November 2001  Email this  Print this
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REDUCE YOUR DEBT
Take Charge
by Elizabeth Razzi & Catherine Siskos Suddenly, it seems the very weight of the U.S. economy -- if not the world economy -- rides on the broad shoulders of the American consumer. Will we confidently plow ahead, buying cars and clothing and computer gizmos? Or will we hunker down and conserve cash? In World War II, citizens on the home front were exhorted to save, save, save, whether it was tin cans, cooking grease or war bonds. In the first war of the 21st century, we are being exhorted to spend to keep the economy out of recession. But before you march out to save the economy, is your own house in order?
The latest statistics show a nation already shouldering record-high installment debt, some $700 billion -- mostly on credit cards. That works out to $10,000 for a family of four -- and doesn't count home mortgages or car loans. Today's credit card debt has ballooned three and a half times since 1990.
Clearly, millions of Americans are already in too deep. Before the year is over, personal bankruptcies are almost sure to hit a record high (see "The Last Resort").We'll show you how to find help if you're in too deep. And if you're already on top of your game, we'll show you ways to flex your financial muscles by borrowing smart -- and cheap.
Control your cards
Stories of Americans whose finances have been sabotaged by little pieces of plastic are legion. And it's no wonder: Interest accruing at 18% or more a year can quickly drain your future purchasing power. The average family that carries a balance on its cards owes about $8,100, according to CardWeb.com, a firm that tracks the industry. At 18%, that costs them nearly $1,500 a year or $125 a month that they can't spend or save.
If you carry a balance on your cards, do you even know what the interest rate is? If not, check the small print on a recent statement or call the card issuer and find out. You can probably find a better deal.
For inspiration, consider what 66-year-old Ira Stoller accomplished. Startled by the realization that he had run up $40,000 of debt on his cards, he swore off using them (except for gasoline for the long stretches he spent on the road as a salesman) and set out to pay off the debt and stop sky-high rates from draining his wallet.
A key part of his plan was to pay less interest by switching balances to cheaper cards. When an offer for a 9.9% MasterCard arrived in the mail, Stoller transferred $9,000 from a card with a 20% rate. Bingo. The interest charges fell by 50%. As similar promotional offers rolled in, the rates kept dropping -- 4%, 2%, 1% and finally 0%, for six months. "That was manna from heaven," says Stoller, who moved balances to as many 0% cards as he could find and used that vacation from interest to pay down more of the debt.
Before the rock-bottom teaser rates expired, he switched the balances to other cards with bargain introductory offers. By his reckoning, going in and out of about 40 cards saved him thousands of dollars in interest. Last year Stoller paid off the last of his credit cards, and he hasn't carried a balance or paid a dime in interest since.
Paying off your balance in full each month actually earns you a free loan from the card company. But carry over a balance and the relentless interest clock starts running on past and future purchases. And missing a payment can cost you dearly.
Consumer Action, a nonprofit organization that surveys credit card issuers each year, found earlier this year that 69% of issuers jack up the rate -- to as high as 29.99% in some cases -- after just one late payment. Many issuers will even raise the rate if you're late paying on another issuer's card -- regardless of your payment record with them. That's on top of late fees, which have more than doubled in the past five years, to as much as $35. And the issuers have become stricter about enforcing their deadlines. "It used to be five or ten days past the due date before they'd hit you with a late fee, and now it's a few hours," warns Robert McKinley of CardWeb.com.
A saving strategy
How soon you should mail in your payment depends on whether you carry a balance. "If you pay in full each month, stretch the time out and use the bank's money as long as you can," says Gerri Detweiler, author of The Ultimate Credit Handbook. But if you carry a balance, mail your payment as soon as the bill arrives. "Because the interest is figured on a daily basis, the earlier your payment arrives, the less interest you pay," she says.
As far as issuers are concerned, it's the squeaky-clean wheel that gets the grease. The lowest rates, best deals and most negotiating power for having fees and finance charges waived go to customers with sterling credit. That means paying on time and staying under 80% of your card's limit. If you miss a due date and get slapped with a penalty, call the card issuer and ask for a break.
If you routinely carry big balances on your cards, finding a cheaper source of credit can pay off handsomely. Borrowing against the equity in your home, for instance, converts the high-rate, nondeductible debt of your credit cards into one that is not only substantially cheaper but also tax-deductible (more on this strategy later).
When looking for ways to cut the carrying charges on credit card debt, don't overlook the power of your savings. Michael Furois, a financial planner with Planning Associates, in Chesterton, Ind., has seen clients keep $5,000 in a savings account instead of using it to pay down the balances on their cards. "Their savings are earning 2% and their credit cards are costing them 16%," says Furois. Raiding the piggy bank to pay down such debt instantly hikes your return by 14 percentage points.
Or, like Stoller, fight back by chasing sweet deals. But beware of hidden costs. Some issuers charge fees of 3% to 5% of the amount transferred and have introductory-rate periods that are as short as two months before the rate jumps. Many cards also charge a higher interest rate for new purchases than they do for balance transfers, and apply your payments to the lowest-rate debt first.
The good news is that some card issuers offer low fixed rates to cardholders with good credit so that you may not need to keep transferring balances. But don't wait for the best rates to come to you in an offer in the mail. Call your issuer and ask for a better deal. When Curtis Arnold was chasing rates for the $20,000 he owed on several cards, he periodically called issuers and said he was thinking of switching unless they gave him a lower rate. "Occasionally they would say nothing was available," he says, but most of the time he got what he wanted. He has since founded CardRatings.com to help consumers find the best deals. Consumers who have the best credit and carry a balance have the best chance of getting such breaks.
A break on student loans
Those struggling to repay student loans will get a break next year when the end comes for the silly rule that now allows a tax deduction only for interest paid during the first five years of repayment. Starting in 2002, qualifying interest can be written off no matter how long it takes to pay off your loans. Also starting next year, grads with higher incomes will be allowed to deduct their student-loan interest. The deduction will phase out as income for single taxpayers rises between $50,000 and $65,000, and for married couples between $100,000 and $130,000.
Interest rates on student loans also have been falling. The rate you pay depends on the type of loan you're paying off and when you borrowed the money, says Vicki Zacchetti of Collegiate Funding Services. If you have a Stafford, Perkins, PLUS or any other variable-rate loan, the interest rate can change every July 1, and you have until the following July to lock in the rate for the remaining life of the loan -- by consolidating all existing loans into a single new loan. The rate you'll pay is a weighted average of the rates on your old loan, rounded up one-eighth of a point. Today's low rates make this especially enticing.
Borrowers get only one shot at refinancing. So if you've done so already, you're stuck with your current rate, unless you pay off the loans with another kind of debt, such as a home-equity loan.
"In a lot of cases, though, student loans have such competitive rates that they're not worth paying off with a home-equity loan," says Andrew Keeler, a certified financial planner with Everhart Financial Group, in Columbus, Ohio. This is particularly true if you are paying less than $2,500 in interest a year -- the amount that's tax-free on student loans.
Downshift your car loan
The 2001 Lexus RX 300 that Mark Freeman bought last May was costing him a mint. At 8.25%, the monthly payment on his $40,000 car came to $850. Meanwhile, his stock portfolio was stuck in neutral and showed signs of shifting into reverse. So Freeman, 41, cut loose his Microsoft and Schering-Plough stock, exercised his stock options to buy -- and then sell -- Cisco Systems, and used the resulting $40,000 in cash to pay off his Lexus a month after buying it. "Stocks probably aren't going to go up much this year, so if I pay off the car loan it's like getting an 8.25% return," says Freeman.
Some financial planners applaud this approach. Others cringe, warning about capital-gains taxes on the liquidated stock and denouncing the idea of trading an asset that can appreciate for one that will surely depreciate. There's no certain answer whether Freeman's move will pay off for him, or if a similar strategy would work for you. It really comes down to the prospects of the stock you'd sell and what other options you have for investing the money. After all, if you sell stocks or mutual fund shares for a loss, you could grab a valuable tax deduction as well as eliminate interest payments on a car loan.
You might also be able to reduce the cost of your auto loan by paying it off with funds borrowed on a home-equity line of credit. The point is this: Look at what you're paying on the money borrowed to put you in the driver's seat, and then take the time to look for cheaper alternatives.
Make your mortgage work
When it comes to consumer debt, the home mortgage is the big kahuna. You have a multiplicity of ways to borrow to buy a home, as well as opportunities to use home equity as a source of low-cost credit for other purposes. The fact is, debt secured by your home is usually the cheapest way to get your hands on cash.
Refinancing may sound like old hat. After all, as interest rates have fallen in recent years, millions of homeowners have already cashed in. Because the cost of refinancing has dropped to an average of just one-half point -- $500 on a $100,000 loan -- it takes only a small rate break to make refinancing pay off.
Jeff Bates, executive editor of Slashdot.org, an online newsletter, is typical of today's smart mortgage manager. With a $500,000 mortgage, Bates knows that even a small rate change can yield big savings. Although he took out his loan only last year, when rates fell, he jumped on the opportunity to cut his monthly payment by $600. As a guy who practically lives on the Web, he went for an Internet-based mortgage from Quicken Loans, which cut out the need to actually schedule meetings in a loan officer's office.
He cut his mortgage payment from $4,500 a month to $3,900 a month by pushing his already good rate of 7.25% down to an even better 6.625%. He paid about $1,000 in fees (but no points) to snag the deal. "I figured that in two months I'd make my money back," he says.
Bates is also evidence of the comeback of the adjustable-rate loan. Short-term interest rates, which influence ARMs, are more sensitive to rate cuts by the Federal Reserve Board than are the rates on 30-year mortgages. The rock-bottom rates on ARMs are attracting buyers again, especially those who don't expect to hold on to their mortgage long term.
Last year Bates bought his West Newton, Mass., Colonial-style home with a "5-1 hybrid" loan. He still had four years to enjoy the fixed rate of 7.25% before the loan would switch over to a rate that adjusts annually. But he has tentative plans to move in a couple of years. So when he refinanced, he saw no need to lock in a rate for even five years. He jumped on the lowest rate he could find: His 6.625% loan is a one-year ARM. As you think about the best mortgage for you, consider how an ARM or a hybrid might fit into your plans. Why pay a higher rate to lock in a 30-year loan if you're likely to move within the next two or three years?
Second shot at equity
How much home equity do you have -- that is, how much more is your home worth than the balance on your mortgage? In the late '90s, a wave of questionable advice suggested that homeowners pull out some of their equity (via a cash-out refinancing or a home-equity loan) and invest the money in the roaring stock market. Interestingly, that borrow-low-and-invest-high advice hasn't been heard lately. But borrowing against your home to pay off higher-cost debt makes sense.
In fact, refinancing high-rate debt (especially credit card balances) is the number-one use for home-equity loans and lines of credit, according to the Consumer Bankers Association. Financing a home improvement is number two. And you can expect lenders to pitch you even more offers.
Only 24% of U.S. homeowners have home-equity debt, aside from the mortgage they used to buy the house, according to Doreen Woo Ho, president of the national home-equity group at Wells Fargo & Co., one of the nation's largest mortgage and home-equity lenders. "There is $5.5 trillion of untapped equity that is eligible for a line of credit or loan," she says. Brace yourself for a flood of offers. And don't automatically throw them in the trash with the other junk mail. It's a sure thing that you're better off tapping your equity to pay off higher-rate credit cards and consumer loans -- as long as you don't run those high-rate debts back up again. A tax-deductible rate of 7% or 8% always beats an 18% rate on a credit card. After Uncle Sam and state revenuers subsidize the mortgage debt with tax deductions, the real cost of a 7% home-equity loan is likely to be less than 5%. (The law allows you to deduct the interest on up to $100,000 of home-equity debt.)
A fixed-rate home-equity loan -- with a regular payback period -- is the safest route to freedom from high credit card balances. Of course you have more flexibility with a line of credit that you can access by debit card or check. Interest accrues only on the amount borrowed, and most lenders allow you to make interest-only payments during the early years of the loan. Rates are usually pegged to the prime rate. Borrowers with the best credit scores can shop around for a rate equal to prime; most borrowers can expect to pay one-half to one point above that benchmark. | 
GETTING STARTED