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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Credit Card Refinance Calculator

If you have credit cards with balances and are only making the minimum payments, you should look into consolidating your debt. Otherwise, it will take you a very long time to pay off the balances and you will pay a lot of interest in the process. Look into taking advantage of any balance transfer offers you may receive in the mail, but be sure to look them over carefully. Here are a few things you should consider when performing balance transfers with credit cards:

1. Try to pay off highest interest balances first.
   This just makes logical sense. You are paying more interest each month and compounding at higher rates. Paying these off first will help improve your cash flow quicker.
2. Do not perform a balance transfer on a card that already has a balance.
   Say you have a card with a $3,000 balance at 24% interest and a total credit limit of $10,000. You receive a promotional offer in the mail for a 2.99% fixed for life and decide to put $7,000 more on the card at the promotional rate. Sure you may have a great rate for the $7,000 you’ve refinanced. However, when you make payments on the new balance, it is very likely that payments will go towards the lowest interest rate first. That means that you will still paying 24% interest on a $3,000 balance.

   That means in the first month, you will add $60 to the $3,000 balance. If that wasn’t bad enough, the interest is compounding each month and the additional amount added increases each month! $60 will be added in the first month (balance = $3,060), $61.2 will be added in the second month (balance = $3,121.2), $62.42 will be added in the third month (balance = $3,183.62), etc.

3. Open new credit cards sparingly.
   More than likely you don’t have a lot of $0 balance credit cards lying around for taking advantage of promotional balance transfers. You may need to use a balance transfer offer for a new credit card in order to get the ball rolling. If you do open a new credit card, see if you can get a credit limit for at least the balance on your highest interest card. If you can get a credit limit that will cover the balances on multiple cards, even better.

   Once you have paid off one ore more of your balances with the new card, don’t cancel your old credit cards!!!! Not only could this potentially bring down your credit score (see my article on building and rebuilding credit), but you can now take advantage of balance transfer offers on your old credit cards. If you contact your old credit card companies, it is very probable that they have balance transfer offers you can use.

   If you still have high-interest balances to pay off, use the balance transfer offers on your old cards that you paid down to a $0 balance. It is better to use balance transfers on your existing cards as much as possible without opening new credit cards (and without conflicting with rule #2). This will keep the number of inquiries on your credit report to a minimum, and will make it easier to keep track of your balances and rates.

4. Fixed rates vs. introductory rates
   Be very careful when using introductory rates. These typically have an introductory period (12 months, 18 months, etc.). You can expect to pay a very high rate once the introductory period expires. Use balance transfer offers with introductory periods only if you will have enough time to pay it in full before the introductory period expires. As a rule of thumb, it is probably better to use balance transfers with introductory periods for smaller balances. The payments to pay the balance in full before the period expires will be lower and more manageable. If you have very high balances, you might want to use fixed rate for life offers instead of those with introductory periods. Otherwise, you will need to play the credit card shuffle once more, before the introductory period expires.
5. Be aware of the transfer fees
   More often than not, balance transfer offers come with transfer fees. Typically, the fee is a percentage of the balance transfer amount with a minimum and maximum fee that will be charged. If the fee is very high, it may take some time before you actually begin to realize any savings by performing the balance transfer. You should be very careful when performing a balance transfer with a high fee and an introductory period. If the fee is too high and the introductory period is too short, it may be more expensive than just simply not refinancing and maintaining the balance on your old card.

If all of this sounds cumbersome (and it is), you can always take the easy way out and get a 36-month fixed rate loan with Prosper. Prosper is a lending community where people can lend money to other people. Rather than borrowing from a bank, you’re borrowing from multiple individuals that compete to fund your loan. This often results in a much lower interest rate than you might pay with a bank or credit card.

If you do decide to play the credit card shuffle, please check out my Credit Card Refinance Calculator. It’s a nice little tool I put together that can help you figure out whether or not it is worth taking advantage of a balance transfer offer. It performs a comparison between your current credit card and refinancing with a balance transfer offer.

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When I was in college, I was often solicited around campus to sign up for credit cards to get free t-shirts and other goodies. I always avoided the temptation and never signed up for any credit cards. In my mind, credit cards were a bad thing to be avoided at all costs. Unfortunately, I didn’t realize by turning down those offers that I was also turning down the opportunity to begin building my credit history. Building credit is extremely important, especially if you plan on becoming a homeowner some day.

I remember the trouble I had of having no credit as I entered the workforce and how frustrating it was. I would often receive junk mail offers for credit cards with annual fees, but never signed up for any of them. I think it is rather ridiculous to pay an annual fee for the privilege of spending your own money. So what alternative is there to getting a credit card with an annual fee? I began building my credit history by opening a secured credit card with Bank of America.

Secured Credit Card
With a secured credit card, you give a deposit to the lender and they hold it for a certain period of time (I think mine was a year). The deposit held will earn a nominal amount of interest and is held as collateral for the credit line. The credit limit for the card is equal to the amount of the deposit made. Although it seems that Bank of America now charges an annual fee for their secured credit cards, I’m certain there must be others out there that will not charge an annual fee.

Automatic Payments
It may seem like stating the obvious, but you should always make your payments on time. It may also seem like an easy task, but it isn’t so easy for lazy people such as myself that don’t like to pay bills. The best thing you can do in regards to making your payments is to set up automatic payments. I know this was the best thing I ever did to build a good credit history and maintain my credit rating as high as possible.

A lot of credit card companies will allow you to set automatic payments online with their website. You can set up automatic payments to pay the balance in full or make the minimum payment. Also, you can probably use your bank’s online bill pay to automatically make your payments on credit cards as well. Check your banking online bill pay to see if your credit card company offers e-bills. Then you can set up your bill pay to either pay the balance in full or make the minimum payment.

I highly recommend you pay your entire credit card balance(s) each month if possible. Contrary to popular belief, carrying a balance DOES NOT help you to build credit. It only results in paying unnecessary interest and finances charges. The important thing is to make sure that you make the payments, not that you “are actually borrowing money.” Do not pay for anything you do not have the money to pay for. If you wish to buy something you can’t pay for now, save for it and then buy it when you’ve saved up enough money to do so.

I would also suggest setting up automatic payments for everything, such as credit cards, utilities, phone bills, insurance, auto loans, mortgages, etc. Although the payment history for non-credit accounts do not appear on your credit history, nonpayment of accounts do. So make sure to always pay your bills on time no matter what they are! If you’re ever really strapped for cash and you need to make a late payment on something, DO NOT pay any of your credit accounts late.

Making Late Payments
Delay a payment on a water bill, electricity bill, or phone bill before you ever make late payments on a loan or credit card. Late payments on non-credit accounts will not hit your credit report until they have been sent to a collection agency. Companies will attempt to collect late payments themselves before sending them to collection agencies. I would guess that most companies do not send their receivables to a collection agency until they are at least three months late, so being late a month or two on your phone bill probably won’t hurt your credit.

Another important tip if you ever have to pay any of your bills late: do not be late with insurance payments. Nonpayment of insurance premiums can result in cancellation of your policy. Heaven forbid you decide to pay your insurance premiums late and you need to file a claim. If the policy was canceled due to nonpayment, you will be SOL and will have to pay everything out of pocket. You could also have problems reinstating your policy, getting a new policy, and may end up paying higher premiums.

Buy a Car
Buying a car (if you need it) is another good way to build credit. Of course, if you can get a 0% financing deal, it’s the best way to pay for a car. If you have limited credit history, it may not be possible to get a 0% auto loan. It may not also be possible to get 0% if you decide to buy a premium model such as an S2000 (like I did). If you get a high rate on your auto loan, you could always refinance it on Prosper or some other lender. Be sure to set up automatic payments for your auto loan to keep your credit history pristine.

Credit Inquiries
Try to keep your credit inquiries to a minimum. If you have a lot of inquires, they will bring down your credit score. If you are trying to get a loan, ask for quotes based on your current credit score and income. Do not allow anyone to run a credit check until you’ve decided on what lender you will use. In other words, don’t give them your social security number until you know for sure that you will be borrowing from them.

It takes two years for an inquiry to be removed from your credit history. More recent inquiries (within the past 6 months) will have more impact on your credit score than older inquiries. If you have had very few inquires within the past two years and have held a credit card for some time, be sure to contact your credit card company and request an increase. It will help to improve your overall score, as it will lower your credit card utilization percentage.

Low Utilization
It is important you try to maintain a low balance in terms of your overall available credit. Of course, when you first start building your credit this may be difficult to do if you have low credit limits. Slowly but surely, your credit card limits will be raised. If you feel your credit limits are too low, you can always request credit line increases. I have even been able to request a couple of credit line increases on my Bank of America credit card without credit inquiries! They gave me the increases based on my excellent payment history.

A while back, I received a 0% offer on one of my cards with no balance transfer fee. I thought I would be clever and take out the maximum ($13,000), put it into a high interest account, and pay it back before the introductory period expired (6 months). Although I did make about $200 or so by doing so, it did come at a price. I saw my credit score drop from around 800 to around 730.

My score has gone up to around 750 since then, but it has taken some time to recover (over a year). I think a few credit line increases on some of my accounts have helped to bring it back up. It is important for me to note that I paid the entire balance in full and paid it on time. Therefore, the high balance must be affecting my score as well my current credit card utilization. Otherwise, as soon as I had paid off the balance, I would have seen my score jump back up to 800. Although I lowered my own credit score, I learned a valuable lesson: don’t max out your credit cards.

Keep Lines Open
Although canceling unused credit cards may sound like a good idea, it is actually more likely to lower your score. This goes along the same lines of maintaining low credit card utilization. Creditors like to see a credit card utilization ratio of around 30%-35%. If you cancel an unused credit card, your overall credit limit on all of your credit lines will go down. This will result in raising your credit card utilization and lowering your credit score.

So how many credit cards should you have? It is probably a good idea to have at least one credit card with each of the major credit card companies: Visa, Mastercard, Discover, and American Express. If you do get an American Express credit card, I’d recommend getting one with no annual fee (such as their Blue Cash card). You really shouldn’t need any more than one credit card with each of these companies. To increase your overall credit limit, rather than open new credit cards, ask for increases on your existing cards.

Once you’ve begun establishing/restablishing your credit history, if you make your payments on time, keep credit inquiries to a minimum, and keep your credit card utilization relatively low, you should be well on your way to building a good credit score.

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