debt Archives - Page 3 of 3 - Bankers Anonymous

June 28, 2015

Dueling Mortgage Gurus and Uncertainty

One of the things that makes finance endlessly fascinating (to me!) is that perfectly sound logic for one situation turns out to be perfect madness in another situation.

In my best moments I appreciate the ironies and contradictions. In my worst moments I despair for people whipsawed by the seeming complexities of financial choices.

Most middle-class folks grapple with one of these important choices – a home mortgage – at least once in their life. I’m a big fan of the choice to buy a home with a mortgage but even there, a controversial battle rages.

Anti-debt

On one side of the ring stand the anti-debt gurus like Dave Ramsey. While Ramsey really wants his followers to pay cash for their homes (which is fairly absurd), he has strong rules about what to do if you decide to borrow. For example, Ramsey says

Always make at least a 20% down payment, to avoid high interest charges and expensive private mortgage insurance.
Always get a 15-year mortgage rather than a 30-year mortgage because you will pay it off sooner, typically enjoy a lower interest rate, and you’ll pay significantly less interest over the life of the loan.
Never take on mortgage debt with a monthly payment that will command more than 25% of your take-home pay.
Always avoid adjustable rate mortgages which shift the risk of higher interest rates from the lender to you.
Never borrow additional home equity in the form of a home equity loan or line of credit.1

Ramsey – who built a real estate fortune and then went bankrupt by the age of 30 – preaches a low-debt or (preferably) no-debt financial lifestyle as a curative for people with past debt problems. He knows of what he speaks, and he has a certain strong logic for his points.

On the other hand, personally, I’ve broken each and every one of his rules. So I can’t actually advocate following his advice.

Pro-debt

On the opposite side of the ring, another financial guru Ric Edelman advocates the opposite approach.

Since Edelman’s contrarian position flies in the face of conventional wisdom, I enjoy presenting his points even more.

Only make the bare minimum down payment on your house – thereby freeing up your remaining capital for investing in the market, where you can earn an annual return higher than what you pay on your mortgage debt.
Always get a 30-year mortgage rather than a 15-year mortgage, to take advantage of the tax deduction on mortgage interest.
Never pay off your mortgage early or at all, because mortgages are the best way to borrow extremely cheaply. Again, use the borrowed money to invest profitably in the market.
If the value of your house rises, consider freeing up the equity to invest, through a home equity loan or line, rather then let your net worth stay locked up and unused in the form of your house. That way, Edelman says, if the value of your house drops you’ll at least have withdrawn the money and have use of it for emergencies.
Quickly paying down and eliminating your monthly mortgage payment is not an important goal because, as a homeowner, you’ll always have to pay insurance and real estate taxes anyway. Since you can’t eliminate those obligations, why bother trying to eliminate your mortgage payment?

You get the idea. When Ramsey says “Zig” Edelman says “Zag.”

Edelman presents some compelling math for his arguments. If you accept his assumptions then you could end up wealthier in the long run.

However, Edelman does not account for the psychological difficulty of saving money. Specifically, many of us benefit from the ‘forced savings’ of paying a mortgage, and few will have the discipline to take the extra monthly cash flow as a result of a 30 year mortgage and invest it for the long run, rather than squander it on iced latte frappuccinos.

As a result, I’m pretty sure some portion of people who take Edelman’s advice to heart will end up like the proverbial broke guy having to wear a barrel for pants. It kind of all depends on your specific situation.

My choices

In my own life I’ve had both adjustable rate mortgages and fixed rate mortgages. I’ve borrowed more than the conventional 80% limit. I’ve had 15-year and 30-year loans. I’ve paid extra principal on a biweekly basis, and I’ve also borrowed heavily against my home equity line of credit. I’d like to think I had compelling logic for each decision, or at least a sober mind for understanding what I was doing.

How to decide

I think my point is that the more wholly convinced a guru is, the less certain you should be. The stronger they lean in, the less likely they are to be correct in all circumstances, for all people. Ramsey’s got a great plan, for example, for people who’ve been bankrupt in the past or who have a history of debt problems. Edelman’s approach is closer to my own experience because he’s linking some risk-taking to long-term wealth creation, which I tend to do in my own life. But where you fall on the risk spectrum is a key determinant of their relevancy to your own situation.

Big Ideas vs Little Ideas

Nate Silver’s 2012 book The Signal And The Noise presents the dichotomy of a guru or pundit’s ‘big idea’ vs. ‘small ideas.’ While punditry rewards people who have ‘big ideas’ and ‘hot takes’ on topics, the reality is that certainty and big ideas come at a cost. Predicting the future – one of Nate Silver’s specialties – is a difficult business for people with big ideas. They rarely get it right. Instead, Silver advocates adopting a nimbler approach to observing the world.
When I read gurus like Ramsey and Edelman, I remind myself that their certainty is a sign of the ‘big idea’ thinking that Silver warns against, when we might be served better by smaller ideas, more responsive to changing conditions.

The more certain I am, the less likely I am to be wholly right.

A version of this post ran in the San Antonio Express News.

Please see related posts:

Book Review: The Signal And The Noise by Nate Silver

My 15-year mortgage – I am a Golden God

Rent vs. Buy a house

Home Equity Lines of Credit are awesome

The Latte Effect in my own life

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I have strong pro-HELOC views, as I’ve written about in the past . ↩

June 18, 2015April 14, 2017

Ask An Ex-Banker: FICOs Score and Monthly Balances

Note: See Part I on FICO Scores, which inspired this question from a reader.

Dear Banker,

I’ve been getting copies of my 3 credit reports annually since 2005.

I’m concerned about a change in the reported information from Capital One and Chase. My reports used to reflect
1) amount billed
2) scheduled (minimum) payment
3) actual payment

The latest reports from Transunion and Experian no longer reflect the “actual payment” amount, so although my reports show all payments made on time, it doesn’t reflect the full balance being paid monthly as opposed to the minimum payment.

I feel like I have to alternate credit cards in order to have a zero balance every other month so it doesn’t appear that I’m making minimum payments and carrying an unpaid balance.

I’ve contacted Capital One and Chase to ask them to report the actual payment amount as they used to, but all I get is a standard response “we’re correctly reporting your account” to the credit bureaus.

Am I wrong in thinking that if they report amounts in addition to whether or not the account is “paid on time”, they should include actual amount paid as well as amount billed?

Thank you
Bette in SA

—

Dear Bette,

Thanks for reading, and for your good question.

The most important element for FICO scoring (35%) is whether bills are paid ‘on time,’ so if you’re consistently doing that, your score will reflect that, and the fact that there’s a balance on your report is (mostly) irrelevant.

The FICO algorithm doesn’t care whether you make minimum monthly payments or full-balance payments. As long as payments are being made ‘as agreed’ according to the fine print you signed with your credit card company, your FICO score can’t distinguish between people who carry a balance and people who pay off their balance every month. What I mean is your score won’t be hurt by minimum monthly payments, nor can you really boost your score by making maximum/full balance payments. There is (almost) no distinction between them, for scoring purposes.

Small caveat: One small part of your score reflects your ‘usage amount,’ meaning what proportion of your available credit balances are used at the time of the score. Meaning, if you had a total of $10,000 in available credit among all your cards, and you were using $9,750 of that with a credit card balance, that could slightly lower your score. Not much, but a little.
Conversely, If you had a total of $10,000 available credit, but only showed up with a monthly balance of say $300 (leaving you with $9,700 available unused credit), that would slightly raise your score. Not much, but a little.

credit_score_auto_loans — A useful graphic linking credit scores and auto-loan rates

That would be the only sense you could be concerned about the monthly reported balance as you described. However, if you have many thousands in available credit and only hundreds in reported balances, those reported balances are basically irrelevant for your score.

As for you question to Chase and Capital One – I’m sure they won’t change their reporting methods. They just do an automated snapshot on a monthly basis to send to the credit bureaus. On any given day of that snapshot, we (the consumer) may have an outstanding balance on our card, even if we don’t carry any balance month-to-month.

My strong advice – don’t try to alternate card usage, and don’t worry about it, it’s not hurting your credit.

Michael

Please see related Posts

FICO Part I – What’s in the Score?

FICO Part II – Ignoring FICO and also why FICO is awesome

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June 15, 2015June 7, 2018

FICO Scores – Part I

I’m 43 years old and I have a terrible confession to make: I still know my SAT scores by heart. Wait, it gets worse. I still know my PSAT scores by heart. I know, I know, I’m that guy. I’m not proud of this so let’s move on quickly to another semi-related topic: FICO scores.

Unlike the SAT, everybody should track his or her FICO score throughout adulthood.

I bring up the SAT analogy because you should no more apply for a loan without knowing your FICO score than you would think of applying to college without knowing your SAT score. Like the SAT, FICO serves as a sorting mechanism determining your eligibility, in this case, for lending products.

Any credit card, auto-loan, mortgage, or business loan application you submit will prompt your lender to pull your credit score as a major determinant of your access to their best, or worst, products.

Unlike the SAT, however, you only need to remember one single number to achieve total success: a 720 FICO.

An online universe of FICO-score nerds exists and I’m not writing with that audience in mind, any more than I would encourage SAT nerds to remember their scores 25 years too many. (Yes, I’m looking right at you, mirror.)

FICO determines loan quality
If you’ve got a 720 FICO, considered by most banks the cutoff for “Prime” loans – the ones with the lowest interest rate and best terms – then you can stop nerding out about your FICO score. A higher score than 720 gives you nothing but bragging rights.

If you’ve got lower than a 720 FICO, expect to pay more in fees and interest, with fewer options. Borrowers in the high 600s may still qualify for what’s known in the banking world as “Alt-A” loans. Borrowers with a FICO score in the mid 600s or below either qualify for Subprime loans – a high interest rate, high fees, and somewhat punitive terms – or no loan at all.

What to do

So how do you access your score? The FICO company, as well as the three credit bureaus Equifax, Experian, and TransUnion each offer personal credit reports and scores for less than $20 each. You can spend a couple of minutes online to access your report and score, and I highly recommend doing this before applying for a loan anywhere.
You really don’t need to buy more than one score with one report from one bureau, so you should be able to accomplish your goal for under $20.

Free credit report?
Consumer advocates trumpet the idea that you can get a free credit report each year, which is true.
But that report does not come with a FICO score. I don’t think that a credit report without a credit score fully equips you with all the knowledge that you need.

To return to my college analogy, a free credit report with no FICO score is like a college application full of essays but no SAT score. You are not getting the full benefit of seeing your application the way a bank sees it, which is ultimately one of the main points of reviewing your credit profile. I advocate spending the money to get the score along with your credit report.

Inputs to FICO
So what does FICO measure? The Fair Isaac Corporation, the company behind FICO, reports that five factors go into their mathematical formula, all of them measurements of past borrower behavior.

I’ll list the factors in order of importance, according to their formula.

First: – Have you ever missed debt payments, and if so, how often and how recently? (35 percent)
Second – How much do you owe now? High debt lowers your score, while low debt compared to your available credit actually raises you score. (30 percent)
Third – How long have you been borrowing money? A longer time raises your score, while a shorter time lowers your score. (15 percent)
Fourth – FICO considers some types of credit like installment loans riskier than other types of credit like mortgage loans, and adjusts your score as a result. (10 percent)
Fifth – Have you applied recently for credit? This lowers your score a bit, as it shows you need to borrow money. (10 percent)

Lesson One: Time
Reviewing these five factors, we can see that the biggest determinant of your score is time: Specifically, are you timely with your bills, and how long have you responsibly handled debt?
Because of the impact of time, even younger borrowers with perfect credit history cannot achieve very high FICO scores (in the 800s), whereas older borrowers have a natural advantage because they may have very ‘old’ credit lines boosting their scores.

Lesson Two: No tricks
You should never make a financial or borrowing decision based on how it will affect your FICO score. Instead, just do the ‘right thing’ in your situation, and the FICO will work itself out. Paying your bills on time, lowering your balances when you can, building up a long-term track record of ‘safe’ borrowing behavior is the only reliable method for boosting your FICO.

Plenty of ‘services’ claim to be able to boost your credit score, but I would never recommend attempting any of these. Like many other areas of finance, the best practice is to ignore short cuts and tricks. Just stay focused on the long-term unsexy practice of paying back your debts. The FICO score will work itself out in the long run.

When I say you should avoid tricks and mostly ignore your FICO score, I don’t mean to ignore the underlying issue of settling past debts. The best practice is to make like a Lannister, and always pay your debts.

Next week I’ll write about when to totally ignore your FICO score, but also the financial advantages of not ignoring your FICO.

A version of this post ran in the San Antonio Express News.

Please see related posts:

Ask an ex-banker: FICO scores and monthly balances

FICO Part 2 – When to ignore FICO, and why FICO is awesome

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January 22, 2014January 22, 2014

Book Review: I.O.U. by John Lanchester

In reading and reviewing John Lanchester’s I.O.U. – Why Everyone Owes Everyone and No One Can Pay I continue my quest for the best contemporary histories of the 2008 Crisis.

One reason to study and understand a crisis like 2008 is to avoid repeating it. George Santayana’s pithy justification for historical review – “those who do not learn from history are doomed to repeat it,” – is apt, and not just because my father-in-law is a Santayana scholar.[1]

Another reason to study the 2008 crisis is to respond appropriately with a public narrative, and ultimately with financial policy, based on what we learned. I frequently shake my head at both the public narrative about what happened, and I also grit my teeth about financial policy. So I keep looking for the best accounts of the crisis.

Lanchester’s I.O.U. is one of the best. He’s a stunningly clear writer who usefully adopts colloquial language to explain financial concepts. Most non-finance readers need analogies and narratives to grasp a synthetic credit default-swap CDO, and Lanchester wields these beautifully.

Lanchester was researching contemporary City of London[2] life for his excellent Capital – which I reviewed here – when he realized that the financial innovations of The City were:

Fascinating in and of themselves
Completely opaque to non-financial people
Suddenly wreaking havoc around the world

The result is a clear, entertaining, and informative analysis of the causes of the crisis. Lanchester’s review is more comprehensive about the global financial system, for example, than Michael Lewis’ more narrowly-cast The Big Short, which relied on a few closely-drawn characters and their profitable trade against the sub-prime mortgage market.

Unlike the US-oriented histories of the 2008 crisis, Lanchester writes from the UK perspective, rounding out what we may already know from Andrew Ross Sorkin’s Wall Street-oriented Too Big To Fail, for example.

Lanchester reviews the proximate causes of the crisis

a) Extraordinary, hidden leverage in the world’s largest banks (Chapter 1)

b) Financial innovation in securitization models but with limited actual historical data behind the models (Chapter 2)

c) An over-reliance on home ownership as an investment, both in the UK as well as in the USA (Chapter 3)

d) A system of mortgage underwriting and securitization that removed consequences from the originators (Chapter 4)

e) An intellectual failure to consider our tendencies to misunderstand risk (Chapter 5)[3] and

f) A blindness of regulators to the hints of future disaster (Chapter 6).

Lanchester does not risk readers’ ire by shifting some portion of responsibility for the crisis from lenders to borrowers – something I actually appreciated about Edward Conard’s Unintended Consequences – but he’s got a satisfactorily complete narrative of the causes of the crisis.

Have you read a book yet on the 2008 Crisis that is funny, clear, accurate, and in plain English?

I owe you a recommendation.

Try I.O.U.

Now you owe me.

Please see related post: Book Review of Capital by John Lanchester

and please also see All Bankers Anonymous Book Reviews in one place

[1] Can I interest you in Santayana’s most accessible work, the 1935 novel The Last Pilgrim? This edition is edited by my father-in-law, and overall, good stuff. Among other things, The Last Pilgrim offers an interesting view of turn-of-the-last-century Boston Brahmin life. Boston Brahmins were, and are, some impressively thrifty folks.

[2] “The City of London,” or “The City” for non-financial folks does not mean the whole municipal entity including Buckingham Palace and Parliament and all the rest, but rather is shorthand for the capital city’s financial sector. In the UK when people say “The City of London” they mean the equivalent of saying “Wall Street” in the U.S.

[3] Lanchester acknowledges an intellectual debt to Nassim Taleb in this chapter, from his excellent books Fooled by Randomness and Black Swan.

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January 9, 2013January 21, 2016

Ask an Ex-Banker: Medical Debt

Dear Banker,

I have a question about medical debt. My 36-year-old sister just suffered a brain hemorrhage, collapsing at work and sent to the hospital. I am happy to say that she is expected to make a full recovery, but the treatment and ensuing hospital stay involved a week in intensive care, a neurosurgical “procedure,” numerous CT scans, and many, many medicines which she will take for months, if not her entire life. Although she and her husband have health insurance, they otherwise live on a very tight budget, and we are afraid of the hospital bills that will result from this incident.

We “heard” that health-care providers cannot bankrupt people who are unable to pay. If they do the best they can to cover the bills but simply fall short, which they most certainly will, on both counts, does some entity absorb the debt that they cannot pay? The government? The hospital? The insurance companies?

I mean, what do they do if the family simply doesn’t have the money to pay for the essential care she received?

Thank you, Concerned Sister (Alexandria, VA)

Dear Concerned,

I’m sorry to hear about your sister’s condition, and I hope she continues to recover.

Your question is a really important one – as extraordinary medical costs often bring on a financial calamity, following directly on the heels of a health calamity.

I read in your question anguish over your sister’s health – compounded by the anguish of financial insecurity for her even after she achieves a full recovery.

A hospital/patient relationship, in my opinion, is distinct from a business/customer relationship or banker/borrower relationship in a way which should change the way debt gets treated.

By that I mean neither the hospital nor your sister had a choice about the transaction. Your sister clearly didn’t choose to get a brain hemorrhage and her choice of treatment – whether made by her or her family – was made under considerable duress. The hospital, for its part, cannot refuse to treat your sister’s condition, despite its cost to the institution, or her likely ability to pay. She has to have the treatment to survive – given the consequences of not getting treated – and the hospital has to treat her, regardless of the financial consequences.

This absence of choice makes medical debt different from, say, ordinary credit card debt.

In my business experience, and indeed in my basic world view, refusing to pay a debt is akin to stealing. You received something valuable. Reneging on payment means you took that valuable thing without paying. This is hard-assed and perhaps unpopular, but that’s my view. Don’t hate me, I’m an ex-Banker.1

Medical debt stands out, however because of the absence of choice between customer and provider.2 Fortunately, most hospitals take this into account and assume a certain amount of financial indigence in their patient population. In other words, most hospitals make a larger provision for non-payment of their bills than a typical business. Traditionally, most hospitals have been run by religious organizations, governments, or universities that consciously blend a financial approach with an ethical non-financial approach to providing service.3

This approach could mean good news for your sister and your family, as the hospital should be prepared for many patients’ inability to pay their bills in full, including your sister’s.

Now, to return to your specific question of what can happen – and what your family should do. It’s a myth that the hospital can’t push your sister into bankruptcy.

Of course they can. Here’s the worst case scenario:

Let’s say she owes $50,000 to the hospital, and she ducks the bill because, as you say, she doesn’t have the money to pay it. The hospital will refer the bill to a collector, who can initiate a letter and phone campaign to get her attention and urge payments. Occasionally this campaign can threaten her employment, and it certainly will put her through considerable stress.

Following continued non-payment, the hospital may refer the bill to a collection attorney, who may take a period of time to sue her in court to obtain a judgment. With a judgment in hand, the hospital can, in most states, garnish her wages 4, place a lien on her home 5, or haul her into a court for a debtor’s exam to disclose her income and assets.

By the time (at least a year from now) that the hospital has obtained a judgment, the amount due will have risen considerably owing to penalties, interest, and lawyer’s fees.

With a court-ordered judgment, her credit will be wrecked so any future borrowing will be either refused or offered at usurious rates.

Needless to say this is a bad place to be in, and bankruptcy could seem like an attractive option for your sister.

So what should your sister and your family do to avoid this?

Up front, you should make an accurate record of her income and assets.

Ideally, for your short-term purpose, this record will show her inability to settle her $50,000 medical debt.

Next, find the highest ranking person in the hospital’s accounts receivable department and plead your sister’s case, offering to pay something monthly that she can actually afford. If that’s $100/month great, but if it’s only $25/month, so be it.

At a rate of $100/month ($1,200/year) that $50,000 medical debt will never be paid in full. That’s ok. At some point, a year or three from now, your sister can return to the hospital receivables department and offer some lump sum amount ($5,000?) based on her tax refund or house refinancing or ability to borrow $5,000 from a bank. Chances are, at some point, the hospital will welcome the partial settlement and offer debt forgiveness on the remainder.

Not-for-profit hospitals, in particular, budget for non-payment by many patients. Many may budget a particular amount of non-payment per year, so forgiving the $45,000 your sister can’t pay in 2013 may be impossible now since it exceeds their figure, but may be possible later because of the budget in a new calendar year.

As a finance professional who dealt with many non-paying debtors, I was always receptive to minimal monthly payments from an upfront debtor who made clear to me that non-payment and bankruptcy represented a much worse, mutually-assured destruction option. If the hospital accounts receivable department acts rationally it will welcome some regular, low payments now rather than engage in a collections fight with your sister that they’re uncertain to get anything from in the future.

I hope that helps and good luck to your sister and your family.

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Of course we can all imagine scenarios in which stealing may be ethically justified, such as a parent attempting to provide food or basic shelter for their minor children. The ethical imperative and human impulse to survive trumps the ethical imperative to not steal in certain circumstances. Yes, I just agreed to accompany my wife to the movie version of Les Miserables. Jean Valjean stole a piece of bread 19 years ago. That’s fine, I forgive him. ↩
The exceptions being optional medical procedures, such as elective plastic surgery. You had better pay for those butt implants in full, or else I will judge you harshly! ↩
It’s also why I have an instinctual aversion to for-profit medical practice. Yes, there may be some additional efficiencies to be gained from market practices, but medical service is not like other services. In the absence of a choice of whether or not to treat your broken leg, or appendicitis, or brain hemorrhage, pure profit motives can create ethical monstrosities. ↩
Not in Texas for example and a few other states. ↩
Not in Florida for example or Texas and a few other states with ‘homestead’ exemptions. ↩

October 21, 2012February 1, 2013

Ask an Ex-Banker: Home Loans and Home Equity Lines of Credit

Q. Dear Banker, My wife and I are planning an addition to our house. We need the additional space, but I do not want this project to stretch our overall budget. Since I have a specific idea of how much I want to pay, a rise in interest rates would cause us to make different decisions on the project details. Unfortunately, we need to make those decisions now but will not need the money for another 8-12 months. I don’t care if interest rates go down, I like where they are now, but borrowing money before you need it sounds foolish. How does your average Main Streeter hedge against interest rate swings?

Bradley T., San Antonio TX

A. I understand your question to be whether you should borrow money now, before you need it, because rates are ‘low enough,’ and because you worry rates will not be this low in another 9 months when you actually need the money for the home renovation.

My short answer is: “Maybe, although I personally would not” as to whether you should borrow now and lock in today’s low fixed rates, in anticipation of needing money 9 months from now. I’ll explain what I mean by that in a moment. The longer answer, which I’ll detail more fully below that, is that you really need a home equity line of credit, not a fixed-rate home equity loan.

The Short Answer

Should you lock in a loan 9 months early because rates are ‘low enough?’ I’ll make a bunch of assumptions to be able to answer the question specifically, and I hope you can adjust the answer to your own particular situation.

I’ll assume you can get a Prime[1] rate home equity loan for a pretty major $100,000 home renovation at 5%. That means you’ll pay $5,000 per year in interest, or an extra $3,700 for borrowing 9 months early.

$3,700 is not the end of the world for peace of mind, and so I’ll answer “maybe” borrow this way to lock in an attractive low rate like 5% today.

There are a few reasons, however, why I would not borrow money early myself. Foremost, we really have no idea which way interest rates will go in the future.

As a former bond guy,[2] I pay quite a bit of attention to interest rates. Had you asked me at almost any time in the last 10 years whether interest rates were likely to go higher or lower in the next 18 months, I would have said ‘higher’ approximately nine out of ten years, and I would have been wrong approximately nine out of ten years. That’s not because I’m ill-informed, it’s just because it’s much harder to forecast the future direction of interest rates than it seems.

Because of my own deep uncertainty about the future direction of interest rates, I would argue your choice to borrow 9 months early ‘locks-in’ a loan interest ‘loss’ of $3,700, whereas the rate available to you has a 50-50 chance of being higher or lower 9 months from now. If you accept my view, then your interest cost for the next 9 months, by not borrowing, is $0, which is much more attractive than losing a guaranteed $3,700.

But what if, 9 months from now, your fixed rate jumps to 7% from today’s 5%, and you’re locking in a 10 year $100,000 loan at $7,000 a year, rather than the more attractive $5,000 a year interest cost? Well, in that case, if you carry the full sized loan for 10 years, you’ll pay a total of $20,000 more in interest over the life of the loan. In that stark (probably-worst-case-scenario) example you will have lost out, and you will curse my advice, as well as my children’s children.[3]

Given that the starting position of borrowing early is that you’re $3,700 poorer, however, I see many more scenarios in which you come out ahead by not borrowing early.

If you plan to pay down the loan principal faster than 10 years, for example, or rates shoot up less than 2% over 9 months, or rates stay the same, or rates go down even further, you will have broken even or ended up better off by not borrowing early. So that’s why I wouldn’t take today’s rates.

The Longer Answer

Instead of a home equity loan locking in today’s good fixed rates, what you actually need is a home equity line of credit (HELOC) from which you can borrow money and pay down at any time.[4],[5]

When I started a business in 2004, I met with an elderly entrepreneur who gave me great advice: Obtain the largest possible home equity line I could, not because I needed it now, but, because as an entrepreneur I needed to be ready to take advantage of opportunities whenever and wherever they might arise.

He was right. In fact, any person who is both a home owner and a business owner, needs to stop everything right now and start applying for a home equity line of credit. Why are you still reading this blog post? Go, do it, now. I’ll wait.

Ok good, you’re back. You’re welcome.

In your case, Bradley, the potentially higher rates one year from now will be more than made up by the fact that you can borrow only the amount you need, as you need it, for your home renovation. The slower drawdown of debt principal and the faster payoff of principal via a home equity line of credit is virtually certain to save you interest costs in the long run.

I believe the fact that HELOC rates are floating – they may go up or they may go down over time – are more than made up for by the variable amount of principal you can take out only as and when you need it. Over the course of your planned home improvement project, if you borrow for example $33,000 for some period of time, rather than the full $100,000 loan, you’re obviously paying 1/3 of the interest costs than you would on the full amount, during the period of the smaller borrowing. My point is that even if you end up with the same peak amount of borrowing, $100,000, you’re likely to have paid significantly less in interest in getting to that point. Most of the time, those savings will outweigh the probability-weighted cost of higher future interest rates.

A special note for small business owners, new and old: If you’re just starting out, the HELOC may be your only ticket to borrowing money cheaply and flexibly. Banks only pretend to lend to small businesses, and they certainly do not lend to new small businesses, so it’s hardly worth trying that route. Banks do lend, however, against houses and home equity, so you’ve got a shot there.

For experienced small business owners: You still need the largest home equity line of credit possible. You never know when the commercial property right next to your office may become available, and when having $50,000 in ready cash is the difference between acquiring the real estate of your dreams and paying more to lease office space for the next 30 years. If you have to go to your bank to apply to get the loan to buy the property next door, you’re too late. You need the home equity line so that you can credibly represent to the sellers your ability to close the transaction within 1 week, in ‘cash.’ That is how the pros do it.[6]

[1][1] Meaning, you have excellent credit, at least above a 720 FICO. The FICO people sell their scores from all three major credit rating agencies here for about $35. It’s worth it to pull your score once in a while, so you can confirm you’re eligible for the best rates and there’s no weird activity on your credit reports. Don’t let FICO trick you into paying $14/month. That’s stupid.

[2] No, not the Daniel Craig type of Bond guy, much to my wife’s chagrin.

[3] Which is as good a segue as I can think of for repeating Jack Handey’s Deep Thought: “I believe in making the world safe for our children, but not our children’s children, because I don’t think children should be having sex.”

[4] This entire ‘Ask an Ex-Banker’ advice column today assumes you are a responsible borrower, and that debt incurred through a home equity line of credit will go toward productive home and business improvements and not be blown on subsidizing your unsustainable consumer-driven lifestyle. In your case, Bradley, since you live in San Antonio, that means you can’t blow the whole line of credit on Alamo Lego miniatures and bad Tex-Mex food. But since www.bankers-anonymous.com readers are, almost by definition, extremely responsible with debt, this hardly bears mentioning.

[5] Most HELOCs give you a drawdown period of, say, 10 years, followed by a payback period of another 10 or 20 years.

[6] While I’m very much in favor of HELOCs for small business owners, I need to acknowledge in the fine print here that things can and have gone wrong for small business owners putting their houses at risk. Of course this would be terrible. When you get a HELOC for your small business, make sure you save it for an opportunistic can’t lose situation, not use it to keep your flailing, unsustainable, small business alive.

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