Homeowners: Pay Property Taxes and Insurance Yourself

Generally, home mortgage payments consist of 4 parts:

  • principal (a partial payment toward the amount that was initially borrowed)
  • interest (the cost of “renting” the remaining loan balance)
  • property taxes
  • insurance

mortgageWhen someone borrows money to buy a house, the lender has a good reason to want to make sure that the property is insured and the taxes are paid.  (If the house were destroyed in a fire or other accident, the lender would have no way to collect the debt if the borrower walked away.  If the taxes aren’t paid, the local government could seize the house and sell it to pay the unpaid taxes.)  Because lenders prefer to make sure that insurance and tax bills are paid, and paid on time, they include those costs in the monthly payments and pass the money along to the insurance company and local government as needed.  The money is kept in a separate “escrow” account in the mean time.  Federal Housing Administration (FHA) loans always come with an escrow account and include insurance and taxes in the payments.

Many homeowners like escrow accounts just fine.  It’s convenient.  Not making insurance and tax payments means two fewer things to worry about.  Someone lacking in financial discipline might not be able to put enough money aside for the tax and insurance payments, and that could lead to trouble.  Simply forgetting to make the payments can lead to late fees, or worse.

However, someone who is able to manage their money and wants to spend a little extra time doing so might want to consider a no-escrow loan.  While this does not reduce your taxes and insurance costs, it does let you keep your money in your own account until you need to make the payments.  This might allow you to earn some interest from the bank (or credit union!) where you keep your checking and savings accounts.  Additionally, you might more easily meet some minimum balance requirement that eliminates monthly service charges.

It’s usually easier to avoid escrow on a new loan and harder or impossible to remove an escrow requirement from an existing loan.  Even if you can avoid escrow, watch out: banks might charge a higher interest rate on a no-escrow loan.  As always, shop around and negotiate.

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The Cost of Credit Cards

Data from the Federal Reserve show that Americans owe close to 1,000 billion dollars of revolving debt* (which I’ll refer to as credit card debt).

Dividing the total credit card debt ($1,000,000,000,000) by the adult population of the United States (the 245 million (245,000,000) persons over age 18) shows us that, on average, every American adult carries a total balance of about $4,000 on his or her credit cards.

Note that this is an average for all adults.  Because we know that some adults have no credit card debt, we can be certain that the average total credit card balance of adults that do carry credit card debt must be higher than $4,000.  Many of them carry these balances for months, or years, or decades.

How much does it cost to carry a credit card balance?

The answer depends on two things:

  • the size of the balance
  • the credit card’s interest rate

Let’s assume Joe College gets his first credit card.  A short time later he has spent $1,000 — all charged on the card.  Thereafter, the credit card balance doesn’t go much higher (let’s say that’s close to the card’s credit limit, and Joe’s a smart guy; he knows he’ll be hit with an penalty fee if he goes over the limit and it will be bad for his credit score).  If Joe paid off the entire $1,000 as soon as he got the bill, then there’d be no balance and therefore no interest charge.  But that’s not what happens.  Joe makes payments in an attempt to pay it off, but too-often he gives in to temptation and uses the card to buy something he wants, or there’s something he urgently needs and he charges it.  Thus, the balance is sometimes a little below $1,000, sometimes a little above $1,000, but it averages $1,000 for an entire year.

Most credit cards have interest rates between 10% and 30% per year.  People with good credit scores (who are probably likely to have low balances) might get cards with rates that are lower, while those with bad credit scores might have cards with interest rates that are even higher. So let’s assume the interest rate on Joe’s card is 15%.

The average balance on Joe’s card is $1,000 and he pays 15% interest per year.  How much does that cost him?

The annual amount of interest paid is a simple calculation of the interest rate as a percentage of the average balance, or:

[interest rate] / 100 × [$ average balance] = amount of interest paid per year

which in our case is:

15 / 100 × $1,000 = $150

or:

0.15 × $1,000 = $150 **

The $150 is broken down into monthly changes of $12.50 that are added to each month’s bill. If Joe paid only $12.50 per month, the $1,000 balance would never be reduced.  If he didn’t even pay the $12.50 interest change each month, his debt, the credit card balance, would grow as the interest would be compounded.  (His debt would also grow because he’d be hit with a late fee that would almost certainly be even higher than the month’s interest charge.  A payment greater than $12.50 would reduce the balance by whatever amount was additional to the interest.

We assume that Joe makes the payments that are normally required, which takes care of each month’s interest charge and applies some additional amount to the balance — but, as already noted, Joe keeps making purchases with his credit card, so the average balance is continually at $1,000.

This costs him $150 per year.  Consider that for a moment.  After 7 years, Joe will have paid more than $1,000 in interest, effectively doubling the cost of the first $1,000 worth of purchases he made soon after he got the card.  If he keeps going he will pay for those purchases several times.  After another 7 years, the credit card issuer will have another $1,000 of Joe’s money, … and so on for as long as Joe carries that balance on his credit card.  If Joe ever pays late or misses a payment on this credit card or any other debt, it’s quite likely that the credit card issuer will increase the interest rate on Joe’s card.  If the rate goes up to 20%, Joe will pay $1,000 every 5 years.  At 30%, he will pay $1,000 in interest charges every 3 and 1/2 years.

borrower_is_slaveLet’s remember that Joe’s spending spree stopped when he reached the card’s credit limit.  After that — after he charged that initial $1,000 — he was able to keep new charges on his credit card and what he was able to pay in equilibrium.  It’s that initial $1,000 that made Joe a borrower.  If he had been able to find that equilibrium when the credit card balance was $0, and kept his average balance at zero by charging only what he could afford to pay off each month, he would have saved that $150 each year.

The Bible says that the borrower is slave to the lender.  That should make us wonder: What was it, in that first $1,000 of charges, that was so important, so essential, that Joe had to have it, even at the cost of turning himself into a slave?  There’s an excellent chance that after he’s paid over $1,000 in interest, Joe can’t even remember what he’s paying for as he finishes paying for it for the first time and begins paying for it the second (or third …) time.  As the old saying goes, the purchase should outlast the payments.  If Joe can’t even remember what it is he’s paying interest on, can it be important enough to pay for it over and over again?

Think how much better off he would be if he had resisted the temptation to over-use his credit card.  If he had

  • cooked dinner at home instead of going out to a restaurant,
  • invited friends to play cards or a board game, or just watch TV, instead of going to a movie, concert, or sporting event,
  • had friends over to his house to drink a few beers instead of going to a bar or club,
  • shopped for new (to him) clothes at Goodwill or similar thrift store,
  • gotten free or nearly-free furniture, television, stereo, etc.,  from Craigslist or hand-me-downs from friends or family.

Had he done those thing, he would have been at least $1,000 richer every 7 years.

Now consider that the average American has a credit card balance of over $4,000.  Take a look at Joe’s story again, but multiply every number by 4.  A balance of $4,000 at 15% costs $4,000 in interest payments every 7 years.  At 20%, it’s $4,000 every 5 years.  At 30%, $4,000 every 3 and 1/2 years (which is well over $1,000 per year!).

Look at yourself: Are you an average American?  Are you running a credit-card-interest tab (put it on the card, put it on the tab) that’s costing you hundreds, or thousands, of dollars each year?

Remember the annual-spending tip.  If you earn, say, $50,000 per year and you’re paying $500 in credit-card interest, then interest on credit-card debt is costing you a full 1% of your income.  Are you paying 1% of your income in interest when at the same time you’re not even saving and investing 10% of your income for your own future … and maybe telling yourself you can’t save 10%, there’s nothing you can cut down on.  Well, how about cutting down on the credit-card interest you pay?

The moral of the story should be clear: If you don’t have a credit card balance, do everything you can to avoid getting one.  If you have one, do everything you can to pay it off.


* Revolving debt is basically what people owe on bank-issued credit cards and retailer-issued store and gas cards, which allow the borrower to make additional charges without any additional application process. Thus, many borrowers add new debt as fast as they pay off old debt. Home equity line of credit (HELOC) loans would also seem to fall into this category, but the Federal Reserve does not include loans secured by real estate in total revolving debt.

** The actual calculation used by credit card issuers is a bit more complex.  It involves dividing the interest rate by the number of days in a year (~365) and multiplying that by the average daily balance each month.  But our approximation works well enough for our purposes.

Einstein, Algamish, and Compound Interest

compound_interest
“Burritt’s Universal Multipliers for Computing Interest, Simple and Compound” by Elijah Hinsdale Burritt

Albert Einstein probably never said,

  • “Compound interest … one of man’s greatest inventions.”
  • “The most powerful force in the universe is compound interest.”
  • “Compound interest … the greatest mathematical discovery of all time”
  • “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”

At least, despite all of the appearances of these and similar quotes attributed to the great physicist in modern personal finance literature (and all I’ve seen were published long after Einstein’s departure from this sphere), I’ve never seen any that had a proper citation.

The formula used to calculate the future value of an investment with compound interest is pretty cool.  Maybe that’s what Einstein was talking about.  But I digress.

While there’s a lot wisdom in those (probably) spurious “Einstein quotes”, and I especially like the last one, here’s another saying about compound interest that I like even more (and I don’t know who said it):

Compound interest can either work for you or against you.  You decide.

Borrow money and you’re in debt.  If things go as planned, you pay all of the interest and part of the principal in a given month.  (Of course, you should pay more than just whatever part of the principal is required by the lender.  You should pay more so you can get out of debt as quickly as possible)  But if don’t manage to pay all of the interest you owe in a given month, then that interest is added to the principal.  Let that happen and you owe more than you initially borrowed.  Then you owe interest on the interest!  That’s compound interest working against you, whether it’s a loan against your car or just your signature.  Another reason to avoid debt.

But:

Put your dollars into a good investment.  They earn more dollars.  Then put those dollars you earned into the same investment.  They will earn even more dollars along with the dollars that were invested first.  It goes on forever.  That’s what’s so powerful about it.

In The Richest Man in Babylon, Algamish says it this way:

Every gold piece thou keepeth is a slave to work for thee.

Every copper it earns is its child that also can work for thee.

If thou wouldst become wealthy, then thou must keep and save.

And every coin thou keepest must work and earn, and their children must also work and earn, that all may help to give thee the abundance thou dost crave.

 

 

Please Don’t Get A Car-Title Loan

car_title

It makes me sad and angry to read, “Back in 2007, the couple took a $500 car-title loan that mushroomed into a $3,000 headache”, in a news story about car-title loans.  Clearly, there’s something morally wrong here. Lenders just shouldn’t lend money to people who can’t pay it back.  These lenders not only lend money, they count on profiting when the borrowers are unable to repay.  That’s when the lenders pile on the fees and the loan gets rolled over into a new loan.  The story of a $500 loan growing into a $3,000 debt is only one of thousands of such stories.  Many of these loans grow much larger.

We could discuss what the couple should have done (work more, spend less, beg or borrow from family and friends instead of going to the car-title loan place).  Or we could discuss what kind of laws might help protect people from this sort of lending (limits on interest rates or fees? mandate that all loans must allow repayment in some large number of monthly payments?).

But what I want to say most is simply this: Debt can be an awful, evil, horrible thing and must be used with extreme care and caution and avoided as much as possible.

If you aren’t able to borrow a small amount like $500 by just filling out a couple forms and signing on the dotted line (without putting up your car or any other valuable property as collateral), then you shouldn’t be borrowing money at all.  The system is telling you that you are not a good borrower.  You are not a good risk.  If you proceed you will be treated accordingly.

The rich rule over the poor, and the borrower is slave to the lender.
— Proverbs 22:7

Noticing the Net

You’ve probably experienced how much more real something is when you see it with your own eyes instead of just “knowing” about it by reading about it or seeing pictures.  It sure works with the Grand Canyon.  My kids were certainly more impressed by the real thing than they were with the pictures they saw before they went to Arizona.

Of course, I’ve known for many years that my Net Worth is:

  • The Sum of all Assets
    (mostly the total value of all my investment and savings accounts and the value of my house; however, cars, furniture, and other valuable possessions should also be included but in my case these are of relatively little value)

Minus

  • The Total of all Debts
    (my home mortgage [more than zero] and any student loans, car loans, etc. [zero] and credit card debt [close to zero and paid in full at least once per month]).

And yet until recently I had never actually calculated my exact net worth.  I had only done some very quick estimates.  Years ago, I knew my net worth was negative, because the mortgage was large and was roughly net_worth_2016equal to what my house was worth, my investments and savings were small, and unfortunately I had more debt on a credit card than I could pay off in a month.  (Please learn from my mistake; never allow that to happen.)  I paid off the credit cards.  Gradually the large mortgage became smaller and my house grew in value along with my savings and investments, such that for years I knew that my net worth is a nice-sized positive number, but still it was only a rounded, vague estimate that I calculated in my head.

Since I started using one of the on-line saving and spending trackers (mint.com in my case; there are other similar services), my net worth has been much more precisely fixed in my mind.  Whenever I want to see it, there it is: all my assets, all my debts, and the net total.

One effect of this is that it makes me think even more than before of the importance of paying off that mortgage.  Because now it’s shown to me ever more clearly that the net worth comes from both the assets (which I want to increase) and the debts (which I must decrease).

This seems obvious, I guess.  Like I said, I always “knew” that’s how it worked.  But actually seeing it frequently somehow makes it more real.

Now, when I pay my mortgage, I don’t just see money leaving my checking account, which is the “money gone” phenomena that occurs whenever I buy anything.  Instead, I see the money (a) leave my checking account (seen as “Cash” in the screenshot image above), and then the same money (b) decreases my debt — so the effect on my net worth is zero.  Normal spending (spending for consumption, not investing) decreases my net worth.  All that happens is some amount gets subtracted from “Cash”.  Paying off the mortgage is different: it both reduces the amount of cash I have and at the same time it also reduces the amount of debt I owe.  Seeing that happen, even if it’s only some colored pixels in a little box on a computer screen, motivates me and makes me want to do even more to decrease that debt.

Just Three More Payments and They’re All His

One of the fun things about live bluegrass music performances is that it seems to be standard practice for bluegrass musicians to include jokes and humorous anecdotes in the show. I guess this is an old tradition.  You can hear it in the old radio broadcasts of the “Grand Ole Opry“, and the tradition has been carried on in public radio’s “Prairie Home Companion”.

saddle_shoesAt a free concert in a local park (of course I go to free concerts) I saw Monroe Crossing, a bluegrass band led by a man who not only sings and plays guitar, but also knows how to tell a joke. Some of his jokes were a running gag the subject of which was the youngest band member: his youth and good looks, his nice clothes, and his fancy saddle shoes.  One of the jokes that referred those beautiful shoes ended with the punchline, “Just three more payments and they’re all his”.

Part of the humor was the way he said the line: slow, sardonic, and after a well-timed pause.  It’s also funny because it seems absurd.  Pay for shoes on an installment plan?  That’s how most people pay for cars!  (Although it would be better if they didn’t.)  A loan?  For shoes?  Paying interest to a moneylender to get a pair of shoes?  Ha!

But think about it.

If you buy shoes, or clothes, or lunch and dinner with a credit card and if you don’t pay 100% of the balance every month before any interest accrues, then you’re the butt of the joke.