It’s almost always smart to substitute low-cost debt for high-cost debt, and home equity loans cost less. The money you save can be used to reduce your home equity debt or to raise the amount you contribute to a tax-deferred retirement account.All the Best Ways to Borrow Money to Invest
The rich didn’t get that way by saving pennies.
That’s only what they tell their biographers.
They made their fortunes on borrowed money.
Don’t borrow to spend. Occasional debt on a credit card never hurt anybody, but permanent indebtedness to support an implacable spending habit is a staggering waste. A loser’s game. At 18 percent interest, you are paying an extra $18 for every $100 you spend. Why would you want to throw that much money away? You’re living rich while growing poor.
But don’t be shy about borrowing to invest. That’s how people get rich. They use OPM—Other People’s Money—to build something of value for themselves. Here are the classic steps to wealth: First, shed consumer debt. Second, build assets through home ownership, saving money, and investing. Third, borrow prudently against some of those assets to invest for even more net worth.
Investment debt is money you borrow to acquire an asset that, with luck, might rise in price. You’re gambling that the price increase will more than cover the loan’s cost. You hope to be left with a profit after selling the asset and paying off the loan.
A mortgage is the most ubiquitous form of investment debt. A college loan comes second—an education is an investment because it builds your earning power or the earning power of your children. A loan to start or buy into a business can multiply your money many times if the business succeeds. A car loan supports both your earning power (you drive to work) and your investment program (by buying a car with borrowed money instead of cash, you’re left with more earnings to stash in a tax-deferred retirement account). Even a debt consolidation loan is worthwhile if it lowers the interest you have to pay and you don’t run up your debts again.
Borrowing to invest in stocks, however, is a high-risk proposition. If you’re feeling crazy, you can borrow against other stocks to do this (page 310). But never buy stocks with money borrowed against your house or your retirement account. They’re the building blocks of your security.
The critical test of the value of any loan is that the money you borrow not disappear (say, into lizard-skin shoes or gear). It should be used in some way to maintain and improve your wealth.
When you borrow to invest …
1. You can afford any debt that will support itself. Can you rent out a duplex for enough to cover its costs? If so, and if you have savings to cover the mortgage in case something goes wrong, and if you like being a landlord, go ahead.
2. You can afford any debt that you can easily repay out of personal earnings. If your job is secure, up to 40 percent of your income can be committed to monthly repayments, including mortgage repayments. When you borrow against your salary, however, you should generally be making a liquid investment—that is, an investment that’s instantly salable at the current market price. If you lose your job and you’re pressed for cash, you can dump the investment and eliminate the debt. Mutual funds are liquid. Second homes aren’t. When you finance a second home out of earnings, you should either be dead sure of your job or have enough savings to carry the mortgage for a year or two if your income falls.
3. You can go into debt to make an illiquid investment as long as you have a substantial amount of liquid securities or money in the bank. Say, for example, that you borrow to buy a piece of land that you intend to subdivide and sell as separate building lots. Then you lose your job. The land may not be salable except at a giveaway price. But your lender (that stone-hearted bean counter) thinks you should keep on making monthly payments anyway. How will you manage? No sweat, as long as you have a lot of cash or stocks that you can liquidate. If you don’t, never finance an investment like this. You’ll be playing dice with your solvency.
When you want a loan, don’t put on the sackcloth of a mendicant and approach your banker on bended knee. You are a customer in a money store. Everyone wants your business if you’re a good credit risk. You can negotiate terms just the way you negotiate a new-car price. Bankers expect borrowers to be choosy and are astounded when they’re not.
In any city, the most costly lender may charge anywhere from 2 to 6 percentage points more than the cheapest one. A poor credit risk may have to accept those terms; a good one doesn’t.
Your search for a loan should start with the online lenders such as E-Loan (www.eloan.com) or LendingTree (www.lendingtree.com). They often have the lowest rates and fees and disclose them in full (no surprises when you close!). You can handle the entire transaction online or speak with the lender over the phone. Next, consider a credit union if you can find one to join (page 44). Finally, look at banks. In general, smaller institutions charge lower rates and fewer fees than large ones and may be more willing to negotiate. You might also get a discount by borrowing from your primary bank (although online lenders might even beat the discounted rate). At a bank, always make an appointment to see a loan officer; don’t just wander in off the street. Innocents wander; smarties prearrange.
Make a list of the things you want to know: annual percentage rate, fees, down payment, monthly payments, repayment schedule, interest rate options, and, on variable loans, your risks if interest rates rise. Ask: “Is that the best you can do?” “Will you cut a quarter point off the interest rate?” “Will you lower the points I have to pay up front?” If it’s a big personal loan, ask: “Can I borrow at less than the prime lending rate?” (That’s the bank’s benchmark rate.) Then say, “Thanks very much, I’ll think it over,” and leave. You can negotiate with online lenders just as you can in face-to-face situations. Larger loans (say, $50,000 and up) get better terms.
Check two online lenders against what a bank or credit union will offer. If your favorite bank has a higher interest rate than the others, tell it what the competition is doing. If it wants your business, it will come down. You’ll get the best rate if you have at least two lenders bidding for the loan.
If you don’t qualify for an online or bank loan on the best terms, you shouldn’t be borrowing to invest. You’re simply not solvent enough to take the risk. Consumer finance companies lend to people with lower credit ratings, but they charge higher interest rates and fees. They may want your house as collateral, even for very small loans. If you take a series of small loans, you’ll find fee piled on fee, making borrowing hugely expensive. That’s no way to get rich.
It may sound uncharacteristically wild of me to suggest your home as a source of risk capital, but that is the principal source that many of us have. If you think you can profit by borrowing money against your home, it’s worth a try. But only if you can comfortably carry the larger mortgage; and only if you’re sure of your income; and only if you’ve applied the rules of sound investing (chapter 21); and only if you expect the investment to appreciate by more than your net interest cost; and only if you’re not gambling on stocks; and only if you wouldn’t be devastated if your house declined in value or the deal flopped. That’s a lot of “onlys.”
You borrow against your equity, which is the difference between the value of your home and the mortgages you carry. It’s the cash you’d realize if you sold the house and repaid the bank.
Generally speaking, people feel more comfortable tapping their homes for real estate investments than for stocks. For example, you might use your equity to finance a rental property. Well-chosen real estate usually won’t lose half its value in a year the way that stocks can (unless you bought into the bubble, a once-in-a-lifetime wreck). A home is also a good source of college money: an investment in future earning power.
But—if your outside investment goes sour, you lose the money and can’t repay the loan you took against your home, you’re stuck with higher monthly payments for the duration of the mortgage. If your life goes sour—you get sick or lose your job and can’t make those mortgage payments—you forfeit your home. Think the new investment through with care before financing it with money borrowed against your house.
The loan of choice today is a second mortgage, also called a second trust, which pledges your house as collateral. It has become standard issue, like a car loan or blue jeans. Practically everyone has them, for one purpose or another. They come in the form of a loan with fixed terms or a home equity line of credit. Some lenders also give second mortgages on condominiums and mobile homes.
Home-equity loans are a child of the tax laws. You can tax-deduct the interest on a second mortgage up to $100,000 (although the loan can’t exceed your home’s fair market value). By contrast, you get no deduction at all for interest paid on auto loans, some student loans, credit card debt, and personal loans.
Second mortgages come in two main types:
A traditional second mortgage works just like a first. You borrow a lump sum of money and pay it back over a fixed term, usually 10 to 20 years and sometimes 30 years. The interest rate may be fixed or variable. The minimum loan runs in the $40,000 to $50,000 range. Good credit risks can borrow online or from a bank or credit union. Marginal credit risks should try for a Title I Property Improvement loan insured by the Federal Housing Administration (FHA) and offered by a limited number of banks. Go to the U.S. Department of Housing and Urban Development (HUD) (www.hud.gov) for more information on these loans, as well as for the names of FHA lenders in your area.
Borrowers, however, have fallen in love with a different kind of second mortgage: the home equity line of credit. It’s a loan tailor-made for our self-service times. Instead of borrowing a fixed amount of money, you arrange for a fixed amount of borrowing power (typical minimum: $5,000 to $10,000; maximum: $100,000 to $500,000), available over the next 10 to 15 years usually at a variable interest rate. During that time, you can take a loan anytime you want, with no further approval from the bank.
Different lenders provide different ways of tapping your home equity line. You might use a special check, put down a credit or debit card, attach the credit line to your regular checking account, make a phone call asking that funds be transferred into your account, or make transfers online. There may be a minimum initial draw, such as $5,000, and minimums of $250 or $500 for subsequent draws. You pay interest only on the money that you actually use.
How fast you repay a home equity loan is often up to you. Depending on the lender, you can generally choose to:
1. Pay interest and a portion of the principal each month, erasing the loan over 5 to 20 years.
2. Pay only the interest for 5 to 10 years. After that, you might renegotiate the loan terms, continuing to pay interest only. Or you might have to start reducing the principal at a big jump in monthly costs.
3. Make fixed monthly payments even though you have a variable-rate loan. When rates rise, you may be paying less than the interest due, which ramps up the size of your loan and costs you extra money. Not advised!
4. Pay substantial amounts each month to clear up the loan as fast as you can. If this is your plan—and it’s a good one—get a loan without prepayment penalties. Some lenders charge $500 or so for accounts paid up within the first 2 or 3 years.
Whichever payment method you choose, a home equity loan is payable in full when the house is sold.
Home equity lines are offered by online lenders, commercial banks, mortgage banks, credit unions, consumer credit companies, finance companies, and even some large brokerage houses. Online lenders and credit unions often have the best terms. Finance companies have the worst.
Note that your borrowing power isn’t guaranteed. Any lender may reduce or freeze your credit line if your home’s value falls.
Should You Take a Home Equity Line or a Traditional Second Mortgage? A traditional second mortgage is all discipline. Your interest rate is usually fixed, so the loan won’t cost more if rates go up. You cannot easily add to the loan—no temptation there. It’s a good way to borrow for a single purpose, such as redoing the kitchen. It’s the right loan for people on limited budgets. And it’s a good defensive loan in a shaky marriage. The money goes toward something you both want, and there’s no other borrowing power on tap. This loan is the wrong choice, however, if you want to be able to borrow in the future, at various times.
For multiple loans, go for a home equity line of credit. Once you’ve opened the line, you can borrow against it whenever you want. It’s the right choice for meeting a series of needs, such as college tuition for the next four years. Most lenders charge variable interest rates—typically at a margin of one to three percentage points over the prime interest rate. So your monthly payments can rise and fall. This loan is safest for people with comfortable incomes who won’t faint when rates go up.
Which is Cheaper, a Traditional Second Mortgage or a Home Equity Loan? That’s hard to tell. You can’t necessarily compare their annual percentage interest rates (APRs) because they’re figured differently.
On a fixed-term second mortgage, all the financing fees are considered part of the APR. That’s the loan’s true cost. On a home equity loan, however, finance fees are not included in the APR. Some home equity lenders don’t charge any finance fees, in which case their APRs are true. When lenders do charge fees, the APRs understate the loan’s true cost.
In general, both the interest rates and closing costs on fixed-term second mortgages are higher than on lines of credit. But not always. To compare these loans, list all their costs: their interest rates, any financing fees (application fees, points, and loan origination fees), and any service fees (for title search, survey, appraisal, credit check, legal work, and so on). Most home equity lines charge nothing up front but typically levy annual fees of $50 to $75. The few loans with high up-front fees may not be worth their cost.
Should You Finance a Car with a Home Equity Loan or an Auto Loan? Unfortunately, you can’t necessarily compare their annual percentage rates of interest to see which is the better deal. Up-front fees are figured into the APR for the auto loan but not for the home equity loan. The comparison is fair only if the home equity lender doesn’t charge any fees. Otherwise that loan costs a little more than it appears.
The auto loan might be cheaper if you can get a super-low-cost promotional loan. Otherwise the home equity loan should be cheaper because you can tax-deduct the interest.
Should You Take a Home Equity Loan to Pay Off Your Credit Card Debt? I can think of two reasons to say yes and four to say no. First, the positives:
It’s almost always smart to substitute low-cost debt for high-cost debt, and home equity loans cost less. The money you save can be used to reduce your home equity debt or to raise the amount you contribute to a tax-deferred retirement account.
Furthermore, home equity interest is tax deductible on loans up to $100,000 if you itemize deductions. There’s no tax write-off for credit card interest. (There’s also no write-off for home equity interest if you use the standard deduction.)
Now the negatives:
Most credit card debts are paid off within about 15 months. That holds down the interest bill. On home equity lines, however, loans usually linger much longer. Some people treat them as permanent debt to be paid off when the house is sold. So despite the lower interest rate, a home equity loan might cost you more.
You might borrow against your home to clean up your credit card debt, then run up your credit cards all over again. That gives you double the debt you used to have.
With so much home equity at your fingertips, you might shop up a storm. Your home value could vanish in a mad afternoon at the mall.
When you don’t repay your credit card debt, the lender duns you and may sue. At worst, this ruins your credit record. But if you don’t repay home equity debt, you can be foreclosed. For this reason, you shouldn’t pile all your consumer loans onto your house, regardless of the tax advantage. In an emergency, you need some loans you can duck.
Bottom line: It’s fine to refinance non-tax-deductible consumer debt with a home equity loan if you pay it off fast and resist new debt. Otherwise forget it. To spendaholics, home equity lines are a doomsday machine. For calculators that will help you decide whether to consolidate debt, go to www.mtgprofessor.com.
Should You Consolidate Debt By Refinancing Your First Mortgage, or Should You Take a Second Mortgage to Do the Job? When making this decision, don’t rely on the advice of a lender or mortgage broker. They may tell you to refinance because that earns them the biggest commission. You need to determine which will cost the least over the years you expect to be in the house. To help you do this, check the calculators at Mtgprofessor.com. In general, the refi will be better if you can lower the interest rate that you currently pay. If not, the second mortgage is usually the better choice. Your calculation also has to consider costs such as closing fees and mortgage insurance, as well as the number of years you expect to be making payments. You do yourself no good if you lower your monthly payments but stretch them out for so many years that you raise the total interest cost.
Should You Borrow If You Plan to Move? This is the downside nobody thinks about. When you sell your house, you have to pay off your first mortgage and the home equity loan. That leaves you less cash to put down on your next home and may stop you from trading up. If your home drops in value to less than the amount of the loans against it, you won’t be able to move unless you have extra cash on hand to repay the bank.
If you think you’ll move in four or five years, buy your car with a separate auto loan and leave your home equity alone.
Should You Agree to a Home Equity Line If Your Marriage is in Trouble? Absolutely not. And tell the bank, in writing, to freeze any lines that you already have. When you’re married, it takes only one signature to originate a home equity loan. One spouse could borrow up to the limit of the line and spend the money, yet you’re both responsible for the debt. A divorce-court judge ought to tell the spouse who took the money to pay it back, but you can’t count on that.
1. Don’t open a larger credit line than you really need. If you apply for a credit card, the lender will check your credit report to see how much borrowing power you have already. A large, unused home equity line shows that you could add substantially to your debts. As a result, your card may carry a higher interest rate.
Banks usually lend a maximum of 75 to 80 percent of the value of your house, minus the amount remaining on your first mortgage. On a $200,000 house with a $120,000 first mortgage, for example, you could get $30,000 to $40,000 more. If your income seems too low to carry so large a debt, the bank ought to lend you less. Some lenders, however, stretch you right to the edge of your income and beyond. It’s up to you to say “Enough.”
In the past, a few lenders let you borrow up to 100 percent of equity. Homeowners came to grief when prices fell and they owed much more than their homes were worth. Don’t be tempted to borrow more than 75 percent of your home’s current equity value. You must leave a cushion for yourself in case conditions change.
2. Compare costs before deciding on a lender. You probably look mainly at the interest rate. But there’s something even more important, called a margin. That’s where the real money lies.
On a typical home equity loan, the interest rate floats one to three percentage points above the bank’s prime (or benchmark) lending rate. Those one to three points are the margin, or spread. Higher margins are good for the lender and bad for you.
As an example, say that the prime rate is 5 percent. You’re offered prime for six months (the teaser rate), then prime plus a margin of two percentage points—7 percent in all. A competing loan goes for half a point under prime, or 4.5 percent, but with a 3 percent margin. After the teaser period, the competing loan will cost 7.5 percent. If you look only at the interest rate, the second loan seems more attractive. But adding the margin shows the first loan to be the better bet. The lower your credit score, the higher the margin you’ll pay. Poorer risks might be charged prime plus 5.5 percent or more.
Lenders often won’t disclose the margin unless you ask. So ask!
Most lenders charge no up-front closing costs, so normally there’s no reason to take a loan that levies them (for example, points, application fees, and other charges). There’s usually an annual fee in the $75 range. There may also be transaction fees or fees for closing your credit line within the first two or three years. Ask about them.
Some equity lines come with fixed interest rates. They cost about 0.5 percentage points more at the start than variables do. You might be allowed a onetime rate cut if the general level of rates declines. You might also be able to convert a variable-rate loan to a fixed-rate loan after a certain number of years.
Always look for discounts. There may be an interest rate discount for dealing with the bank that services your first mortgage or a discount for making monthly automatic payments from your bank account.
3. Check the caps. There’s usually no limit to how much your rate can jump in a single year. The maximum rate on your home equity loan could be as much as 18 percent or more. In short, these are pretty risky loans. Find out how your monthly payment would change if rates went up. Some lenders have introduced reasonable annual and lifetime caps, so ask about them.
Where there’s a ceiling, there’s sometimes a floor. Your rate might not be allowed to drop below 5 or 6 percent. If the general level of rates goes much further down, however, you can usually refinance.
4. Read the fine print. Lenders use tiny type for information that they don’t care if you overlook. So do yourself a favor: put on your glasses and read through the loan agreement.
You’ll probably learn that your credit line can be reduced or frozen if: (1) you don’t pass continuing credit checks, (2) the value of your house goes down, or (3) interest rates have risen above the cap. You’ll discover any prepayment penalties. You’ll learn when and how your interest rate adjusts, what all the fees are, when your credit line expires, all the repayment terms, and whether you’ll face a single large payment when the loan ultimately falls due. On credit lines opened since November 7, 1989, most of the terms are guaranteed. But not always, so check!
When a lender freezes your home equity line, the letter will tell you the reason for the action and how to appeal. If your credit score fell, build it up again and ask for your line to be reopened. If the value of homes in your city have declined, have your own home reappraised—maybe its price has held up. If your appeal fails, try for a lower credit line instead of a total freeze.
5. Ask about the bank’s policy on subordination. That’s a big but important word. A second mortgage is always subordinated to the first, meaning that if you can’t pay and your house is sold to cover the debt, the holder of the first mortgage gets his money first.
Let’s say that mortgage rates have dropped and you can now get a new first mortgage at a lower rate. The bank that holds your home equity line has to subordinate its loan to the new mortgage you’re taking out. Usually, that’s a routine bit of paperwork, perhaps costing you a modest fee. But some banks won’t do it, which locks you into the mortgage you have currently. If you see this in a home equity loan agreement, don’t sign! There are plenty of other home equity lenders around.
6. Repay early and often. Lenders encourage you to take 10 or 20 years to repay. But stretching out your loans over that length of time is a sucker’s game. If you use your home equity line to buy a new car every three years and make only the minimum payments, you could find yourself paying for your present car plus the four previous ones all at once. That’s a lot of money down the drain.
Fit your payment schedule to the purchase. Get rid of a debt consolidation loan in a year and a half. Clean up an auto loan in three to four years. Don’t let a home improvement loan hang around for more than seven years. Reduce a loan that is carrying a successful investment, so that you’ll have the equity to make more investments.
7. Beware the call clause. Lenders reserve the right to call, or force you to repay, a home equity loan that might be in trouble. This could happen if you miss some payments or if you endanger the bank’s interest in the house, perhaps by not keeping it in good repair. Exactly what can trigger a call will be outlined in your loan agreement. The moral: back up your home equity loans with liquid investments. You should be prepared to make six months of payments even if you’re out of work.
8. Don’t be tempted to reborrow. If you’ve paid off your loan, the lender will do everything possible to get you into debt again. You’ll get blank checks in the mail at holiday or tax time, when you just might want some extra money. You’ll get marketing calls that offer special interest rate deals. Hang tight. Hold that balance at zero.
Lenders also market to people who have almost used up their credit lines. Borrowers in that position often start to repay. “Egad!” say the banks, “We don’t want that!” Suddenly, you’ll discover that your line has been raised by $5,000 or $10,000, so you can easily borrow more. Thwart them by repaying anyway.
9. Don’t bet against the real estate market. If house prices in your community are getting beaten up, stay away from home equity loans. If you take a big loan and then need to move, you might blow your entire equity in paying off your mortgages and covering the real estate broker’s commission. You’ll have little or nothing to put down on another house. What if you can’t sell the house right now and decide to rent it out until the market improves? Your home equity contract might not allow it. Check it out. Home equity loans are safer in better times.
It’s Okay to Borrow Against Your House When
You put no consumables, such as parties or clothes, on the credit line. Put these on a credit card and pay them off in the same month.
You use the line to consolidate expensive credit card debt and repay the loan fast.
You use it for unavoidable consumer debt, such as buying a car, and repay it fast.
You use it for major investments: education, home improvements, or buying property that you can afford to hold. These investments should yield more than the cost of the loan.
You don’t run up other loans on top of those on your home equity line.
You can handle the payments comfortably. If your income drops, you can sell assets to repay the loan.
You have other sources of cash to help make a down payment on a new house if you move.
You hate and fear home equity lines. You worry when you use them. You treat them like time bombs.
It’s Wrong to Borrow Against Your House When
You love home equity lines. They’re mother’s milk. You feel wealthy when you use them.
You borrow to support your consumer spending habit.
You will stretch out the loans for many years, paying jillions of dollars in interest.
You think of the loan as a permanent debt, not to be repaid until you sell your house.
Your job is shaky.
You’re borrowing to make an investment but have chosen rotten investments in the past.
You’d be left with so little equity that if you sold your house and repaid all the loans, you couldn’t afford the down payment on a new house.
You will need your home equity pretty soon to pay for your children’s college.
You can’t repay if your income drops, except by selling the house.
Home values in your area are going down.
When you refinance, you get a new first mortgage and use the proceeds to pay off the old one. You’d normally do this in order to get a lower interest rate. If your house has risen in value, you can take a larger mortgage than you had before and use the extra money for other investments.
If you’re going to tap your house for funds, you have two ways to do it: refinance with a larger first mortgage or add a second mortgage—either a fixed-term loan or a home equity line of credit. To choose, compare the following:
Up-Front Costs. Refinancing usually carries higher up-front costs. Fees run in the area of 1 to 2 percent of the mortgage amount, although your own lender may do the job for less.
Interest Rate. Refinance if you can get a lower interest rate. If the rate will be higher and you still want to raise money, take a home equity loan instead. The home equity loan will carry a higher interest rate, but it’s paid on a smaller amount of money. That should make the combined loans cheaper than if you had refinanced the whole amount.
Flexibility. You can’t beat a home equity line. You borrow periodically rather than in a big lump sum and pay interest only on the money you actually take.
Term. When you refinance, you start your primary mortgage from scratch, with payments typically lasting for 15 or 30 years. Home equity loans usually run for shorter terms, so you pay less interest in the long run.
Risk. How fast and how high could your monthly payments rise if interest rates go up? Your risk is higher with variable-rate home equity loans. Minimum monthly payments change immediately, and rates can run much higher than on first mortgages.
What You Can Tax-Deduct on a Refinancing
Both of these rules apply to your primary house and to one vacation house. A cabin, condominium, mobile home, and even a sleep-in boat can count as a house.
These rules are also subject to a cap. You can’t deduct mortgage interest on loans higher than $1.1 million on your regular house and vacation house, combined. If you borrow more, however, and use the extra money to start a business or make investments, the interest may be deductible as business or investment interest.
Up-front points paid to the lender when you refinance normally have to be deducted over the life of the loan, with this exception: if part of the loan is used to improve your principal home, you get an immediate write-off for the points attributable to that portion of the loan.
When you have cash values in your life insurance policy, you can borrow against them. The money stashed in your policy keeps on earning interest. But an amount equal to your loan may earn interest at a lower rate.
That loss of interest raises the cost of your loan, so you’re paying more than you realize. Instead of the 6 percent or so that your policy states, your actual loan rate can be 8 or 9 percent.
To see how to figure the true rate of interest on a loan against a universal-life insurance policy, see the example that follows. The footnotes show you how to adjust for loans against whole-life or variable-life policies.
Typically, the agent will claim that you’re paying 1 or 2 percent. Untrue. The cost of a life insurance loan is about the same as a home equity loan. The difference is that policy loans aren’t tax deductible.
Borrowers normally don’t pay the interest out-of-pocket (although they could). Instead they add each year’s interest to the loan, raising the amount they’ve borrowed. The policy’s death benefit will be reduced by the total owed.
As an example, say that you have a policy with a $100,000 death benefit and borrow $30,000. Initially that leaves $70,000 for your heirs. Each year the cash value will rise by the premiums you pay and the interest your money earns, but it will decline by the insurance charges and the unpaid interest on the loan. If you keep that loan for many years or increase your borrowing, you may tear the policy apart. The net cash value may decline to the point where it can’t support the insurance benefit anymore. You’ll have to start repaying the loan or else let the policy lapse. If the policy lapses, you’ll generally owe taxes on the amount by which your loan exceeded the premiums you paid. The tax bill can be a shocker if the loan was large.
Ask your insurance company or agent for a computer-generated policy illustration showing what might happen to your cash values and death benefit over your life expectancy, with and without the loan. That tells you whether your policy can last and how much you’ll leave for your beneficiaries, assuming current interest rates. Get a new illustration from time to time.
If you borrow to invest and the investment earns less than the true rate of interest you’re paying on the policy loan, you’ve made a mistake. Counting both
the investment and what remains of the policy, your heirs will get less than if you had left the policy alone.
It often doesn’t occur to people to repay their policy loans. That’s another mistake. You improve your financial position by taking a lower-earning asset (say, a 5 percent bank account) and using it to repay an 8 or 9 percent policy loan. Repaying is the financial equivalent of investing, tax free and risk free, at the effective policy-loan rate. Put another way, you’re earning a true 8 or 9 percent by repaying the loan.
If you do tap a universal policy for funds, leave enough money there to be sure that your insurance will stay in force for the rest of your life. If you take out too much, the policy may expire before you do. Your insurance company or agent can tell you where the withdrawal limits lie. As usual, the policy’s death benefit will be reduced by the amount you withdraw.
For more on cash-value policies, including the question of whether to take withdrawals instead of loans, see page 379. Withdrawals from universal-life policies reduce the death benefit without running up interest charges.
The bank will lend you money against your CDs. But do you really want that loan? Would it be smarter to cancel the CD, pay the early-withdrawal penalty, and use cash for whatever you want to buy?
To answer this question, use your handheld calculator and your common sense. Figure out how much interest you’d pay on the loan; compare it with the money you’d lose by cashing in the CD (you’d lose your after-tax interest earnings plus the early-withdrawal penalty). Then …
Loans against CDs aren’t as cheap as the lenders make them out to be. Say that your banker offers you a 6 percent car loan, when your CD is earning 4 percent. The banker might say that you’re paying only 2 percent “real” interest (subtracting the interest you earn on the CD from the interest you pay on the bank’s auto loan). That appears to be a better deal than, say, a 3 percent promotional loan being offered by an auto dealer down the block. But it’s not! To prove it, apply the banker’s “logic” to the auto loan. If you keep the 4 percent CD and pay the car dealer 3 percent, you’re gaining 1 percent “real.” The auto loan costs less.
To find the cheapest loan, ignore net-cost gimmicks and compare each loan’s annual percentage rate: the bank loan versus the auto loan. The lower the APR, the less it costs. If you use the cash in your CD to reduce or eliminate the loan, that’s the cheapest strategy of all.
Loans against securities are called margin loans. You usually borrow from a stockbroker, although banks are in this business too. You can borrow up to 50 percent of the value of stocks listed on a stock exchange, well-diversified mutual funds, some over-the-counter stocks (over-the-counter means that they aren’t sold on formal exchanges—see page 867), and listed convertible bonds; up to 75 percent of the value of listed corporate bonds, up to 85 percent on municipal bonds, and up to 95 percent on Treasury securities. Your brokerage firm may set its own limit at something less than these maximum amounts. You generally need an account with a discount stockbroker to borrow against no-load mutual funds (those are funds with no up-front sales charges).
Margin loans are usually used to buy securities. With just $10,000 cash, you can borrow enough money to buy up to $20,000 worth of listed stocks or $200,000 worth of U.S. government bonds.
But you can borrow against your securities for other purposes too. Interest rates on margin loans run 1 to 4 percentage points over the broker call rate, which is what banks charge brokers for their money. You don’t have to make any loan repayments. The interest compounds in your brokerage account, payable when the securities are sold.
There are two major risks with margin loans:
1. Interest charges and sales commissions can easily eat up any profit you make on your securities.
2. If your stocks drop too far in price, the broker will ask for more collateral in the form of cash or securities. That’s what’s known as a margin call. If you don’t have the money, some of your securities will be sold to cover the debt. You usually get a margin call if the value of your interest in the securities, net of the debt, shrinks to 30 or 25 percent of the market price.
Here’s how that happens: The monthly statement from your broker may show, in one corner, your “borrowing power.” The broker encourages you to use the money to buy a car or take a vacation. (The firm earns a nice piece of change on these loans.) He or she forgets to tell you that it’s not an ordinary loan. Suddenly the market drops, and you get a margin call. You have to repay part of what you borrowed or lose some of your securities. But you’ve spent the money and haven’t got any extra cash, so you have to sell some of your stocks.
There goes some retirement money down the drain.
If you borrow from your broker, don’t do it for spending money. Borrow only to buy more securities in hopes of increasing your net worth, and don’t hold the margin loan for long.
After paying loan interest and brokerage commissions, you might earn less on a margined investment than if you hadn’t borrowed at all. This true story is best told by example.
Say that you have $5,000 to spend on a $50 stock. You can buy 100 shares for cash. Or you can buy 200 shares, putting up $5,000 and borrowing another $5,000 from your stockbroker. If the share price rises by $5, the cash investor grosses $500, or 10 percent. The margin investor makes $1,000, grossing 20 percent on his or her original $5,000. Wow! Gimme a loan.
But what if you hold your margined position for a year? You’d pay $500 on a loan that charged 10 percent interest. You paid your discount broker maybe $13 in sales commissions (more at a traditional brokerage firm). That’s $513 in costs, subtracted from your $1,000 profit, for a net gain of $487—a 4.87 percent return on $10,000 invested. Compare that with the unmargined investment: a $500 profit minus $13 in sales commissions for the same $487 gain, but a fatter 9.7 percent return on a $5,000 investment, and with less investment risk. So maybe the loan isn’t such a hot idea. For it to work, you need either large gains or fast ones, so you don’t have to hold the margined position very long.
On the downside, margin loans are poison. Still using the same example, assume that the share price drops by $5. The cash investor loses 10 percent, but the margin investor loses 20 percent plus the extra commission and interest expenses. If the price drops by $12 a share, the margin buyer has to put up more money or be partly sold out.
Yes, if you’re a proven success as an investor and will use those loans to compound your winnings. Yes, if you’re able, temperamentally, to sell losing stocks quickly. Yes, if you know the cost of your loan and will balance it carefully against your potential for profit.
No, if you’re a new or uncertain investor, because you’ll probably go wrong. No, if you’re a long-term investor rather than a quick trader. No, if it wouldn’t occur to you to borrow unless your stockbroker suggested it. No, if you’re borrowing to take a vacation or buy a car; that simply consumes the investments that you are laboring so hard to build. No, if you’re dabbling in mysterious investments that you only faintly understand. Some of the biggest losses in the crash of 1987 were taken by investors who borrowed against stocks to pyramid stock-index options. They didn’t have a clue what they were doing. Many wound up losing far more money than they invested.
Collateral is property you put up to guarantee or secure a loan. Stocks, certificates of deposit, automobiles, and real estate can all be used as collateral. The lender will grab them if you don’t pay.
An unsecured loan is given on the strength of your paycheck and credit history. If you don’t pay, the lender can only sue. The interest rate is higher than on secured loans, and the repayment period often shorter. For these reasons, these are not suitable sources for investment loans (although many an entrepreneur has bootstrapped himself or herself with credit card advances!).
The line of credit tied to your credit card is the commonest source of unsecured loans. The lender gives you the right to borrow up to a certain amount—maybe $1,500 to $10,000—whenever you want. You get the money by slipping your card into an ATM, writing a “convenience check,” visiting the bank, or asking the bank (online or by phone) to transfer the cash to your checking account. There’s usually a 2 to 5 percent transaction fee, and you’ll probably have to borrow in multiples of $10 or $25. Interest rates are high—often 25 percent, not tax deductible! Credit card advances are handy for sudden emergencies, but clear up these expensive loans as fast as you can.
For a cheaper bank loan, ask about a personal credit line attached to your checking account. That might cost you 9 or 10 percent, and 8 percent at a credit union.
If you have a good salary and a high net worth, you might qualify for “personal banking.” Someone is assigned to your account, and it’s his or her job to make you happy. Whatever you need—loans, brokerage services, certificates of deposit, Treasury securities—your personal banker makes it work. Interest rates are negotiable. High-income clients can usually get a better deal than anyone else because they bring the bank more business.
How much you can borrow unsecured depends on your salary and the value of your assets, such as savings, investments, and real estate. It’s not illegal to puff your net worth a bit by taking an optimistic view of the value of your house. But if you borrow more than you can handle, you’re the loser in the end.
It’s a lousy idea to borrow against your retirement plan for spending money. But borrowing to make an investment—a solid, well-considered investment—can work. Stocks and bonds are usually available within the plan, so you wouldn’t borrow to buy more of them. But you might want to borrow to buy real estate or invest in a business.
A loan from a retirement plan does not necessarily deplete your assets. Sometimes it enlarges them. Follow me through an optimal transaction, and I’ll show you how.
1. You borrow money from your retirement plan and invest it.
2. You pay interest on the loan, at 1 to 3 percentage points over the prime rate. That interest payment usually goes right into your own retirement account, so you’re paying interest to yourself instead of a bank. If your retirement fund had been earning 6 percent on the money you borrowed, and you pay 9 percent on the loan, your account has just picked up an extra 3 percentage points.
3. You repay most loans over 5 years, in regular monthly or quarterly amounts. As I see it, that’s a form of forced saving. If you borrow to buy a principal residence, your monthly payments are amortized over 10 to 30 years, depending on the plan. Loan repayments are usually deducted automatically from your paycheck.
4. Your retirement fund gets its money back plus interest. Meanwhile, the money you borrowed is (one hopes) prospering in your outside investment. It has to earn at least enough to cover the extra income taxes this loan will cost.
One drawback to loans against retirement plans is the extra tax you pay. The loan interest normally isn’t tax deductible. Neither is the money you use to repay principal. So that money is taxed twice: once when you earn it and use it to make loan repayments into the plan and again when you retire and take it out of the plan. Put another way, you put after-tax money into the plan, and it’s taxed again when you take it out.
Loan interest is deductible only if it meets the following two tests: (1) you borrow your employer’s contributions, not yours (the employer would have to segregate these funds, and few do); and (2) the money is used for a deductible purpose, such as running your small business or making an investment.
Sometimes your retirement plan is earning more than the interest charged on loans. Then the loan creates a loss. For example, say your retirement investments yield 10 percent, but you’d pay only 9 percent if you borrowed the money out. That’s a 1 percentage point loss, which would compound over time. The loan’s true cost becomes 10 percent (the 9 percent loan rate plus the 1-point drop in yield). You might find a bank that charges less.
It’s unlikely, however, that all of your plan’s investments earn the same high rate of return. If you borrow, you can arrange for the loan to come from the lowest-earning assets.
The plan charges a lower interest rate than you could get at a bank, counting both the direct loan rate and any loss your plan takes by lending to you rather than making other investments. A home equity loan will almost always be better than a retirement plan loan because interest on home equity loans is tax deductible.
You pay a higher interest rate on the loan than your plan is earning on its investments. That way you are adding assets to your plan.
Your outside investment earns enough to cover its tax cost, plus something extra to compensate you for the risk you took.
You’ll be with the company long enough to repay the loan. If you quit or are fired, a few companies let you continue the payments as scheduled. More likely, you’ll have to repay the loan immediately. If you don’t, it’s treated as a withdrawal. You’ll owe income taxes on the remaining loan amount plus a 10 percent penalty if you’re younger than 59½. Retirees may be allowed to repay on the original schedule, even if others aren’t.
1. Up to 50 percent of the assets in your company savings or profit-sharing plan or $50,000, whichever is smaller. If you borrow any more, it will be treated as a taxable withdrawal.
2. If your plan is worth less than $20,000, you may be able to borrow up to $10,000 as long as the loan is adequately secured.
With Keogh plans, you can borrow if you’re an employee but not if you own the business or are self-employed. With Individual Retirement Accounts, you cannot borrow at all.
For more on retirement accounts, see chapter 29.
You’re going to hate this. The deduction is so complicated that it makes no sense for me to try to explain it. For the gory details, ask an accountant or get a current tax guide. I’ll just give you the gist.
If you take out a loan to make an investment, the interest is deductible to the extent that you have net taxable income from investments (after deducting your expenses).
Say, for example, that you collect a net of $1,500 in dividends and interest. That allows you to write off $1,500 of interest paid on loans that were taken to make investments. If you pay more investment-loan interest than you receive in investment income, the extra can be carried forward and deducted in future years.
What if you borrow money and do two things with the proceeds: buy some stocks and buy a car? The interest on the money used to buy stocks falls under the investment rule—deductible to the extent that you have net investment income. The interest on the money used to buy the car falls under the consumer loan rule—not deductible at all. Are you still with me? If not, call a tax preparer.
What if you borrow against your house? The interest is fully deductible as mortgage interest as long as you stay within the loan limits (page 306). The interest on larger loans can be deducted as investment interest if you use the money to make other investments.
What if you borrow to buy tax-exempt municipal bonds? The interest on such loans is never deductible.
What if you borrow to fund an Individual Retirement Account? No interest deduction is allowed.
What if you borrow to buy investment real estate? The interest is deductible against your rents, as well as against income from limited partnerships and other tax-shelter investments (check the tax guides for the passive activity rules). If you have a vacation home that you rent out, larger amounts of interest are sometimes deductible (page 605).
What if you borrow to start or expand your own business? All the interest is deductible as a business expense.
What if you borrow from your retirement savings plan? You get no tax deduction for interest on any part of an unsecured loan attributable to your own pretax contributions plus the money your contributions earned, or for money commingled with money your employer put in. But you do get a write-off if you borrow for a deductible purpose and take money that the employer contributed. See if you can specify that those are the funds you want. Some companies let you put up home equity as collateral, which makes the interest on any loan deductible.
What if you contributed after-tax money to your company plan? You can borrow against it for a deductible purpose and get the write-off.
What if you borrow from your retirement savings plan to buy a principal residence? The interest is deductible only if you put up your house as collateral for the loan. Some company plans let you do this; most don’t.
What if you’re a key employee of the business (generally, an owner or an officer) and borrow from the company savings plan? You get no interest deduction, no matter what you invest in.
How to Ensure That You Get Your Proper Interest Deductions. When you borrow money for more than one purpose, don’t put all the loan proceeds into the same bank account. Keep separate checking accounts for personal borrowing (which is nondeductible), business borrowing, and investment borrowing.
Say, for example, that you take a $50,000 bank loan to buy a car for your own use, a computer for your business, and some stock. Put $28,000 for the car into your regular personal account, $2,000 for the computer into your business account, and $20,000 for the stock into an investment account. That makes it clear how much interest is deductible on each part of the loan.
Don’t put all the loan proceeds into your personal checking account. If you do and wait more than 15 days to buy your business computer or make an investment, some of the loan may be treated as funding your normal living expenses. That will reduce your loan interest deduction.
I’ll stop here. The actual rules are even more complicated than I’ve suggested. It’s madness to have to pay for extra bank accounts just to keep track of your tax deductions. Even thinking about it can drive you nuts.
Car dealers love you when cars aren’t selling well. On certain models, they’ll offer the lowest interest rate on the block—as little as 0 to 5 percent on two- to three-year loans, sometimes up to five years when manufacturers want to “move the metal.” When dealers and manufacturers are fat, their interest rates rise. Then the best choice might be a home equity loan.
Always compare the two types of loans after tax. Your payback schedule is more flexible on a home equity loan and you can deduct the interest if you itemize on your tax return. On loans from any other source, there’s no potential write-off.
If you don’t want to borrow against your house (or don’t own a house), find out—before you car shop—what interest rate you can get from an online lender or your own bank or credit union. Compare that with what the dealer offers when you’re ready to buy. Dealers usually have competitive rates, especially for buyers with good credit ratings.
For an online financial calculator comparing different ways of financing a car, go to one of the auto sites such as Cars.com (www.cars.com) or Edmunds.com (www.edmunds.com).
Many dealers offer only fixed-rate loans because that’s what customers prefer. They let you budget for the same payment every month.
Variable rates are available too. Consider them only if you can get the loan for at least one percentage point less than the cheapest fixed-rate loan around. You deserve a lower payment for shouldering the risk that rates will rise. A variable-rate loan will be cheaper if interest rates decline, stay level, or rise just a little bit. But these loans have no caps, or high caps, so you’d be hurt if rates took a sudden jump and remained on that new plateau.
If you do choose a variable-rate loan and interest rates rise, one of two things will happen: (1) Your monthly payments will go up but probably not by very much. On a $20,000, 5-year, 7 percent loan, an increase to 10 percent would cost you an extra $29 a month. (2) Your payments will stay level, but the term of your loan will be extended. Taking this same example and assuming that the rate rose after the first 12 months, you’d owe an extra 6 months’ worth of payments.
Some lenders add upfront fees (documentation or loan fees) that raise the effective cost of your loan. Compare each loan’s annual percentage rate (APR) to see which is cheapest. Rates can vary by one to two percentage points within the same metropolitan area.
When you borrow to buy a car, you usually need a down payment. But not always. The finance companies owned by some manufacturers may lend you the entire amount if you have a good credit history. Some lend more than your cost to help cover the amount still owing on a prior loan or lease. You can also find large loans at some banks. Expect to pay one to three percentage points more than you would for a regular loan.
You’re no longer poison if your credit history shows a bad patch, you’ve only recently been employed, or you’ve already borrowed a heap of money. Instead you’re a “subprime borrower.”
A few credit unions give subprime auto loans. So do some of the nation’s largest banks. But your best source may be the auto dealer. You’ll pay a higher rate of interest than prime borrowers do, and there may be a higher down payment. You won’t be able to bargain the car price down quite as far. But you’ll get a loan. After a year, recheck your credit. If you’ve paid all your bills on time and are steadily employed, you may be able to refinance at a lower rate.
Your current lender is the first place to go to refinance. It will want to keep you as a customer.
The longer the term, the lower the monthly payment and the easier it is to buy today’s expensive cars. Auto finance companies owned by manufacturers may let you borrow for five and a half to six years, or even seven years for a luxury car and a customer with a top credit rating. Some banks and credit unions also go to seven years on luxury cars. On a $30,000 loan at 7.5 percent, you will pay $206 less a month by stretching the loan to six years instead of holding it down to four. The downside is that the longer-term loan costs you an extra $2,530 in interest.
To hardened spenders, interest costs are a yawn. So I’ll give long-term borrowers something else to worry about. (What good is a personal finance book that doesn’t give readers something to worry about?): A long-term auto loan may prevent you from trading in your car as soon as you’d like. Why? Because you’re “upside down”—the industry’s term for owing more than the car is worth.
Most auto loans of five years or longer are typically upside down for the first 36 to 40 months, unless you made a substantial down payment of 15 percent or more. Then they straighten up. Gradually you build equity value. That equity gives you a trade-in allowance when you buy a new car.
But if you want another car before 36 to 40 months have passed, there’s nothing to trade with. You have negative equity. Your car’s net value is less than, or not far above, zero.
Ideally, a car should be financed over the number of years you expect to drive it. If you like a new car every three years, buy it on a three-year loan. If you took a longer-term loan and still want to trade after just three years and your loan is upside down, you have three choices:
1. Find the cash to get out of the old loan. You have to pay the difference between the loan balance and the trade-in value. Your savings take a hit, but your debts don’t balloon.
2. Roll your negative equity into the loan you take to buy the new car. Effectively, you’re now carrying two auto loans instead of one. That’s expensive and not worth it except for a very good reason—for example, because your old car is a maintenance nightmare or guzzles too much gas. If you take a home equity loan, work on paying it back over 4 years or so. Stretching it out to 10 or 15 years puts you even deeper into the hole.
3. Shine up your old car. Keep it tuned up, with the brakes lined and the oil changed. Do what it says in the owner’s manual. Make small repairs as they come along. Swallow a big repair if you have to. Stick with the car until it’s paid for or until you have enough equity to make a trade. This option gets my vote every time. Your car can run reliably for 100,000 miles or more.
Nowadays, a used-car loan may cost about the same as a new-car loan, or only slightly more. Lenders have learned that four- and five-year-old cars have plenty of life left in their engines. There’s also a wealth of good cars coming off three-year leases.
Lenders aren’t the only ones to notice. Increasingly, people with good credit ratings are turning to the “preowned” market for luxury cars or second and third cars for the family. The best loans go to the best credit risks who buy expensive, newer-model cars. The older the car, the lower its price; and the lower your credit score, the higher the interest rate a dealer will charge.
You should finance the car over the number of years that you expect to drive it and no longer. That’s because it will have lost much of its value by the time you’re ready to give it up. You don’t want to be paying interest on a big loan to carry a car worth only $2,000 in the marketplace.
In most cases, your best financing choice will be a home equity loan, especially if you itemize on your tax return. Just be sure to schedule payments at a rate that will repay the loan in full by the time you’re ready to junk the car. If you don’t own a house or have no spare equity in your home, start your search for a Car Loan With An Online Lender Or A Credit Union.
What’s a “Certified Preowned” Car? It’s a car in good condition with average mileage or less, inspected and repaired by the dealer and carrying a manufacturer’s warranty. Not all cars advertised as certified meet these tests. The key is the warranty. If you pay for it separately, it’s merely an extended service contract. In true certified programs, the warranty comes from the manufacturer and is included in the price.
It’s cheaper to pay cash if you have the money. It also feels good not to have the monthly debt.
But some auto dealers (who make money on car loans) have come up with a clever, computerized gimmick to bamboozle customers into thinking that loans are a better deal.
For example, say you have $10,000. You can put it into a certificate of deposit earning 5 percent interest or use it toward buying a new car. The dealer may argue that it’s smarter to choose the CD and take out a 7 percent auto loan.
Here’s the dealer’s four-step “proof”:
1. If you leave your $10,000 in the bank for four years, you’ll earn $2,155 in interest, pretax.
2. A four-year, $10,000 auto loan will cost $1,494 in interest (the interest is less than you think because it’s paid on a declining loan balance).
3. So by keeping the CD and taking the loan, you’re apparently $661 ahead.
4. Furthermore, the dealer croons, debtors do even better when the loan’s term is up. Say the car is worth $5,000 at trade-in. If you bought for cash, you effectively have $5,000 in hand. But the borrower supposedly has an amazing $15,661—adding together $5,000 from the trade-in, the $661 gain in interest, plus the $10,000 still in the bank!
Before you decide that the road to riches is paved with auto loans, sit back and think a minute. There’s something the dealer didn’t mention. How are you going to repay the $10,000 loan?
If you take the monthly payments out of your bank account, your $10,000 in savings will be wiped out before the loan is entirely repaid.
If you make the monthly payments out of personal earnings, you’ll be giving up $11,494 (the interest and principal repayments) that you could have saved or invested. Either way, the loan costs you more than paying cash.
So pay cash if you have it. Then take the equivalent of the monthly payment, which you’re not spending on the auto loan, and use it to replenish your savings. At the end of the term, you’ll have your car and more than $10,000 back.
I’d vote for the loan, however, in one of four circumstances:
1. Your fat savings account was a windfall—a gift, an inheritance, a winning lottery ticket—that you’d never be able to replace.
2. You have credit card debts. You’ll save more money by using your cash to pay down those high-rate loans.
3. You need a ready savings account. Never tie up all your cash. Save something for unexpected expenses.
4. You haven’t been funding your retirement plan to the max. Save for retirement first, even if it costs you interest on an auto loan.
The same arguments apply to the question of whether to make a large down payment or a small one, if you have the choice. Make a small down payment if you’ll use the extra money for one of the four purposes above. Otherwise make a large down payment.
For the poor of pocketbook but rich in taste, auto leasing is hard to beat. You can drive out of a dealer’s lot on four of his classiest wheels for a small up-front deposit and lower monthly payments than you’d owe on most auto loans. Payments are lower because you’re not financing the car’s entire cost.
Briefly, here’s how leasing works:
You negotiate a car price (the capitalized cost). The leasing company subtracts the amount it expects to get for the car on resale after you turn it in (the residual value). You have to pay only the difference between those two prices (the depreciation). As an example, consider a $30,000 car with an expected resale value of $12,000. If you lease it, you pay only $18,000 of principal—the difference between its $30,000 price (including various fees) and its turn-in, or residual, value. That reduces the amount you have to pay each month. You’re still charged implied interest (the rent charge) on the full negotiated price. But out-of-pocket costs are far lower than if you’d financed the car at its full $30,000 price.
Leasing isn’t for everyone. Here’s what to consider when making your decision.
You Shouldn’t Lease If
You expect to keep your car for many years. If you lease for a while, then buy when the lease runs out, you’ll usually pay more than if you purchased the car up front. This isn’t always true, but it’s true often enough.
You hate monthly payments. Loan payments eventually stop, but lease payments never do. It’s like burying your grandfather in a rented suit.
You’re hard on your cars, driving them many more miles than average. The excess-mileage charge on a lease may raise its cost to more than you’d pay on an auto loan.
You have no car to trade in and not enough cash for a down payment (although many lenders give no-down-payment loans).
You have the cash down payment but can—excuse me, will—put it to work earning more than 10 percent a year, says Randall McCathren of BLC Associates in Nashville. That’s actually easy for many people. You can earn more than 10 percent on your money just by paying off credit card debt that is costing at least that much in interest.
You want lower monthly payments.
You want a more expensive car than you could afford otherwise.
You’re trading in your car in the fourth year of a six-year auto loan and owe more than the car is worth. You can’t afford to pay off your old loan and make a down payment on a new car too.
You want to drive a new car every two to four years and don’t mind having permanent monthly car payments.
You make plenty of money and want someone else to worry about keeping your car in good repair. For an extra fee, the lessor will do all the maintenance and lend you a car to drive while yours is in the shop.
You’re looking for business tax breaks. Business use of your car is deductible whether you lease or own. But because of quirks in the tax law, business lessees can typically write off more of the cost of the car than owners can.
You want to reduce your state’s sales tax. In most states, you’re taxed only on your monthly payments, not on the car’s full purchase price.
You want a guaranteed trade-in price, so you don’t run the risk of seeing your car’s market value drop by more than you expected (14 mpg gas-guzzlers, anyone?).
This depends on two things: (1) the car’s final value when you turn it in. That would be the residual value if you leased; it’s the trade-in, or resale, value if you bought. (2) the effective interest rate you paid—the implicit lease rate on a lease or the annual percentage rate on a loan. Counting all fees, the implicit lease rate is usually higher than the auto loan rate, making leasing more expensive. But the leasing company may guarantee a final residual value that turns out to be higher than you could have gotten on a resale.
Over the past 10 years, leasing often turned out to be cheaper than buying because certain cars lost value (depreciated)—for example, 14-mpg gas guzzlers. If you bought those cars, you took a beating on their trade-in value. If you leased them, you benefited from the higher residual value that the leasing company guaranteed. The company took the resale loss instead of you.
Two Circumstances When Leasing Will Be Cheaper
1. It’s cheaper to lease when the automaker subsidizes the transaction. In this case, the implicit interest rate in the lease will be less than you’d pay for an auto loan, and the lessor may increase the residual (resale) value that it guarantees.
There’s no way to tell directly when a lease is being subsidized, but the dealer can calculate the implicit lease interest rate for you. You can then compare it with the interest cost of taking a loan. As for whether you’re getting a subsidy on the depreciation rate, you’ll have to take the dealer’s word.
2. It will have been cheaper to lease if, at the end of the lease, the car’s market price is lower than its guaranteed residual value. By rolling into a new lease, you’ll have saved yourself the cost of trading in the car for less than you expected. If you want to own the car, the company might let you buy it at its current, low market value rather than at the higher value specified in the lease. You can’t know in advance, however, whether your lease will work out in this lucky way.
When Buying Will Be Cheaper: You pay lower interest on your loan than the lessor offers, and your car maintains (or improves on) its expected future market value.
How to Get the Most Future Value Out of a Car, Whether You Lease or Buy: Choose a car that tends to depreciate less than similar vehicles. In the view of Kelley Blue Book, that’s one in a popular color (silver, white, gray, black); optional equipment that’s typical for the car (say, automatic transmission, not manual transmission); and attractive extras such as leather seats or an audio system with MP3/iPod compatibility (or whatever the latest in music is in the year you buy). Gas-efficient cars do better than the competition.
A Definition That People Leasing Cars Need to Know
The “money factor”—a number that dealers typically use to calculate the monthly charge. It’s a decimal, such as .00292. The higher the money factor, the higher your monthly payment. As a broad generality, you can multiply the money factor by 2,400 to approximate an annual interest rate. It’s not exact, but it gives you a good idea of what you’re paying for the money.
The leasing process is pretty simple. You typically make one month’s payment up front plus a refundable deposit roughly equal to one month’s payment, and drive away. On subsidized leases, or if your credit is less than sterling, the lessor may want a down payment too—usually 5 to 10 percent.
On a closed-end lease, your basic costs are fixed. At the end of the term, you can usually buy the car you’ve been driving at a guaranteed price or turn in your keys and get a new one. You can lease the same car a second time if your first lease ran for two to four years. Almost all consumer leases are closed end.
On an open-end lease, which is generally offered only for business use, you pay less per month. Your final cost, however, depends on the car’s resale value. If it sells for more than the leasing company expected, you may get a refund. If it sells for less, you pay the difference.
On both types of leases, you buy your own auto insurance. You’re responsible for general maintenance unless you buy a maintenance contract. You’ll generally owe an extra 10 to 15 cents a mile for driving more than 12,000 miles a year. (Watch this excess mileage charge; some lessors hit you for 20 or even 25 cents on more expensive vehicles.) There are extra charges for excessive wear and tear, such as cracked glass, lost trim, bald tires, torn seats, and deep dents. Look for an itemized list in the lease. The leasing company decides how much wear is excessive and generally will not overreach. If you get sore, your dealer won’t send new customers the lessor’s way. Some lessors build the cost of $500 to $1,500 of excess wear into the leasing price; others sell it separately as an option.
Don’t Lease the Car for a Longer Period Than You Expect to Drive It. Some drivers go for 5-year (or even 66- and 72-month) leases because of the superlow monthly payments. The dealer might even say there will be no problem breaking the lease if you want to switch to a brand-new car. But there will be a problem. You generally face an “early termination deficiency” for the depreciation that you haven’t paid for yet. It could be 5 to 10 percent of capitalized cost or more (at least $1,500 to $3,000 on a $30,000 car). The dealer might be able to roll the debt—called negative equity—into your next lease, but not always.
The formula for determining the balance of your lease payoff will be printed in your contract, probably in Sanskrit. To avoid that cost, drive the car for the lease’s full term.
What Happens If Your Leased Car is Stolen or Wrecked? That’s usually counted as an early termination. Your auto insurance will cover the car’s market value. But in most cases, money will still be owed on the lease. Major lessors typically offer gap insurance, which covers your portion of the loss. Don’t drive away without it.
Check the Lease’s Fine Print If You Think That You Might Move Out of State. A few leasing companies charge an extra fee if you do. A few make you convert the lease to a loan. Tell your car dealer that you want a national lessor that doesn’t care where you live.
1. When you start talking lease, the dealer will offer you “$XXX a month.” That’s usually based on the car’s full list price, which is more than you ought to pay. Before talking monthly payments, bargain down the price of the car. That gives you a lower lease price, too. To be sure you’re getting that lower price, check the car’s capitalized cost on the lease contract. (Note that you won’t be able to bargain very much if you’re buying an advertised “manufacturer’s special.”)
2. You can lower the lease cost by making a down payment up front. But a smarter use of that money may be to lower your credit card debts. Credit cards ding you for higher finance costs than you pay in the lease.
3. Ask to see more than one lease contract; every dealer has access to several different sources. Compare all fees, such as the acquisition fee for acquiring the car and the disposition fee for selling it. They’re not the same at all companies.
4. If you’ll drive more than the standard 12,000 miles a year that leases usually allow, buy excess mileage in advance. For example, you might arrange to drive the car for 15,000 miles. That’s cheaper than paying for an extra 3,000 miles when you turn the car in.
5. A growing number of credit unions offer cheap leases to their members.
6. Leasing companies are required to make standard disclosures on their leases. That makes it easy to compare one lease with another, to see which offers the better terms. Always comparison shop.
7. At the end of the lease, find out the market price of the car. If it’s substantially higher than the guaranteed residual value, don’t passively turn the car over to the dealer and lease or buy a new one. Instead ask for a turn-in value higher than the guaranteed residual. The dealer might treat the extra value as a down payment on your next car or even give you cash. If the dealer refuses, consider buying the car. You could resell it yourself or trade it to another dealer for a better lease.
If the market price is lower than the lease’s residual value, here’s a different strategy to consider. Ask to buy the car at its current, lower value. If the dealer says no, turn in the keys and buy a car just like it that’s coming off someone else’s lease. You’ll get the lower price.
8. Sometimes you’re offered a chance to extend your lease for another two or three years. Compare this with the cost of leasing a new car. When there are factory-subsidized deals, the new car may be cheaper.
Er, I mean a preowned car, which is the idiom that dealers prefer. Originally, companies offered leases only on luxury preowned cars. But now they’ll lease almost any car that’s no more than four years old and hasn’t been driven more than 60,000 miles. Formerly, used cars came with 30-day limited warranties at best. Today’s cream puffs are often “certified” by the manufacturer as being completely reconditioned. They even come with another two- or three-year warranty good for up to 100,000 miles.
Compare the price with the cost of leasing the same car new. Used cars don’t get manufacturers’ incentives, so the lease might save you only $20 to $50 a month. For that price, you might prefer something new.
1. You bargain the car price down, give the dealer your old car, and make a down payment. But the dealer still bases the lease on the car’s list price, not on the lower price you negotiated. If this happens, all the money you put toward the new car has effectively been stolen. To protect yourself, ask for a printout of the lease contract before signing and check it for the car’s capitalized cost. That should reflect the list price, minus the discount you negotiated, minus the value of any car you traded in, minus any rebate the dealer is offering, minus your down payment, plus taxes and such incidentals as fees, rustproofing, and maintenance agreements. Your lease payments are based on the capitalized cost. Federal law requires the dealer to tell you the capitalized cost, although he has to itemize it only if you ask. Fortunately, most leasing companies now require itemization in their contracts—so read the contract.
2. You intend to buy a car, but after the negotiation, the dealer gives you a lease to sign instead. You’re told it’s a special, low-priced deal. You don’t notice it’s a lease, because the salesperson’s hand covers up the heading on the contract. The lease is based on a high car price. When you discover the deception and protest, the salesperson claims that you always knew you were leasing the car. To avoid this, take the documents home and study them before signing. Your intended car won’t go away. At the very least, hold the documents in your hand and read them before signing. Dealerships have waiting areas that you can use.
3. You’re attracted to a lease with an especially low monthly cost. But it’s cheap only because the allowable mileage is low; you might be buying just 10,000 miles a year. If you drive another 5,000 miles a year on a four-year lease, you might owe $3,000 when you turn the car in. To avoid this, estimate realistically how much you drive and cover it in advance. A 10,000-mile allowance gives you only 27 miles a day. A 12,000-mile allowance gives you almost 32 miles. A 15,000-mile allowance gives you 41 miles. If you’re faced with a big mileage bill at the end of the lease, it may be smarter to buy the car instead of turning it in.
4. You’re overcharged for wear and tear. When you turn the car in, the dealer says “no problem.” But after it’s been wholesaled, you get a large bill. If you don’t pay, it goes on your credit history. To avoid this, most leasing companies mail out a detailed description of what counts as excess wear. You can also have your car checked by their third-party inspector (not the dealer) just before the lease ends, to see what you might be responsible for. They’ll conduct the inspection in your presence. If there is indeed excess wear, you can use their cost estimate to decide whether to make repairs yourself or buy the car and keep on driving it.
When comparing leases on the same car, shoppers usually look only at the monthly payment. That can mislead you. It doesn’t take into consideration the amount you paid up front. For a true comparison, look at “Total of Payments”—the top-right disclosure box on the lease contract. The lease with the lowest total payments is the best deal.
If you plan to buy the car at the end of the lease, add the total payments to the end-of-lease purchase price. The car with the lowest total cost is the best deal.
Simplify your shopping and (maybe) find a better deal by buying your car online. You negotiate the price on new and used cars by e-mail, which gives you more time for thought. Most of the online services ask you to fill in a form, detailing the make and model you want as well as any special add-ons. The site forwards your request to dealers in your area, who respond with offers. You take the negotiation from there. Your options include Autobytel.com (www.autobytel.com), Cars.com, Edmunds.com, and Kelley Blue Book (www.kbb.com). Taking another approach, CarsDirect (www.carsdirect.com) prenegotiates with local dealers and offers you a single, no-haggle price on the car you want. Finally, auction sites such as PriceGrabber.com (www.pricegrabber.com) put the specs of the car you want online, where local dealers can bid for your business.
If you have the time and interest, you can e-mail competing dealers yourself. Choose the car you want, draw up an exact list of the desired equipment, and ask the dealers for a bid. They have staff on hand to respond to e-mail buyers. It’s a terrifically efficient way of finding the best deal in your area.
If you want a lease, try online sites such as LeaseCompare.com (www.lease compare.com). They’ll show you three different offers as well as put you in touch with a local dealer who might want to bid even lower. If you think you paid too much for your current lease, you might be able to refinance it on better terms at LowerMyLease.com (www.lowermylease.com). New leases can be had on cars that are less than four years old, without your having to turn in the car and pay early termination fees. To find leases subsidized by the carmakers’ finance arms, go to Edmunds.com, enter the car you want, and then click on “incentives.”
In a big city, with public transportation, maybe you don’t need to own. Look into car sharing, through companies such as Zipcar (www.zipcar.com). You pay a monthly fee for the right to reserve a car and drive it for a specified period of time—a few hours or a few days. Drivers usually have to be at least 21 years old with a good driving record. On college campuses, the minimum age may be 18. The deal includes insurance, so you don’t have to buy your own. If you already own a car, Zipcar can give you access to a second vehicle for someone else in the family to drive.
1. Pick the right lender. Credit unions and direct online lenders often charge less than banks offer at their branch offices. Competing lenders may be as much as 2 or 3 percentage points apart in rates, which is discoverable only by people who price-shop.
2. Pick the right annual percentage rate (APR). Don’t look only at the interest rate. Look at the APR, which usually counts up-front fees as well as the interest itself. (Exception: the APR on home equity loans excludes any up-front fees, so this type of loan costs more than it first appears.)
3. Pick the right time period. The longer the term, the more expensive the loan because the rate is a little higher and you make so many more payments. If you’re doing something constructive with the money, such as investing in a retirement account, never mind the longer term. But on depreciating assets such as a car, keep the term as short as possible.
4. Put on the squeeze. Many borrowers don’t realize that lenders compete. If bank A will give you a fixed rate loan at 7.6 percent and you tell that to bank B, dear old bank B may counter with 7.4 percent. If it’s an auto loan, the dealer may chime in with 7.2 percent if you’re a good credit risk. This happens only to borrowers who price-shop. If you’re borrowing a lot of money, you might get a quarter point off your interest rate just by asking for it.
5. Avoid traditional installment loans. They’re often front-end-loaded (the fine print will say that they’re computed by the rule of 78s). You pay a higher interest rate in the early months than you do in the later ones, which penalizes you if you pay off your loan ahead of time. You also get no benefit from making extra principal payments along the way.
The better loans charge the same interest rate every month (simple interest). Given two loans with the same annual percentage rate, the one charging simple interest will cost less over the life of the loan than the one computed by the rule of 78s.
How can you tell if you’re offered a simple-interest loan? The installment agreement will say that the interest is figured “on a simple-interest basis.” Be sure to check.
6. Don’t buy credit life, disability, or unemployment insurance from the lender. These policies sound like a good deal. They cover your minimum monthly payments for a certain length of time if you’re disabled or unemployed. If you die, they pay off the debt up to the maximum stated in the policy. Some also pay the policy maximum if you become totally disabled. The maximum may be less than your total debt.
These policies are expensive, and their coverage can be full of loopholes. What does it mean to be disabled if the condition is temporary? Are some conditions not covered? Are you considered unemployed only if you qualify for unemployment insurance? (That’s the usual case.) Do you have to be working full time? Do they cover the self-employed? (Usually not.) Fall afoul of the fine print and the policies won’t pay. There’s usually a 14- or 30-day waiting period before they pay on unemployment or disability claims, by which time you may be back to work. Even if they accept your claim, they make the minimum payment for a limited period of time (a few months to two years). After that, you have to pick up the debt again.
Some lenders hide the fact that they’re selling you insurance. They call it a “payment protection plan” or some similar name. But it’s credit insurance all the same.
The price of credit insurance is usually rolled right into your loan, so you wind up borrowing—and paying interest on—your insurance premiums. It’s a costly system that often enriches the loan officer personally. At some banks, he or she earns a commission on the sale.
Sometimes the lender adds this coverage automatically and asks you to sign. That’s called “sliding the policy.” The lender hopes you’ll say okay just because the paperwork is done. But don’t submit to that kind of pressure. By law, this insurance is optional. Tell the lender to redo the contract, leaving the insurance out.
What’s the alternative to this type of insurance? Buy term life insurance (page 343) to pay off your debts at death—it’s much cheaper per $1,000 of coverage than credit life. Cover minimum payments during a bout of unemployment with your personal savings, spouse’s earnings, or unemployment pay. If you’re temporarily disabled, you may get disability payments from your employer. Credit disability insurance is no help to the permanently disabled because it pays so little and for such a short period of time.
Does credit life insurance ever make sense? Only if your health is so bad that you can’t qualify for term life insurance.
For a big loan, a lender wants a financial statement and, often, copies of three years of income tax returns. What do you earn? What’s the value of your house, your other real estate, your savings accounts, your stocks? How much do you owe? Put down everything you can think of, including any bonuses due. How much you can borrow depends on what you earn and what you’re worth.
During the 2002–2006 real estate bubble, bankers were making mortgages without proof of income—so-called liars’ loans. You could claim whatever income you wanted, and the banks charged a higher interest rate for letting you get away with it. But those loans came to grief. (Why am I not surprised?) Now lenders want to know the facts.
It’s getting rarer to be turned down for credit. Lenders take you but charge a higher interest rate. If you are turned down, they have to say why. If it’s because of something they saw in your credit report, get a copy of the report and check it for errors (page 265). If it’s because your credit score is too low, there’s no easy fix. But the turndown letter should mention some things that weighed against you, which, over time, you might be able to fix. If the lender is a local bank or credit union, make a date to talk. There might be something you can do immediately.
Never give up. If one lender won’t take you, another one might. Lenders that charge higher interest rates take borrowers with lower credit scores.
A cosigner is best defined as a saint, an idiot, or a parent. If your child can’t get an auto loan, credit card, or apartment lease based on his or her credit alone, you might be asked to cosign the application.
The moment you do, that loan is just as much yours as your child’s. Its payment history goes on your credit report. If your kid doesn’t pay the bills on time, your credit record shares the black mark. If the child defaults, you are shown as having defaulted too—a sin that will put you into credit hell for seven long years. It does no good to argue that you didn’t know your child wasn’t making payments. You’re expected to keep track.
You’re liable for every nickel of a debt that you cosign. The lender may not even bother pursuing the original debtor or collecting the security that the debtor pledged. As cosigner, you can be asked for the money immediately, in cash. Many children can be trusted not to wreck your credit report, but others can’t. To them, even a saint might say no.
If you say yes, tell your child or other cosignee about the risk you’re going to run. He or she may not realize that the payments will show on your credit report. Ask to be told immediately if the debtor can’t pay. And don’t yell about it, or the child might be afraid to tell you. From the start, ask the lender to send you a copy of each monthly bill.
If you find out too late that the loan is in delinquency, take over the payments immediately. Then contact each of the three major credit bureaus to see if you have a credit file there. If so, add a statement to your record explaining why the payments were late.
Credit card issuers ignore the personal statements in credit reports. But if you apply for a mortgage or a personal loan, the lender may see the explanation and give you a chance to make your case.
What if the world falls apart? Your income drops, your spouse gets fired, you can’t pay your bills, your children are crying, and you have to give away the dog? With all these overhanging risks, isn’t it dangerous to borrow to invest?
Not if you follow sound principles. First, make suitable investments (chapter 21). Second, construct an escape hatch for yourself.
To save yourself if hard times strike, your investments should meet one or more of the following tests:
1. They must be liquid, meaning that they can easily be sold to pay off your debt. Mutual funds are liquid. Vacant lots are not.
2. If not liquid, your investments should yield enough income to carry themselves. If you buy a condominium to rent out, your tenant’s rent should cover the mortgage, taxes, monthly maintenance, insurance, and other expenses, plus 5 to 10 percent for emergencies. That saves you from having to unload the condo at a giveaway price if your personal earnings drop.
3. Any investment that is not liquid and not yielding enough income should be backstopped by liquid investments. For example, if you buy a rental property that isn’t covering its costs, you should have enough money in mutual funds or in the bank to support the property and cover your living expenses for 12 months. If you don’t have this much liquidity, don’t make such investments. They’re too risky for you.
4. The value of your investment shouldn’t fall below the size of the debt that’s carrying it. If its price declines, put it on the market while you’re still ahead. Sell it as soon as you can and pay off your loan.
Debt isn’t a free pass to the high life. Overused, it can bankrupt you. But well used, debt is one of the building blocks of wealth.