unions aren’t always the best deal. I find it absurd they didn’t see the opportunity to make interest they would not have been able to make otherwise. The minimums would have stayed the same and his credit score is improving, so there is little risk in defaulting. It would have been an easy $6,000 income for Wells Fargo. While local credit unions usually have a good reputation for really looking at the customer’s needs, it was clear the guy didn’t even have a clue here. I’m pretty sure that’s turned me off of Wells Fargo, if they can’t even understand math any high schooler could do. Granted, if the person is in financial trouble, they may be willing to sacrifice and get a higher rate for a longer term (I imagine most refinance deals are like this), but my roommate was clear that he simply wanted to be able to pay off his debt earlier. It was obvious he got some sort of standard treatment instead of someone paying attention to his debt and giving him a workable solution.

3. The raw power of extra payments. Even $15 extra per month cuts the total credit card payment term in half or more. It is clear that to pay off any debt, you should first try to put extra money into it, then try to get the rates lowered. Only when you find lower interest rates should you move money around. But anyone can come up with an extra $25 per month and be out of debt in three years, and most can find $55 for only two years. Even if you sacrifice something little, it’s totally worth that extra bit. Even $10 extra per month takes years off your repayment schedule.

So, while it’s disappointing he won’t get the easy way out (we single guys love the thought of only having to pay a single bill towards debt), at least there is a more workable solution than the credit union could offer. While it’s certainly not always fun to lower your standard of living to make extra payments to debt (it’s more fun to buy than pay for things you bought a long time ago), it certainly makes mathematical sense. Here’s hoping he can squeeze in some extra payments, and perhaps his creditors will give him a little break on his rates.

12
Jul

A Free Car? Not Really…

By David 0 Comments
Categories: Major Purchase and Scenario

Today I found this post on Dave Ramsey’s “Drive Free” plan via The Simple Dollar, even though it’s been around awhile. Now, I’m a good INTJ and love thinking through scenarios. It’s what makes getting out of debt fun for me! I loved seeing the math on this one, as I heard about this plan a year ago and immediately thought there was something fishy about the math, and the simple reality that cars depreciate. Fast.

Put simply, Dave Ramsey’s plan fails on several grounds. First, you should plan on saving upwards of $450 per month for it to work remotely. Second, you’ll be buying some incredibly unreliable cars at the beginning, causing potential need for major repairs, ruining any chance of this working. Third, you won’t be in a new car for 6-7 years or more at the rate of upgrading. Fourth, you have to pay taxes/tag/title every year! Fifth, it doesn’t change the fact you’re putting away $450 a month for the next decade or more. For someone who has a lot of good monetary advice, it surprised me how wrong he is on this point.

This inspired me to figure out my own scenario. As a nuclear engineer, I was/am all too familiar with the concept of decay, and the types of models they present. I’m not so hot on calculating the cost benefit scenarios of owning a house (yet), but knew I could come up with something that takes advantage of the depreciative value of a new car.

First, I had some conditions. I do not want to ever spend more than $300 per month on a vehicle, unless my financial situation has a major shift in the next decade. Second, I don’t want to buy used again. Third, I want to trade in the car at that sweet spot of few repairs and maximum trade in value, or the plateau in the depreciation curve. I calculated about 7-8 years on most cars for that to happen, given more than average driving (150k miles in 7-8 years). Fourth, I don’t demand an incredibly nice car each time, but I do want to progressively get nicer cars. Fifth, I don’t mind using credit to buy, as long as the monthly payments are ok.

I came up with this:

Car Buying Scenario

As you can see, I’m taking each car long-term. If you have to have the flashy newest car all the time, this isn’t going to work for you. But until I can afford my Bentley, I don’t mind driving a sub-$20k car for the next decade. I prefer to get a small economical car and then upgrade the heck out of it. It makes it feel more luxurious, rather than getting the standard package on a nicer model. I also use consumer reports regularly, so my trade-in values are maximized and I don’t get a lemon. The trade-in values I used in the chart may be a bit off, but the plan still works; just slower.

My current car is a 2005 Impala I bought in Jan 06, with 30k miles at the time. I expect it to last me seven years total before repairs start mounting (compare this to a $4k junker that Dave wants you to buy). At that time, I will have about $8,000 to put towards a new car. This means I can now finance a cheaper amount on a much nicer car, which means I can then drop to a 3-4 year note, rather than 5. This means, in turn, I can upgrade sooner, I can maximize the trade-in value, and will have more years of savings the next time I upgrade. Eventually, I will be able to get a $25k car on a 1-year note, still paying just $250 per month. If you follow it to its natural conclusion, I will one day be able to purchase a $30k+ car with cash.

I purposefully do not calculate in the interest gained during the savings periods. That extra money can be used for the taxes/tag/title. I also do not include the tax benefits in claiming depreciation on the new cars, which also saves you a little bit. If you look at the chart, you can see how even bumping it up to $300 per month would either get me a much better car, or allow me to upgrade more quickly each time. I simply pay $250 or so for the next few decades, and I’ll eventually be in a BMW. Or a nice mini-van, depending on my family situation then.

The issue here is whether or not you feel comfortable using credit wisely. Currently my car note is only 4.8% interest, which would make it stupid to pay cash ahead of time, considering I can earn more than that over five years in one of many available savings accounts. When you factor inflation into the equation, it makes the scenario even better to use credit for a car purchase rather than paying cash up-front. In fact, if you get a good rate like I did, it almost makes more sense to finance the whole car for 5 years every time, and keep your money in savings to use for the monthly payments. I have not run the calculations on that, but I imagine you would be able to add $1-2k to each new car given the extra returns, and a lot of dealers will give you a better deal if they know you’re financing for 4-5 years. Also, if you’re willing to stick with a cheaper car all the time, you can decrease your monthly payment gradually, making your car less of a monthly burden.

The best thing is if problems happen, such as an engine replacement or something major (worst case scenario), it doesn’t ruin your whole plan. You use your current savings, and the next upgrade, you simply buy less of a car or even finance slightly longer. Also, the major thing in all this is that you don’t have to start some plan right away! You simply start where you are (likely making payments on a car), make a commitment to save about two years after repayment before buying again, and let the cascade begin. The point here is that if you don’t have to have the newest thing all the time, and are confident with using credit to your advantage, you can come out better in the long run, without making major sacrifices in the beginning.

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