Credit & Debt Category
Dear Liz: I am trying to help my retired parents refinance their home. Currently they are paying over 8% interest. (This loan should be illegal.) The problem is their credit score, which is around 536. They had a tax lien in 2004 (it has been paid off for over four years) and some minor credit card issues. The total card debt is less than $1,000. I see several bad footnotes on these cards. Some of the cards have a balance of less than $100. What is the best and fastest way to help them get the mortgage they deserve?
Answer: Your parents don’t have a single credit score. They each have their own scores. Mortgage lenders typically get FICO scores for each borrower from all three credit bureaus, for a total of six scores. Lenders look at the middle score for each person and typically base rates and terms on the lower of those two middle scores.
If that number is indeed 536, your parents have serious, recent credit problems. You may not think an unpaid credit card is a big deal, but it is to credit scoring formulas, which are designed to help lenders gauge a borrower’s risk of default. People with unpaid bills are far more likely to default on a new loan than people who pay their bills on time, and their respective credit scores reflect that reality. What people “deserve” isn’t a factor. How they handle their credit accounts is.
What you’re calling “bad footnotes” are likely records of late payments and perhaps charge-offs and collections activity. Those typically can’t be erased, but your parents can stop the ongoing damage to their credit by paying their bills on time and paying off any overdue bills to their credit card companies.
If the accounts have been sold to collectors, the process gets trickier. Paying off collections typically won’t help credit scores, but lenders usually want these accounts paid off before they will make a new loan. Your parents can try negotiating to have the collection accounts deleted in return for payment, but they won’t be able to erase the late payments and other negative marks reported by the original creditor.
Once they start handling their credit accounts responsibly, their credit scores will start to improve. The improvements will happen slowly, though, and they may well miss the opportunity to refinance at today’s low levels.
Dear Liz: I am trying to increase my credit scores so I can buy a house in a couple of years. My scores are pretty bad, but I do have a car loan that I have never been delinquent on. I have recently obtained a secured credit card with a $300 limit. Will a credit card with such a small limit help improve my credit score?
Answer: Yes, but you may need longer than two years to get your scores up to snuff, depending on how bad they are.
Regaining points always takes much longer than losing them, so you should make sure to pay all your bills on time and use your new credit card lightly but regularly. Charge less than $100 a month and pay the balance in full, because there’s no advantage to carrying a balance.
After six months or so of regular payments, consider adding another card to the mix. In a year or two, you may qualify for a regular credit card that will continue to enhance your scores.
Also, make sure you’re looking at your FICO scores, because those are the credit scores most mortgage lenders use. Other scores may be offered for free or sold by the credit bureaus, but they typically aren’t FICOs.
Dear Liz: How can I get a clear and complete picture of the debts that are hurting my credit score? I have my credit report already. I’m a bit lost and I need to get my credit cleared up to buy a home.
Answer: You actually have three credit reports, one at each of the major credit bureaus: Experian, Equifax and TransUnion. Your mortgage lender is likely to request FICO credit scores from each of the three, so you need to check all three reports.
You get your reports for free at one site: http://www.annualcreditreport.com. There are many sites masquerading as this free, federally mandated site, so make sure that you enter the URL correctly. You may be pitched credit scores or other products by the credit bureaus while you’re on this site, but you won’t be required to give a credit card number to get your free reports. (If the site is demanding that you give your credit card number, you’re at the wrong site.)
You should understand that old, unpaid bills may be depressing your scores, but paying them off may not improve those scores. In other words, the damage has been done. You may be able to reduce the impact if you can persuade the collectors to remove the accounts from your reports in exchange for payment, something known in the collections industry as “pay for delete.” But you probably can’t erase the late payments and charge-offs reported by the original creditor before the accounts were turned over to collections, and those earlier marks against you are even more negative than the collection accounts.
That’s not to say you should despair. Over time, your credit scores will improve as you handle credit responsibly. But you shouldn’t expect overnight miracles.
Dear Liz: We received $100,000 from the sale of some undeveloped land. We are trying to figure out the best way to pay off our bills. Our primary residence has a balance of $173,000 at 4.25% and is a 30-year loan. We also own a home we rent out in which we cover the mortgage with the rent income. The balance on it is $131,500 at 4.5% for a 20-year loan. This home is often a burden when tenants change on an average of every 1 to 2 years, and we don’t have the income to cover the mortgage without the rental income. My husband took a $20,000 loan out of his retirement fund for closing costs for our primary residence, a debt that is being paid back through paycheck deductions. We also have an auto loan with a balance of $7,800 at 2.74% and credit cards with varying interest rates with total owing of $22,000. What should we do?
Answer: Your first task should be examining your spending habits to see why you have so much credit card debt. If you don’t fix the problem that’s causing you to live beyond your means, you’re likely to find yourself in a deeper hole eventually, regardless of how well you deploy this windfall.
You also should see if you’re on track with retirement savings. Boosting your retirement plan contributions at work and to individual retirement accounts can help you convert this money into long-term economic security.
Next, pay off the credit card debt and consider retiring the retirement plan loan. If your husband lost his job and couldn’t repay the debt, the outstanding balance would become a withdrawal that would incur income taxes and penalties.
Any money that’s left over can go into an emergency fund to protect against job loss and to keep you from going into debt between tenants. Your low-rate car loans and tax-advantaged mortgage debt aren’t top priorities for repayment, but you can start paying them down over time once your other bases are covered.
Dear Liz: I retired last year. I am 67, have more than $1 million in my retirement accounts, $80,000 in individual stocks, $50,000 in cash and more than $200,000 in equity in my home. I don’t need to tap my Social Security benefit yet and can afford to wait until I am 70 to get the maximum monthly amount. I recently purchased a new car with a 0% loan for five years. That and my mortgage are the extent of my debt. One thing I would like to do is some home improvement. My fee-only financial planner suggested getting a home equity line of credit to cover the repairs and upgrades. This makes sense to me in that it spreads out the burden over time and is tax-deductible. My credit scores are 736, 801 and 839. But I’m finding it difficult to get a commitment from either my credit union or my bank because they don’t see an income. I have been with both of these institutions for more than 30 years and the credit union holds the first mortgage. How do we get the lenders to factor retirement assets into the qualification calculations?
Answer: Last year, mortgage giants Fannie Mae and Freddie Mac issued guidelines on retirement fund annuitization that would allow mortgage lenders to calculate a borrower’s income based on his or her retirement assets.
Lenders, however, have to be willing to go to a little extra effort to learn the rules and apply them properly.
If yours aren’t willing to do so, then it might be time to take your business elsewhere. A mortgage broker (referrals from http://www.namb.org) may be able to connect you with a lender who’s more up to date.
Dear Liz: My wife of 34 years died five years ago. Her father is 94. He has accumulated a large amount of wealth over the last 40 years. I always made a point of staying out of financial discussions between my father-in-law and his daughters. He told us for years that upon his death all his wealth is to be divided between us (my wife and me) and her sister. Recently, a gold digger reappeared on the scene. My father-in-law and his late wife took her in at a young age when her parents died. I don’t know if she was ever formally adopted or not, or how that affects the situation. My question is, do I have any legal rights, upon my father-in-law’s death, to any distribution of his estate if I am not listed in the actual trust or will?
Answers: Your chances of inheriting from your father-in-law may have died along with your wife.
Sons-in-law don’t really have inheritance rights. If your father-in-law dies without an estate plan, state law would dictate who his heirs would be: typically his surviving spouse (if he has one) and any living children. Even his kids would have no legal right to inherit if he has a will or trust that disinherits them.
Estate plans sometimes make provisions for a child’s spouse, particularly if the money eventually will be inherited by the grandchildren. Such a trust might give you the right to income from assets that on your death would go to your wife’s children, for example. If there aren’t grandchildren, though, the money your wife would have inherited may simply go to her sister (and possibly the “gold digger,” as you describe her, if she’s included in the estate plan).
Of course, if the old man likes you, he could make a bequest to you in his will. But you have no legal right to demand that he do so, and any attempt to pressure him could raise the question of who is the actual gold digger here.
Moving student loan debt
Dear Liz: My daughter has $30,000 in student loans from obtaining her masters degree. The loans have about a 7% interest rate. She will be eligible to have $5,000 forgiven if she works five years in a low-income school. Although she is currently so employed, she does not know whether she will stay there for five years. I have a line of credit available with a 4.8% interest rate. It seems to me that she will pay less overall if she uses my line of credit to pay off her student loans and makes the monthly payment on the line of credit. Does she miss out on developing a good credit score by using my credit? Is it worth paying the higher interest rate to develop that credit history?
Answer: There are several reasons not to use your credit line, and they don’t have to do with her credit scores.
The student loans are helping her scores now and will continue to do so even after they’re paid off, since most lenders continue to report closed accounts for years.
If she uses your line of credit, though, she won’t be able to deduct the interest she pays. Student loans provide a valuable “above the line” income adjustment for most borrowers. They don’t have to itemize to take advantage of this adjustment, which is the smaller of $2,500 or the interest actually paid. The ability to take this tax break is phased out in 2013 when modified adjusted gross income is between $60,000 and $75,000 for singles and $125,000 to $155,000 for married couples filing jointly.
Also, your line of credit carries an adjustable rate that can (and likely will) go higher. The rate would have to rise only two percentage points before it equals the fixed rate on her federal student loans. Federal student loans offer a number of other protections, including income-based repayment options, forgiveness after 10 years in public service jobs (after 25 years otherwise) and forbearance or deferral should she experience an economic setback. She can learn more about these options at studentaid.ed.gov.
Finally, if she failed to make payments on your line of credit, your credit scores would be on the line — as would your home, if the account is secured by your home equity.
It’s commendable that you want to help your daughter, but in this case you both may be better off keeping the debt in her name rather than putting it in yours.
Dear Liz: I’m confused about paying down credit card debt. Some say to pay the lowest-balance cards first and others say the highest balance or the one with the highest interest. I have almost $16,000 on credit cards ranging from a $4,930 balance on a card with an 8.24% interest rate to $660 on a card with an 18% rate.
Answer: Actually, the first question you should ask is “How much credit card debt do I have compared to my income?” If your balances equal half or more of your annual earnings, you may not be able to pay it all off. You should make appointments with a legitimate credit counselor (such as one affiliated with the National Foundation for Credit Counseling at http://www.nfcc.org) and a bankruptcy attorney (referrals from the National Assn. of Consumer Bankruptcy Attorneys at http://www.nacba.org).
If your situation isn’t that dire, the fastest way out of debt is to pay the minimums on your lower-rate cards and send as much money as possible to your highest-rate card. Once that’s paid off, concentrate on paying off the next-highest-rate card, and so on. Some people instead like to target balances from smallest to largest to get a quicker feeling of victory, but you typically pay more in interest with that approach.
Dear Liz: I currently owe $27,000 in student loans at an 11.5% interest rate. I have excellent credit and about $8,000 in savings and contribute 17% of my income to a workplace retirement plan. Should I invest less in my 401(k) and pay off debt instead? I just got a balance transfer offer for 0% for 15 months with a 3% transaction fee. I’m considering taking $3,000 and putting it toward my high-interest student loan.
Answer: If you had federal student loans, transferring any part of your debt to a credit card would be a bad idea. That’s because federal student loans come with consumer protections that allow you to reduce or even eliminate your payments if you fall on hard economic times. You certainly wouldn’t want to reduce your retirement savings to pay off these flexible, fixed-rate loans.
The higher rate you are paying indicates that you have private student loans, which typically don’t have the same protections and which usually have variable rates that will climb higher when inflation returns.
Credit card debt has similar flaws — plus you would lose the interest rate deduction on any student loans you paid off this way. Instead, you may want to investigate the option of refinancing and consolidating your private student loans with a credit union. Credit unions are member-owned financial institutions that often offer better rates than traditional lenders. One site representing credit unions, CUStudentLoans.org, currently advertises variable rates on consolidation loans that range from just under 5% to just over 7%.
If you continued to make your current payments on a consolidated loan with a lower interest rate, you would be able to pay off your loans years faster — saving on interest without jeopardizing your future retirement.
Dear Liz: Two years ago we moved to another state. Our old house hasn’t sold in that time, as the housing market there is terrible. We have it listed for $255,000 and owe $242,000. A recent appraisal came back at $190,000 to $205,000 despite the fact that it’s in good condition and only 11 years old. We were thinking we should do a mortgage release on the property to get rid of it as we just can’t keep up the mortgage payments any longer. We didn’t think a short sale would work because there’s been no interest yet on the property. Any suggestions?
Answer: What you’re calling a “mortgage release” is actually a foreclosure, and it would devastate your credit for years to come. That may turn out to be the best of bad options, but explore others first.
Perhaps there’s been no interest in your property because the asking price is too high. Talk to a real estate agent with experience in short sales about what listing price is likely to generate offers. A short sale would hurt your credit scores, although perhaps less severely than a foreclosure if you can persuade the lender not to report the deficiency balance (the difference between what you owe on the mortgage and the sale price). The advantage of a short sale is that you’d spend less time in mortgage lenders’ “penalty box” and may qualify for another loan within two years.
Dear Liz: I have about $16,000 in student loans at 6.8% interest. At the current monthly payment it would take me about 7.5 years to pay them off. I contribute 10% of my income to my company’s Roth 401(k) plan (my employer matches the first 6% contributed). I also contribute 3% to the stock purchasing plan. I am thinking of cutting back my 401(k) contribution to 6% and not contributing to the stock purchasing plan. Applying the extra money to my loans would reduce the payback period to about 2.5 years. After that, I would increase the contribution amount and diversify with a Roth IRA as well and maybe even begin the stock purchase program again. What do you think?
Answer: Not contributing to retirement accounts is usually an expensive mistake. The younger you are, the more expensive it can be.
Every $1,000 not contributed to a retirement plan in your 30s means about $10,000 less in retirement income. That assumes an average annual growth rate of 8%, which is the historical average for a stock-heavy portfolio.
In your 20s, the cost of not contributing that $1,000 is $20,000 of lost future retirement income. The extra decade of not getting those compounded returns makes a big difference.
People have the erroneous idea that they can put off retirement savings and somehow catch up later. Catching up, though, becomes increasingly difficult the longer you wait. A better approach is to save as much as possible starting in your 20s when the money has the longest time to grow. Then you’ll be in a better position to withstand job losses or other interruptions of your ability to save. If those setbacks don’t happen, you’d have the option of retiring early.
Granted, your plan would require reducing retirement contributions for just a few years. But the federal student loans you have are fixed-rate, tax-deductible debt that you don’t need to be in a hurry to pay off. In the long run, you’d be much better off boosting your retirement contributions.
If you’re determined to pay down your loans, however, use the money you’ve been contributing to the stock purchase plan. Continue making at least a 10% contribution to your retirement plan and increase that as soon as you can.