When it comes to personal finance, most people are very familiar with the concept of cash flow. They know that their monthly pay represents cash flow in and checks written and automatic draft payments each month are cash flow out. As long as cash flow remains positive (the more positive the better), everything is great. However, most individuals do not realize that improving cash flow does not necessarily equate to improving overall savings and increasing one’s net worth. This is because interest expenses can reduce the accumulation of wealth, even though financing purchases (at higher interest rates) may improve cash flow.

What exactly does that mean? Perhaps the easiest way to explain it and understand it is with a good example. Here’s an example inspired by a post David at MyTwoDollars made in which a reader asks whether to pay off a car loan or increase the down payment on a new home:

My husband and I are selling our house and will be netting a profit of $52,000. We are building a $300,000 house and were wondering if we should pay off a Tahoe for $12,000 so we can get rid of a $600 payment or should we put all $52,000 into the new house. I guess I’m asking what the pros and cons would be. Thanks

Unfortunately the reader did not include additional information necessary for my example, namely the interest rates on the car loan and mortgage. I will take the liberty of fabricating the interest rates and some other information. Here are the assumptions we will make for the first part of the example:

• Auto loan balance: $12,000
• Auto loan interest rate: 0%
• Total monthly auto loan payment: $600
• Auto loan total term: 36 months
• Auto loan remaining term: 20 months
• New home purchase price: $300,000
• Down payment on home: $52,000
• Amount borrowed for home purchase: $248,000
• Interest rate on mortgage: 6%
• Mortgage term: 30 years
• Total monthly mortgage payment (principal and interest): $1,486.89
• Auto loan is paid off and money is not used for down payment on home purchase
• After auto loan payoff, monthly cash outflow is $1,486.89

In order for my example to work, I had to make the rather outrageous assumption that the vehicle was purchased with 0% financing. So if the auto loan is paid off the monthly cash outflow will be $1,187.11. Now let’s see what happens if we keep making payments on the vehicle for the remaining 20 months, and use the $12,000 to increase the down payment on the new home:

• New home purchase price: $300,000
• Down payment on home: $64,000
• Amount borrowed for home purchase: $236,000
• Interest rate on mortgage: 6%
• Mortgage term: 30 years
• Total monthly mortgage payment (principal and interest): $1,414.94
• Auto loan monthly payment: $600
• Monthly cash outflow: $2,014.94

Most people would tell you that paying off the car loan will help save $528.05 every month and over the course of 20 months would save a total of $10,561. However, I say that paying off the car loan will actually cost a total of $1,188.30 in terms of overall savings and accumulation of wealth. Certainly I will agree that cash flow will improve by $525.05 every month. However, by reducing the down payment on the new home by $12,000, it will actually cost more to pay off the car loan:

• Total interest paid on a 30-yr. loan for $248,000 @ 6% over 20 months: $24,558.27
• Total interest paid on a 30-yr. loan for $236,000 @ 6% over 20 months: $23,369.97
• Difference: $1,188.30

Keeping the car payment results in a higher net worth after 20 months, because the interest rate on the car payment is lower than that of the mortgage (now you see why I made my outrageous assumption of 0% financing on the vehicle). In terms of accumulating wealth, keeping the car payment is the more prudent decision. However, the majority of people would prefer to improve their monthly cash flow and pay off the vehicle. More often than not, individuals will sacrifice accumulating wealth in order to improve cash flow. Consequently this is the reason why most people never achieve financial independence.

The bottom line: if you ever have the opportunity to pay down loan balances, you should pay balances with the higest interest rates first. You may be tempted to pay off the balance on a loan with a lower rate if the monthly payment is higher than the payment on a loan with a higher rate. Afterall, it would result in better cash flow to do so. However, it would not result in the most favorable net worth to pay off a lower rate balance first. Let’s look at another example with some smaller numbers:

• You have a 36-month personal loan @ 10%
• Monthly payment on personal loan is about $260.
• Original personal loan amount was for $8,000.
• Remaining balance on personal loan is about $3,000.
• Remaining term on the personal loan is 12 months.
• You have another credit card with a $5,600 balance @ 18%
• Credit card has a monthly payment of $120.
• Total monthly payment for both loans is $380.
• You receive $4,000 for your annual bonus. Which balance do you pay off/pay down with the $4,000?

I contend that most people would probably opt to pay off the personal loan, because it would result in a better cash flow improvement. However, paying down the credit card instead would result in a higher net worth. Let’s compare the difference in interest paid over the next 12 months (the remaining term of the personal loan):

	Paying Off Personal Loan	Paying Down Credit Card*
Personal Loan Interest Accumulated	$0	$161.46
Credit Card Interest Accumulated	$969.82	$180.17
Total Cost	$969.82	$341.63
Remaining Credit Card Balance	$1,121.77	$249.48

As you can see, by paying the lower interest balance first ends up costing more in the long run. Although cash flow improves over the next 12 months, you pay more in interest expenses and are left with a higher debt balance in month 13.  A higher debt balance means you have a lower net worth. Not only do you pay less interest in months 1-12, but you will pay less interest in subsequent months and debt will be eliminated faster.  So remember, if you can afford to do so, pay down your loans with the highest rates first.

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Having Trouble Refinancing? Borrow from a Rich Friend or Family Member

Preparing to Refinance

I was talking with a friend that recently purchased his home with an ARM and did 100% financing. With little (or possibly negative equity with home prices dropping), he will certainly have a very difficult time refinancing into a fixed-rate when his rate begins to adjust. As it so happens, his mother-in-law recently inherited a large sum of money. More than likely he will end up borrowing from her and refinancing his mortgage with her. I told him I think it is a great idea, and it is basically peer-to-peer lending on a grand scale. Here are some of the many benefits of borrowing from a friend of family member:

• Very low closing costs

Basically you will just have to pay the local and state government some fees (doc stamps, taxes, recording fees, etc.) for the documentation.

• Quick recovery of closing costs

Because of the low closing costs, it won’t take very long at all to recover your closing costs. It will likely take on the order of a few months as opposed to years with a traditional refinance.

• Low fixed rate

Your friend and relative may even be kind enough to loan to you at 0%, but a fair rate would be something between that of a standard 30-year fixed loan with an institution (assuming that is the term you use) and the interest rate of a high-balance money market account.

• Potentially higher cash flow for borrower

Depending on your current financing situation, because of the lower rate, the refinance may leave more money in your pocket each month.

• Potentially higher cash flow for lender

If the interest rate is higher than that of a high-balance money market account, the lender will enjoy better cash flow as well. Technically speaking, the amortization of the loan will also provide increased cash flow. However, it isn’t additional income since it is additional cash going towards the balance and the balance of the loan (investment) is declining.

Of course, when there are benefits there are also disadvantages as well. In this case, it is the potential ill-will if you were to ever default on the loan or make late payments. So I will offer the following disclaimer: if you are late with payments or default on your loan, a family member may disown or oust you from the family, a friend may never forgive you and will no longer be your friend, and in either case you may be sued and your home may be foreclosed. In other words, I’m well aware that what I’m suggesting in this article probably goes against everything you’ve probably ever heard about borrowing/lending money to friends and family. Now you are aware of it as well.

That being said, there is one major disadvantage for the lender. Even if you do everything by the book and set up a note and everything, if the lender ever wants to sell the note it would likely have to be at a significant discount of face value (because of the low interest rate). So the lender is more or less locked into the investment until the note matures or the home is sold. All-in-all I think it is a fairly good deal for the borrower and lender as long as both parties understand the terms, conditions, and risks.

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When I purchased my new home about a year ago, I went with the builder’s preferred lender because of the lower closing costs with the incentives. Because I also hadn’t yet sold my prior home and really had no cash to put down, I did 100% financing with an 80/20 loan. What’s an 80/20 loan? Well, if you have excellent credit, it is a method of doing 100% financing and avoiding having to pay PMI. It is actually two loans. A primary mortgage for 80% of the value and a second mortgage for 20%. Because the loan-to-value on the first mortgage is 80%, you do not have to pay PMI. Another thing I did was make the primary mortgage interest-only for five years.

Never in a million years would I ever recommend someone do 100% financing with interest only loans, especially in this market! So why did I use this kind of financing when I would never recommend it? First of all, I had plenty of equity in my old home. I owed $190k and ultimately it sold for $290k. Even if I hadn’t sold it, I could have rented it for break-even.

I also anticipated that my prior home wouldn’t sell before closing on the new home (and I was right). I wanted to be able to pay down the mortgage on the new home and be able to improve my monthly cash flow, which is why I did interest-only on both loans. If I had bought the new home with a fixed mortgage, paying down the mortgage would reduce the balance but the payment would remain the same. Paying down a fixed mortgage reduces the amount of time to pay it off and reduces the total interest paid over the life of the loan.

Do I have any regrets? The interest rate on the first mortgage is 6.625%, which seems a bit high to me, especially for a 5-yr fixed period and adjusting after that. I wish I had shopped around a bit for similar terms but at a lower rate. Mortgage rates have been on a fairly steady decline since the middle of last year, so I will likely be refinancing this spring or this summer.

I’ve been keeping an eye on the 30-year Treasury Bond. Although not the same rate, fixed mortgage rates trend similarly to long-term treasury bonds and notes. The yield on the treasury bond also sometimes trends with the stock market indices as well. The 30-year bond hit a low in January right behind the Dow Jones Industrial Average. I’m looking forward to the next time Wall Street has a tough time with economic reports, because it may present the perfect refinancing opportunity.

Shopping for a mortgage can be tough. I had been using BankRate’s mortgage comparison tool for a while, until I came across Yahoo!’s. I like Yahoo!’s better because it allows you to enter an estimated range for your credit score (only has three ranges, but it’s better than 0). It also allows you to filter the results based on the term, monthly payment, points, lock term, and fees. The best feature of all is that the results are a single click away, rather than having to click through several screens on BankRate.

I’ve also been working on improving my credit score. I want to watchdog my score over the next month, so I’m trying out myFiCO’s ScoreWatch free for 30 days. It allows you to monitor your credit score, and when it changes you can receive alerts. Overall, ScoreWatch seems like a pretty good product, although I’m very disappointed in the simulator. You can try different scenarios to see how it improves your credit score, but it gives you a large range for the result (20 points or more) rather than an exact score. You would think that the people that invented the FICO score would be able to give you an exact number! I simulated paying my credit card balance in full, and the result was a score of 760-780. Not very helpful since I already have a score in that range, albeit on the lower end.

ScoreWatch is certainly a great thing to have if you’re looking to refinance soon. Right now my score is 760, so I’m basically right on the line of the top-tier for a 30-year fixed mortgage. I’d like to get just a little bit over the line. Although I never carry a balance on my credit cards, because there is a balance when the statement closes (that I subsequently pay off in full), it appears as a balance on my credit report. I use only one credit card to take full advantage of cash back. This month I’m going to experiment and try paying the balance in full (or as close as I can, give or take a few transactions) before the statement closes. We’ll see if it improves my score.

The last thing I’m doing to prepare is paying down my current mortgage as much as possible. At the end of last year, I used my annual bonus to pay it down considerably. I will be filing my tax return soon, which will also provide a few thousand to pay it down a bit futher. My goal is to get it down to about $150k before refinancing. Right now it is sitting at $168k. Between some cash I have in brokerage accounts, my checking account, and the tax return, I think I should be able to get very close to $150k. I want to have as small of a balance as possible because it will also mean a smaller monthly payment after I refinance. I would be very comfortable with a $150k balance, because I could likely rent out my home at some point in the future for positive cash flow.

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Weakening Economy Can Mean Good News for Homeowners

Credit Card Refinance Calculator

On Tuesday the Federal Open Market Committee (FOMC) dropped the federal funds rate by 0.75% in an emergency meeting. What does this mean for mortgages? The federal funds rate does not actually directly impact fixed mortgages. Because fixed-rate mortgages are long term loans, they tend to more closely follow long-term paper such as the 10-year treasury note and 30-year treasury bond. The 10-year treasury note and 30-year treasury bond have been on a steady decline since July, as have 30-year and 15-year fixed mortgage rates.

Treasury yields have dropped quite a bit in the past two days since the FOMC announcement which is good news for anyone looking to buy a home. The yields aren’t dropping so much as a direct result of the federal funds rate drop, but more because of the message the FOMC has sent as a result of the action they have taken. I read a good article this morning that describes the situation well:

Mortgage rates often dip when investors fearing an economic slowdown grow more conservative and buy up Treasuries and bonds. This causes long-term rates — and by extension, mortgage rates — to fall, creating an opportunity to get better terms on a loan.

Although normally this would be good news for borrowers with adjustable rate mortgages that wish to lock into long-term fixed-rate mortgages, they may still find themselves unable to refinance. During the housing boom many people used adjustable rate mortgages with small down payments to purchase their homes. They did this in anticipation that home prices would continue to climb, and the market value would allow them to build equity in the home. Unfortunately when the real estate market topped out, these individuals were left with very little home equity or even worse, negative equity in their homes.

With little or no equity in a home, it will be very difficult to refinance into a fixed-rate mortgage. Without at least 20% equity in a home, a homeowner will have to pay Private Mortgage Insurance (PMI). This helps lenders to recover losses from defaults and provides no benefit to the borrower. I have no doubt that PMI premiums have increased ever since the subprime lending issues began. This means a higher monthly payment which may not make it worth refinancing since it could possibly push a homeowner into negative cash flow. On top of having higher payments with PMI, payments on a fixed-rate mortgage will include principal as well as interest. Once again, the higher payment could force a negative cash flow situation. Even given all that, with lenders tightening borrower requirements, it may only be possible for those with excellent credit to refinance if they have very little or no home equity.

So what is a homeowner with an adjustable rate mortgage and very little equity to do? Well, one good thing about the reduction in the federal funds rate is that it could possibly lower the monthly interest payments. This would allow a homeowner with an adjustable rate to increase the amount of principal paid, hence build some equity. Hopefully the decrease in short-term rates will help homeowners with adjustable rates to build sufficient equity and allow them to refinance before fixed-rate mortgage rates begin to increase once more.

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I was reading cyncurry’s article Personal Debt – Is excessive shopping due to peer pressure? the other day, and she asks a thought-provoking question:

is it our moral duty to carry on building debt to keep the economy alive?

I don’t know about it being our moral duty to carry on building debt, but it is definitely a part of the economy that is here to stay. The practice of financing spending isn’t limited to consumers. Year after year, the U.S. Federal Government operates with a budget deficit, and on very rare occasion ends the year with a surplus. The amount of consumer revolving debt pales in comparison to the federal government’s. Of course, being the analytical type that I am, I decided to take a look at the numbers.

U.S. consumer revolving debt increased from $850 Billion in December of 2005 to $902.3 Billion in December of 2006. An increase of $52 Billion or 6.15% (Source: Federal Reserve Board G.19 Release – Consumer Credit). By comparison, the U.S. federal debt increased from $8.17 Trillion in December of 2005 to $8.68 Trillion in December of 2006. An increase of $510 Billion or 6.24% (Source: U.S. Department of the Treasury, Bureau of the Public Debt’s Debt to the Penny History Search). The U.S. consumer does have an appetite for credit, but it’s not nearly as big as Uncle Sam’s!

U.S. consumers do love their credit cards, but credit card spending is actually quite minimal in terms of its contribution to the economy. In 2006, personal consumption expenditures were $9.2 Trillion (Source: U.S. Department of Commerce, Bureau of Economic Analysis). That means that credit cards only contributed about 0.57% towards the gross domestic product (GDP) in 2006. The federal government contributed $2.5 Billion to the GDP in 2006, so the increase in federal debt from 2005 to 2006 represents 20% of the government’s contribution to GDP in 2006.

As demonstrated by the huge amount of debt it has taken on, the federal government has supreme confidence in the sustained growth of the U.S. economy. The debt of the federal government represents a huge portion of its spending, but contributes less to the U.S. economy than consumers do. Although consumer revolving debt does seem like a huge problem, I think we are just fine as it relates to the overall economy. However, I didn’t mention non-revolving consumer debt. As you would expect (since it includes mortgages), it is much higher than revolving debt. At the end of 2006, it stood at about $1.5 Trillion. If there is any trouble with the economic outlook it lies therein, as many Americans have adjustable rate mortgages that are adjusting. But that is another story for another time.

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