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dollars & sense

PENNYWISE, POUND FOOLISH
Be Smart About Debt—It’ll Save You in the Long Run
By Daniel Roccato

You would never know it judging by the daily barrage of credit card offers that invade your mailbox, but there really is no such thing as “good” debt. But if pressed, I will admit that there are some types of debt that are “less worse” than others.

There are essentially two types of debt. Convenience debt, for example, credit cards, is related to purchases of consumable goods and services. This is the worst kind of debt and usually has the highest interest rates. To demonstrate my point, let’s suppose you charge a $2,000 family vacation to a credit card with a not too friendly – but common - 21 percent annual interest rate. By just paying the minimum each month, it will take you more than 24 years to pay off the vacation and result in total interest charges of $4,000! Your vacation photos will be faded and dog-eared by then.

You can see why the combination of easy credit and poor financial education results in financial distress for many families. A few simple-to-follow guidelines can help you avoid major financial headaches:

1. If you can’t afford to pay cash, don’t buy it.

2. Keep one credit card for emergencies, car rentals, interest transactions, etc.

3. Pay the full balance every month.

4. Shop for the lowest interest rates with no annual fees.

The other type of debt can be called “asset-related” debt, which is sometimes referred to as “good debt.” This type can be better than convenience debt, since it enables you to fund the acquisition of an asset that will increase in value. The most common example of this is a home mortgage. Other examples include a loan to fund a business start-up or a student loan that enables a person to improve their career prospects. For the most part, asset-related debts can be viewed as a worthy investment that can ultimately improve your overall financial situation.

But even good debt needs to be prudently managed. For starters, be a smart shopper. Lending institutions are extremely competitive and will aggressively seek your business, particularly if you have an excellent credit history. For most of us, purchasing a home will be the single largest investment we ever make. With just a little homework, you can save thousands of dollars when it comes to selecting a mortgage.

Many people will spend more time clipping coupons from the Sunday paper than shopping for a mortgage. Don’t limit your choice to the mortgage company recommended by your real estate agent. By shopping around, you might find a better rate. Be sure to consider small local lenders who might be more competitive given their knowledge of your particular market.

The best way to save money while building home equity faster: a shorter mortgage term. Saying no to a traditional 30-year mortgage in favor of a 15-year mortgage can save you a bundle. For example, at today’s interest rates, you’ll save more than $130,000 in interest costs on a $200,000 mortgage by going with a 15-year mortgage. Sure, your monthly payment will be a bit higher but the savings are just too large to pass up. Check out these statistics to see it in real terms:

Mortgage Example: $200,000

Term    Interest Rate     Monthly Payment   Total Interest

15 Year      5.5 percent        $1,626             $94,150

30 Year      6.0 percent          $1,200           $231,676

While it is important to save for life’s big-ticket items like retirement and college, don’t neglect the debt component of your family’s balance sheet. Let yourself dream for a minute. Go ahead imagine life with a purse that’s not weighed down by plastic, actually being happy to see the mail carrier, becoming one of the “abnormal” Americans without a mortgage. If you like the feeling, get to work!

Dan Roccato is a financial advisor who helps families across the region make wise decisions. Contact him at 856.222.0110