Dear Liz: My wife and I are considering buying a home for the first time. We’re planning to switch our accounts from our bank to a credit union. We’re in the midst of receiving a bad report from the bank, and that’s why we want to change. But is that a wise choice when we want to buy a home? Also, what options do we have for a mortgage when we don’t have any money for a down payment? Are we locked into an FHA loan, or are there other choices? We are middle-class people making an average of $40,000 a year with no kids and OK credit scores.
Answer: If you don’t have a down payment saved, you aren’t ready to be homeowners.
Homeownership is expensive, with lots of unexpected costs constantly popping up. Some are relatively minor, like having to replace a worn-out appliance, while others are major, such as having to replace a furnace or a roof.
That’s why homeownership isn’t a good idea for people who aren’t already in the habit of living below their means and saving a decent proportion of their incomes.
Take the next year or so to tweak your spending and save up a down payment. You’ll need at least a 3.5% down payment to qualify for an FHA loan. A bigger down payment will give you more loan options and won’t leave you upside down on your home from the first day. A 20% down payment is often best, since you can avoid private mortgage insurance.
A year also will give you time to polish those credit scores from “OK” to “good.” The higher your scores, the better the interest rate you’ll receive.
But the fact that you’re receiving a “bad report” from your bank is worrisome. You don’t specify what happened, but anything that could be reported to the credit bureaus, such as a missed credit card payment, could cause major damage to your scores. Simply switching to another institution won’t prevent that. And if you’ve piled up a bunch of bounced checks, your credit reports may not be damaged but you could find it difficult to open new accounts at other financial institutions.
Whatever happened, you should try to straighten it out with the bank before you decamp, even if you ultimately decide to switch accounts.
Dear Liz: I am returning to college in my later years for a second degree. Can I save in a 529 plan for my own college use in two years?
Answer: You can, but why would you want to?
The big benefit to a 529 plan is that your returns can grow tax-free. That’s a boon for parents in higher tax brackets contributing for young children, since their money has years to grow and they can put at least some of their cash into riskier assets, such as stocks.
If you need the money within two years, though, it should be in a cash account that won’t earn much. (The average money market fund pays around 0.02% right now.) You wouldn’t be getting any real growth, so the tax benefit of a 529 plan is minuscule. What you would get are restrictions on how you use the money and possible complications for your tax returns. If you want to use education tax credits, for example, you won’t be able to apply those on expenses you’ve paid with a 529 withdrawal.
A simple FDIC-insured savings account — perhaps at an online bank that pays around 1% — is probably the better way to go.
Dear Liz: Why are companies allowed to advertised “free credit scores” when they’re not really free? They want you to give them a credit card number, then charge you a dollar, and if you don’t call them within seven days to cancel they will charge you $14.95 a month for a credit monitoring service. That’s not free.
Answer: No, it’s not, but these companies profit from people’s confusion about scores.
Many people think we have a right to a free credit score, but we don’t. What we have is a federally mandated right to see our credit reports, which are different from our credit scores. Reports list your credit accounts, whether you’ve paid on time and whether you have negative public records, such as a bankruptcy or foreclosure. Credit scores are three-digit numbers compiled from those reports, but your scores aren’t a part of your reports. The only place to get your free credit reports is http://www.annualcreditreport.com.
If you’re being offered a free score, it’s almost certainly got strings attached like the ones you described, or the score isn’t the FICO score commonly used by lenders.
Dear Liz: I was recently solicited by a credit card company. I didn’t need another credit card, but this offered airlines miles that I collect, so I applied. They didn’t approve the application because: “You have filed for bankruptcy and your previous account(s) with us was included in that filing. This includes any of your accounts issued by (us) such as Visa, MasterCard, store cards or gas cards.” Liz, the bankruptcy was 12 years ago, and I am very well financially situated now. I thought there was an expiration date on bankruptcies appearing on your credit report.
Answer: There is. Bankruptcies have to be removed from your credit reports after 10 years.
Individual lenders, though, are allowed to have much longer memories. And some have opted not to forget. If you ever file a bankruptcy that wipes out debt on one of the accounts they issue, they may never again approve you for credit. That’s perfectly legal.
Not all lenders are so unforgiving, of course, and those who don’t know about your bankruptcy likely will be perfectly willing to extend you credit as long as your credit scores are good. But you’re probably wasting your time trying to induce this once-spurned lender to change its mind.
Dear Liz: My husband and I are in our late 40s. My husband is the sole provider. We have $200,000 equity in our home and a 5.875% interest on our mortgage. We have nine months’ worth of expenses saved in an emergency fund, plus we contribute $100 a month to our son’s college fund and 6% to my husband’s 401(k). We make regular monthly payments on a student loan balance of $12,000 (at 4.167% interest) and a personal loan balance of $12,000 (at 0%). My husband has had two stretches of unemployment over the last five years, each lasting for about six months. We have begun saving in a secondary account and are uncertain how to best use that money. Should we pay off the student loan? The mortgage? Invest in a CD or IRA? Or consider some other investment strategy?
Answer: You don’t say how much is in your husband’s 401(k), but a 6% contribution rate when you’re in your late 40s is unlikely to generate a big-enough nest egg to retire. Boosting that contribution rate should be your priority, and you should consider contributing to a Roth IRA for each of you.
Likewise, saving anything for your child’s college education is smart, but $100 a month won’t get you far. Just for comparison, consider that parents of newborns need to save around $600 a month to pay the full cost of a public college. Those who start later or want to cover a private college have to contribute much more.
Most families aren’t able to save that much, so the next best thing is to simply save what you can — after you’re fully on track with your retirement savings.
You shouldn’t prioritize paying down your relatively low-rate debts over these two far more important goals. But you may want to consider refinancing your mortgage to dramatically lower your rate and perhaps free up more cash for your goals. Just try to make sure the loan will be paid off by the time you plan to retire. A 15-year loan, in other words, might make more sense than refinancing into another 30-year mortgage.
Dear Liz: Why does a request to lower the interest on an existing mortgage require a new appraisal, inspection, title search, etc., when the home is the same? Think how much money could be put back into the economy with a simple keystroke.
Answer: The short and obvious answer is that “nothing is the same.”
Home prices are down 33% from their 2006 peak, with even bigger drops in many areas. Lending standards are dramatically tighter as well. When your loan was originally made, lenders might not have cared much if your home’s size or amenities were fudged, or if the wrong “comparable properties” were used to arrive at your home’s value, or if you made the income or had the assets you claimed. Now they care, deeply, about all of those things.
Even if the world hasn’t changed, your property may have. Deferred maintenance could have reduced its value, while improvements may have increased it. Lawsuits or other problems may have popped up that affect the title.
And when you think about it for a moment, you’ll realize that all those loans that were made so easily in the past — with simply a few keystrokes — are what helped lead to the economic mess we’re in today. Yes, the pendulum may have swung too far and made refinancing unnecessarily tough, but the old easy lending standards were simply unsustainable.
The headline of yesterday’s Wall Street Journal article was casually chilling: “As middle class shrinks, P&G aims high and low” (subscription required). The article talks about how Proctor & Gamble, along with other companies, are adjusting their business strategies to target a consumer market “is bifurcating into high and low ends and eroding in the middle.”
Even scarier were two paragraphs deep within the story:
To monitor the evolving American consumer market, P&G executives study the Gini index, a widely accepted measure of income inequality that ranges from zero, when everyone earns the same amount, to one, when all income goes to only one person. In 2009, the most recent calculation available, the Gini coefficient totaled 0.468, a 20% rise in income disparity over the past 40 years, according to the U.S. Census Bureau.
“We now have a Gini index similar to the Philippines and Mexico—you’d never have imagined that,” says Phyllis Jackson, P&G’s vice president of consumer market knowledge for North America. “I don’t think we’ve typically thought about America as a country with big income gaps to this extent.”
Not that many years ago, it was controversial to even mention the growing wealth and income disparities in the U.S., even though all manner of economists and politicians–including then-President George W. Bush–were on the record as being concerned about it.
Today, the erosion of the middle class–and the supposition that it will continue to shrink–is no longer a controversial notion. It’s the basis of corporate marketing strategies.
It’s well worth reading this thoughtful piece from the Atlantic Monthly, “Can the middle class be saved?” The author’s answer: maybe, but it will require more sensible economic, tax and education policies.
Dear Liz: I was laid off in November 2009. For the first year, I took the unemployment and tried to find a job without success. So, in late 2010, I started my own business, contracting mainly for employers for whom I used to work. Unfortunately, I am making about a third of what I used to make, and even after cutting expenses, there are months that I can’t pay my bills. I have taken two withdrawals from my self-directed IRA this year. Is that the smartest thing to do? Or should I even out my cash flow by writing myself loans from my home equity line of credit?
Answer: You need to accept your new reality, rather than papering it over with ill-advised loans or raids on your retirement accounts.
That means reducing your expenses dramatically to reflect your new, lower income. If your housing expenses eat up more than a third of your current pay, for example, you need to consider your alternatives. You have equity in your home, which should make a sale easier. If you want to hang on to the house, consider getting roommates or even renting out the house while you live elsewhere (if the rent will cover your home’s monthly expenses).
You may have loan payments or other debts taken on when you had more income that you can no longer afford. If that’s the case, discuss your situation with both a legitimate credit counselor (one affiliated with the National Foundation for Credit Counseling at http://www.nfcc.org) and a bankruptcy attorney (find referrals from the National Assn. of Consumer Bankruptcy Attorneys at http://www.nacba.org).
Your home equity should be reserved for emergencies, not used to finance a lifestyle you can no longer afford. And your retirement funds should be left alone for retirement.
Dear Liz: I had to retire because of illness at 44. I have $30,000 in credit card debt. Should I use the $24,000 in my 401(k) to pay off the majority of that debt? The payments are $1,000 a month. My wife and I can afford the payments, as we have a combined gross income of $120,000. But we hate to think we’ll be paying forever and, worse yet, what we’ll pay in interest over time. A home equity loan is out of the question since we only have about $50,000. What should we do?
Answer: Don’t use retirement funds to pay off credit cards. Period.
If it pains you to think about the interest you’re paying, good. That may keep you from running up more debt.
But you’ll pay a lot more in the long run by raiding your retirement fund. First, you’ll lose one-third or more of your savings ($8,000 or more) to taxes and penalties. Then you’ll lose all the future, tax-deferred returns your 401(k) could have earned. You can figure that the $24,000 will easily cost you more than $100,000 in lost future retirement income.
A better approach is to cut your expenses so you can put more money toward paying off your debt. An extra $500 a month could shave a year or more off the time you’re in debt and save you a considerable amount in interest.
Dear Liz: When our daughter turned 18, I was able to get her a credit card with a $750 limit by opening the account myself, with her named as an authorized user. I did not plan to use the credit card myself and did not. We were then able to order her a credit card with her name on it. She used the card for five years, paying the balance each month. When she graduated from college, the same credit card company offered her a rewards card with a $3,000 limit in her name only, leaving me off the account. This was just as I planned it. Now she wants to close the account with the $750 limit that was opened five years ago. Will this hurt anyone’s credit scores? Neither one of us plans to ever use this account again.
Answer: Closing accounts can’t help your credit scores and may hurt them. But if both of you have good scores (FICOs of 740 or above) and other open credit accounts, then canceling this account shouldn’t have disastrous effects on your scores.