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March 29, 2017
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Real Estate & Business

Scott Sheldon
Gauging how much your life debt costs you
February 17, 2017

Your ability to save money can become compromised by the financial obligations you are paying in your life. 

If you have a mortgage and consumer debts, this article will help you determine: Should you stay the course or take action to start getting control of your cash?

The nuts and bolts of a good financial plan include having “preferred debt.” Preferred debt is tax-deductible (a mortgage) and has no consumer obligations that are non-preferred (i.e. credit cards, student loans, car payments, etc.). Non-preferred obligations will compromise your ability to save money.

Consider the following scenario:

John Borrower has a mortgage of $300,000 with an interest rate of 3.875 percent. His mortgage is a 30-year fixed rate loan and his monthly interest payments are $1,410.71. John also has a car loan of $10,000 with an interest rate of 6 percent and a monthly payment of $500. His credit cards total $8,000 with an average interest rate of 16 percent on which he has to pay $400 per month.

John Borrower has a great credit score because he always carried a balance on his credit cards, has never missed a payment, and his credit history is squeaky clean. However, John’s car just broke down and he needs a new transmission that will cost him $3,500. Unfortunately, John’s mortgage payment and other obligations take up a majority of his income and now he has very little money saved up.

What does John do? He turns to his credit cards and goes further into debt. He is reluctant to make any changes to his financial burden. He has a great interest rate on his mortgage, but is he really getting ahead financially?

There is a more proactive approach that John can take that will be more consistent with having a strong financial foundation that will not only make him more credit worthy, but will also give him the ability to save and plan for the future.

The first thing to look at is all of John’s interest rates. True, his mortgage rate is low but the weighted average of his interest rates on all obligations is quite high. His interest payments alone take up a lot of extra money. 

The total amount John owes in debts is $321,500, which includes his new credit debt of $3,500 from the new transmission. 

If you multiply John’s amount owed by each individual interest rate and add it together, John is paying a total of $14,065.00 in interest alone each year.

Broken down: $300,000 at 3.875 percent plus $10,000 at 6 percent plus $11,500 at 16 percent equals $14,065.00 annual interest paid.

Dividing the yearly interest paid ($14,065) by the total amount owed ($321,500) results in John paying an annual average interest rate of 4.375 percent.

If John were to refinance his current mortgage at that average 4.375 percent interest rate, something really interesting would happen to his payments. John is currently paying $2,310.71 each month in debt payments while interest is being accrued on his debts. By combining his debts under one mortgage at the 4.375 percent interest rate over a 30-year fixed-rate term, his monthly payments, interest included, would drop his payments to $1,605.20 each month.

Say what?

If John refinances his mortgage for the purpose of “debt consolidation”, his average interest rate does not change and his monthly payments are lowered. Suddenly, John Borrower is saving $705.51 each month. John can take that money and invest it or start a vacation fund. He can also put it to the side in case something else on his car breaks down. 

Regardless of his plans for the savings, the fact is that he is saving money and gaining control of his cash flow.

Having low rates and high rates on multiple forms of debts probably means you are going to be paying a higher rate of blended debt on all of your preferred and non-preferred obligations over time. 

The reality is that you can save through consolidation and fixing on one lower rate. It might be higher than your current lowest rate, but as John discovered, he could save money by increasing his lowest rate and combining his debts.

The ideal financial scenario for any borrower is to have a single mortgage payment with no debt obligations and to have at least 6 to 12 months of savings (“reserves”) to be used as “back up”. This financial platform increases your borrowing power and is optimal for having a choice and control over your funds.

If you are thinking about taking out a mortgage or making some financial adjustments in your life, work with a lender who has the skill set and ability to really investigate your debts and can show you the real breakdown of your debts and what you are paying over time. You might end up realizing how much control you are missing out on by having payment obligations in an ongoing debt cycle. 

The numbers might astonish you.

 

Scott Sheldon is a local mortgage lender, with a decade of experience helping consumers purchase and refinance primary homes second homes and investment properties. Learn more at www.sonomacountymortgages.com.