by Dave Kutcher
When things are going well it is easy to forget simple financial “rules to live by” because when markets perform they help erase mistakes with little consequence. However, things aren’t always good, and it is at those times when we reflect and wish we had stuck to some basic tenets of financial success for our respective households.
One of the first things each and every one of us should focus on in terms of maintaining financial strength in our respective households is keeping ourselves in a position of strength in terms of credit.
When you have a strong credit management history (high credit score) it means you have access to financial resources under the most favorable conditions. It means you will have access to more resources than those that don’t maintain good credit, you will get access to that credit under the most favorable conditions (lowest cost to access credit) and if you get into serious trouble during “rainy day” events in your life, you will be received most favorably by those with whom you are seeking help.
So, rule number one is to put yourself in a position that will serve you best when times are tough or for when you need to leverage your existing financial resources in order to pursue other financial gains … buying a house as an example.
Anything that you purchase that requires you to access funds that you do not have, such as when you are seeking a mortgage to buy a home, will come to you under the most favorable terms when you have the most favorable record of managing your credit.
The lowest interest rates and most favorable terms go to those who have demonstrated that they can and will meet the terms of their credit arrangements as planned when the credit was granted.
Here is where people underestimate the power of good credit. Let’s look at an example to help us understand.
We have two individuals seeking the same thing; a $200,000 – 30 year mortgage to purchase a new home.
Candidate A has excellent credit and Candidate B has decent credit but less favorable than Candidate A. The two apply for the same mortgage and the terms of the loan are similar, but one received an offer at 6% interest fixed for 30 years and the other receives an offer of an 8% fixed rate for 30 years.
Our starting point of differentiation here is the monthly payment required to carry a $200,000 mortgage over 30 years. At 6% my monthly payment would be $1,199 for 360 months or $14,388 per year for 30 years.
At 8%, my monthly payment would be $1,468 or $17,616 per year for 30 years. Our monthly difference then is $269 or $3,228 per year.
If we assume the difference in monthly payment is manageable, meaning Candidate B can afford the $1,468 under current conditions, one might think there isn’t much to worry about here. Well, to start with, affording the extra monthly expense might be manageable during good times, but perhaps the additional monthly cost will be seen as prohibitive when things are not going so well for this Candidate at some time in the future.
Keep in mind when we say someone might be able to afford the higher payment, when applying for a mortgage, lenders have certain guidelines as to how much the mortgage can be in relation to your overall income and expense ratios. So, you might think you can afford something, but a bank lending you money for that purchase may have a different opinion in that regard.
If that is the case, that difference in monthly costs may actually prevent you from being approved for the $200,000 mortgage you are seeking. The result of which may be that you are required to put down a larger down payment to reduce your monthly mortgage payment to meet the lender’s ratio requirements or you need to find a different home for purchase that requires less financing on your part.
Again, however, let’s assume Candidate B can afford the extra costs at this time and the bank is willing to move forward … what’s the big deal that Candidate B has lesser creditworthiness than Candidate A.
When comparing costs to finance, it is easy to focus on the smallest requirement, the monthly payment … what is a measly $269 per month to get what you are looking for, right?
Let’s start with that small monthly difference and how that impacts the cost of my borrowing over the 30 years. We know the additional annual cost (not accounting for taxes) is $3,228 per years. $3,228 times 30 years equals $96,840, almost half of the original loan amount of $200,000. So, that small monthly difference cost Candidate B almost $100,000 in additional carrying costs simply due to their credit score when they applied for the mortgage. That is a very significant difference on a $200,000 loan.
Now, let’s look at how else that can impact Candidate B’s financial life over time. Candidate A could take that extra $269 per month and add it to their current monthly mortgage as additional principal payments and pay their mortgage off far ahead of the 30-year term … freeing up their monthly payment and allowing Candidate A to enjoy having an additional $1,199 per month to do whatever they want with since it is no longer needed for the mortgage payment.
Alternatively, Candidate A could take that $269 per month and save it toward any short- or long-term goal.
If Candidate A decided to save this additional money over that same 30-year period, even at a modest rate of return on their money, they will have amassed a sum of money far greater than the base difference in required payments noted above of $96,840.
In fact, $269 per month saved over 30 years at 5% interest would total $219,336 … more than twice as much as the base difference of $96,840. So, not only did Candidate A enjoy a lower monthly required payment, but Candidate A also now has an additional $219,336 to use toward retirement, as an example.
At 7% interest the result is $314,582 vs the $219,336 at 5%. And, along the way, had Candidate A encountered some unforeseen financial emergency, they would have the savings on the sideline to access at a time when they might need it the most. Again, alternatively, Candidate A might use that $269 savings to purchase something else they need or want which would otherwise be unattainable had their monthly payment been higher to secure the mortgage in the first place.
Hopefully, you are getting the gist of this message. Small differences add up to big differences and those big differences can have a meaningful consequence for your financial future.
So, maintain good credit and keep yourself in a position of strength for when you need to leverage your assets and income to make larger purchases such as homes, automobiles, etc.
The second basic rule for maintain financial heath in your household is “living within your means”. It is easy to get caught trying to “keep up with the Jones’s” in life. Particularly so if you do have access to credit. But the smart folks know just because you might be able to afford the carrying costs of financing purchases it doesn’t mean you should create that debt service to begin with to provide a lifestyle larger than your income provides.
We see this all the time where people make poor financial decisions to get something beyond their means otherwise. Automobile purchases are a glaring example of this phenomenon where folks will opt to lease a vehicle for personal use because they can now afford a monthly payment for an automobile that is beyond their means as a purchase vs. a lease.
There is a reason a lease payment is less than a purchase payment when buying a new vehicle … it is because you are not actually buying the vehicle. You are renting it for the cost of the purchase price minus the expected value of that same vehicle when you return it to the dealer at lease end. You have paid for the use of that vehicle, been required to treat it as if you own it in terms of maintenance and if you turn that vehicle in with excess wear and tear, you are required to come up with additional money to cover the costs of that extra wear and tear. You have not built up any equity in the vehicle over the course of the lease and therefore have nothing to show for the money you have expended throughout the term of the lease.
Let me give you one simple rule here in terms of leasing vs. buying a car. If you don’t own your own business and have a way to expense that vehicle’s costs to your business, you have no reason for leasing a vehicle at all. It is the worst possible decision you could make with your money. Find a vehicle that will serve your needs that is within your budget as a purchase, not as a lease.
Automobiles are NOT an investment unless you are participating in the collector’s market. Your automobile is a losing proposition in investment terms so the very least you can do is be sure you are gaining equity in something over time that you will be able to use when it comes time for the next purchase. Learn to be ok with what you can afford and stop seeking ways to gain access to things that are beyond your current means. You will always find Jones’s that have more than you.
Additionally, when determining what your means are be sure not to forget that you MUST be saving money for future use. Consider your savings just as any other expense and be sure you are allocating enough money to savings each month to meet your future needs, both short term needs along the way as well as the ultimate savings pool you will need, your retirement funds.
So, basic financial ideals to follow;
When you are young, establish and maintain excellent credit which will serve you well throughout your financial life and do NOT spend beyond your means.
As you mature, finance your own purchases through the savings you amass by being disciplined in your spending habits.
Establish and maintain an emergency fund and leave it alone unless it is absolutely necessary to use it. Hard times will come, and it is usually when you least expect it.
Be sure you have a well-established and sufficient pool of money to meet your needs during retirement when you will eventually be unable to produce income to meet your living needs.
My name is David A. Kutcher, a retired Marine Corp Captain. My business partner in the lower 48 is Richard C. Scott, CLU, LUTCF. For nearly 40 years we have been helping folks with their personal retirement decisions. We encourage you to make an appointment and get ahead of your concerns as early as is possible. You can catch us on the radio every Saturday morning, “Retirement in the Last Frontier”, 8:30-9:30 on AM 650, Keni Radio and on Tuesday mornings, KFQD News Talk Radio AM 750 and FM 103.7. Frontier Retirement, 10928 Eagle River Road; Eagle River, AK 99577, (907) 795-7452.
