Posted on 2 Comments

Why Paying Off Your Loans Early is Dumb

paying off debt vs investing

A whopping 80% of Americans are in debt, and many are working as hard as they can to pay off their loans as quickly as possible. While trying to become debt-free is a popular sentiment in the personal finance community, it’s an incredibly dumb piece of financial advice. To help you understand why paying off your loans early is dumb, I’m going to tell you how debt works, why paying off your loans early isn’t as helpful as you think, and how investing can make you a lot richer.

How Debt Works

Debt is a financial tool that you can use to buy something that you can’t currently afford. You read that right. You can’t actually afford the things you’re buying with debt even though you can afford the payments.

Whether it’s a house, university tuition, or a car, you’re taking out a loan because you don’t have enough cash on hand to make the purchase. To make up the difference between what you have in cash and the price of whatever you’re buying, you take out a loan. To do that, you ask someone, usually a bank, who has enough cash on hand if it will lend it to you.

The bank isn’t going to just give you their money for free though. They also want something out of the deal, so they charge you interest on your loan. Your interest charge is a percentage of the principal or the amount you borrowed and is charged at regular intervals, usually monthly. The longer it takes you to pay back your loan, the more you’ll end up paying in interest. Since you can save some money on interest by paying off your loan faster, people tend to prioritize paying off their loans quickly to maximize their interest savings. But there’s one GIANT problem with this.

Why Paying Off Your Loans Early is Dumb

The problem is the opportunity cost of paying off your debt fast. By putting extra money toward your loans to pay them off early, you forego the opportunity to invest your extra money instead. When you’re evaluating two opportunities, like whether to pay off debt or invest, you want to end up picking the one that will make you the most money. The winner between these two is usually investing.

Before breaking down how much money you’re losing by paying off your loans instead of investing, I have to point out that there is one exception to this rule. Credit card debt. The interest you’re charged on your credit card debt is typically at least several percentage points higher than the return you could expect to receive from investing. Some credit cards actually charge you more in interest than Warren Buffett makes in the stock market, and he’s one of the top-earning investors! So if you have credit card debt, put as much money as you can toward paying that off first, then take the advice in the rest of this post.

Ok, back to why investing is usually a much better opportunity. Let’s say you took out a loan on a $250,000 house at a 3.5% interest rate for 30 years. If you pay an additional $100/month on your loan, you’ll only save about $24,000 in interest and cut down your loan by just 4 years. While $24,000 may seem like a large savings, remember that this savings took 26 years to accumulate. That’s means you saved less than $1,000 each year.

So what would investing that extra $100/month have gotten you? If you’d invested it into the S&P 500 and received a 10% annual return, you would have over $131,000 after 26 years! That’s $111,000 more than you would have saved by making extra loan payments! Even better is that since you won’t be putting that $100 toward your loan, it’ll take you the full 30 years to pay it off, but investing that $100 for that long will give you even higher earnings of $197,000!

You might be thinking, ok but what if I paid an extra $1,000? That would cut my interest down way more, right? It sure would! You would end up saving almost $100,000 in interest and shorten your loan by 17 years! That’s an incredible savings but still pales in comparison to what you could earn by investing instead. The total you would earn from investing $1,000/month for 13 years, assuming a 10% return, is almost $300,000! After 30, over $1.9 MILLION!

So which would you rather have? $197,000 after 30 years or $24,000? $1,900,000 or $100,000? And this, my friends, is the reason why using your extra money to pay off your loans early is dumb.

What to Do with Your Money Instead

While you shouldn’t pay off your debt early, it is incredibly important to make your minimum monthly payments in full on all of your debt. Once you’re making all of your minimum payments, as our examples show, you need to use your extra money to invest and start building your wealth.

An important note is that if you lower your payments to the minimum and don’t invest the difference, you will just be losing more money to interest. For investing vs paying off debt to work, you have to actually invest your extra cash, not spend it.

So how do you do this? My favorite way is to invest in the stock market because historically, it has always gone up and provided positive returns on well-diversified portfolios. Another plus is that it is super simple to do it. Contrary to popular belief, successful stock market investing can be done with little time and effort. If you’re interested in how you can become a lazy investor and eventual rich bitch, check out this post on how to start investing.

It’s time to stop falling for all of the debt-free advice that’s out there. It’s dumb and isn’t increasing your wealth. To truly build your wealth to the tune of hundreds of thousands or millions of dollars, so you can become a rich bitch or simply retire one day, you’re going to need to invest. The earlier you start investing, the more money you’ll make. So go lower your debt payments to their minimums, and start automatically depositing the difference into an investment account, so you can get rich!

Posted on 11 Comments

Are You Afraid You’ll Be in Debt Forever?!

Why You Don’t Have to Be Debt-Free

Chances are, you’re in debt. And you aren’t alone. 80% of Americans have debt and are in the same boat as you. Many of these people also fear that they will be in debt forever, but I’m going to let you in on a secret about debt.

You do not need to fear being in debt for the rest of your life because being in debt is not necessarily a bad thing!

Yes, you heard that right! Having debt does not mean you made a poor financial decision. It also does not mean that you now must strive to become debt-free. Someone who isn’t in debt is not smarter, or better with money than you are.

This is a very unpopular opinion in the finance community, so if you think I’m crazy for saying this, I can assure you that you are also not alone in that regard. To help you understand my thinking and set aside your fear of being debt forever, I’m going to break down how debt works, how you can use it to propel yourself to the next level, and give you my 2 steps for calculating whether or not you should use debt to finance a purchase.

How Debt Works

Before you can understand why debt isn’t your worst nightmare, you need to know how debt works.

Debt refers to money that you owe. When you use debt to finance a purchase, a lender will loan you the amount of money you need to make your purchase, and then charge you a specified rate for using their money. This additional charge is called interest. Loaning money to people and charging them interest on the loan is how lenders, usually banks, make money.

You may be wondering how banks have so much money that they’re able to loan it out. Great question. When you deposit money into your bank account, your bank doesn’t actually keep that money reserved in a special safe for you. Instead, they lend it out to someone else, so that they can make more money from it. While this may sound like a crazy concept to you, this is no different than you making the choice to invest your money rather than save it.

Having an emergency savings is super important, which is why banks have reserve requirements. This is the amount of money they are required to hold in their vault at the nearest Federal Reserve Bank. That’s their emergency savings. Just like you should invest to make more money after you have an adequate emergency savings, banks want to do the same. They do this by lending.

How to Use Debt to Propel Yourself to the Next Level

While I am firmly in the camp that doesn’t think you need to be debt-free to be financially healthy, I do think there are ways to use debt that will benefit you, and ways that will hurt you.

Like we discussed previously, banks use loans to make money. Their goal when lending to you is to make as much money as possible with the lowest risk possible. They do not care about how the loan will affect your financial situation. I repeat, BANKS DO NOT CARE HOW A LOAN WILL AFFECT YOUR FINANCIAL SITUATION. If you meet their risk vs return criteria, they will lend to you.

Now that we’ve established that banks do not have your best interest at heart when lending to you, but are instead focused on how they can make money, it’s important to make sure you also intend to make money whenever you decide to take out a loan.

To help you better understand how to do this, let’s take a look at who wins and who loses when you take on the worst type of debt there is, credit card debt.

When you carry a balance over for more than 1 month on your credit card, you are in credit card debt. When you use a credit card to finance your purchases there are 3 parties involved.

  1. The Credit Card Company
  2. The Merchant (the store you purchased from)
  3. You

Now let’s determine who the winners and losers are in this situation.

1. The Credit Card Company

Credit cards have some of the highest interest rates around. The average interest rate on a credit card is 18%!! Charging you this insanely high rate allows credit card companies to receive higher returns from your credit card debt than from any of their other investments. That means they earn more money from the credit card interest you will pay them than they get from the other types of loans or investments they make.

Winner or Loser? WINNER

2. The Merchant

When you make a purchase with a credit card, your credit card company pays the merchant upfront for your purchase and then bills you for it at the end of the month. Unless you pay them back in full, they then charge you interest on this “loan”, which we already know makes them a winner in this scenario. Since the merchant received cash for your purchase from the credit card company, they’re also happy with how this transaction went down. They don’t care who pays them, as long and they’re getting paid.

Winner or Loser? WINNER

3. You

Now you may think that you’re also a winner in this scenario because you got the item that you wanted, but I have some bad news for you. If the store had told you when you were checking out that you actually had to pay 18% MORE than the sticker price for the item, you probably would have been pissed and walked out of the store. But that is exactly what is happening every time you make a purchase on your credit card and don’t fully pay off your balance. You just end up paying more for the things you buy than they’re worth.

Winner or Loser? LOSER

In this example, you can clearly see that the credit card company wins because they can make huge returns from your purchases if you don’t pay them off immediately. The merchant wins because they get paid in full for your purchases, and you lose because you just end up paying more money for all of your purchases.

Whenever you decide to make a purchase with a loan, it is important to evaluate all parties involved in the transaction and determine who will make money from the transaction, and who will lose money. If you’re the loser, DO NOT MAKE THE TRANSACTION!

Now let’s take a look at an example of how to make debt work in your favor and become a winner in a debt transaction. We’ll use the most demonized loans of all, student loans. Let’s say you’re 18 years old, you can’t afford to pay for college out of pocket, and you haven’t been able to secure any scholarships, so you start looking into your options for student loans. If you take out a student loan, what parties are involved in the transaction?

  1. The Lender
  2. The School
  3. You

Now, who are the winners?

1. The Lender

The lender will end up making money off of the interest you pay on your loans.

Winner or Loser? WINNER

2. The School

The school will be paid in full for your tuition by the lender.

Winner or Loser? WINNER

3. You

You will make an average of $1M more over your lifetime, qualify for jobs that pay higher salaries, and have more opportunities for advancement with a college degree than without one.

Winner or Loser? WINNER

Getting a college degree propels you to a new level that you would have had a much harder time reaching without it. Even though you end up paying more for your tuition if you take out a loan, thanks to interest, the interest you pay will most likely be far less than the increase in your future earning potential. While there are some caveats to this like you have to actually get the degree, some degrees offer higher earning potential than others, and you need to avoid taking out an excessive amount of loans, student loans are a great example of how to use debt as a tool that helps you reach new heights.

2 Steps to Evaluate if You Should Use Debt to Finance a Purchase

The two examples we looked at previously were pretty simple, but in the real world, it’s usually more complicated to evaluate if you’re actually the winner or the loser in a transaction and if you should use debt to finance your purchase. These 2 steps will give you the tools you need to evaluate whether taking out a loan is the right move for you in any situation.

1. Calculate the money out

The first step is to calculate all of the money you’re going to spend on the asset you’re purchasing. These expenses include the following.

  • purchase price of the asset
  • interest you will pay over the life of the loan

Let’s take a look at these in an example where you’re considering buying a house for $200k with a 30-year mortgage at a 3.5% interest rate.

  • purchase price – this is the total price you are paying to buy the house including closing costs, and any renovations you will be funding with your loan. In this example, $200k
  • interest expense – this is the total amount you will end up paying in interest until you pay off the loan. In this example, the total interest expense after 30 years will be $123k

Total money out = $200k + $123k = $323k

2. Calculate the money in

Once you know the total amount you’ll end up spending on the asset, you need to calculate how much money you can make off of the asset. To calculate this, you need to estimate the following.

  • future selling price
  • income generated over the life of the asset

Let’s take a look at these further by continuing with our home buying example.

  • future selling price – this should take into consideration the current value of the home ($200k) plus the appreciation you expect over the next 30 years. Appreciation is an increase in the value of an asset. Homes are an example of an asset that usually appreciates or increases in value. The national average annual appreciation of homes is 4%. Assuming your house appreciates at 4% every year for 30 years, the future value of the home will be $648k.
  • income generated over the life of the asset – In our example, you are planning to live in the home so it won’t generate any income. Examples of how assets can generate income are the rental income you would receive by renting out the home or the revenue generated by a machine you purchased for your business that makes products you can sell, etc.

Total money in = $648k

Now that you know your total spend (money out) vs your total revenue (money in) you just need to make sure the money in is greater than the money out.

From our example.

  • Money out = $323k
  • Money in = $648k

$325k WINNER!

Looks like you’ve got a winner! Assuming you can receive a 4% annual appreciation on your home, you will end up with an asset that is valued at $325k more than you paid for it. The additional $132k in interest may seem like a lot of money, and it is, but not when you compare it to the amount of money you estimate you will make in the future.

And there you have it! You don’t need to fear being in debt forever! As long as you’re using debt to finance purchases that will propel you forward and give you opportunities to build wealth, you’ll be in a healthy financial position, and can rest easy knowing that debt can’t stop you from becoming a rich bitch!

Posted on 13 Comments

How to Use Debt the Right Way

An Overview of the Most Popular Forms of Debt and How to Use Them

There are many different forms of debt, and it seems like millennials have made it their mission to practice using each type. Some debt is great and can help you build wealth. Other debt just ends up costing you more than you should have paid. Below, we break down the different types of debt, and how to use them to make money and avoid losing it.

Credit Cards

Even though millennials talk a big game when it comes to student loan debt, more of us have credit card debt than student loan debt. On the debt spectrum, credit card debt is the absolute worst type of debt you can have because it is EXTREMELY expensive. When you use your credit card, your credit card company pays for your purchase and deducts the charge from your available credit. At the end of the month, your credit card company sends you a bill for the purchases that they’ve paid for, so you can pay them back. If you don’t pay them back in full, they charge you interest on your balance, and that’s how they make money.

The average interest rate on credit cards is about 18%! To put into perspective just how high of an interest rate that is, if your credit card company had invested the money it used to pay for your purchases in the stock market instead of issuing you credit, it could expect to receive an annual return of 10%. Instead, you’re paying them almost DOUBLE that! If you think the finance industry is full of a bunch of money-hungry people trying to steal every penny they can, and you carry a credit card balance, you’re the one making them rich. Credit card companies make enormous returns on all of the stuff you buy but don’t pay off. If you carry a balance on a credit card, the best financial decision you can make is to come up with a plan to pay it off ASAP.

How to Use a Credit Card the Right Way

Even though I just talked a lot of trash about credit card debt, credit cards can be beneficial. The caveat is that you need to pay off your full balance every month. If you pay your credit card off every month, you won’t be charged any interest, and depending on your credit card perks, you could actually save money.

If you earn credit card points for your purchases, your credit card company is essentially giving you a discount. I use the Capital One Venture card for all of my purchases and earn 2 points for every dollar I spend. That translates into $.02 back for every dollar spent or a 2% discount. These points can then be used to purchase things like flights or Ubers. I also don’t get charged currency exchange fees when I travel to other countries and use my Venture card. While getting all of these perks for making purchases with my card, I’m also building a great credit history and increasing my credit score. So, credit cards can be great if they’re used properly. If you’re looking into getting a credit card, NerdWallet is a great resource to use to compare cards. Just remember to not break the number one rule when it comes to credit cards, never carry a balance.

Student Loans

Oh, the most hated loans of all, student loans. While student loans are super annoying and can take many years to pay off, they’re not a bad type of debt to have. Student loans are used to further your education and invest in your future. Look at your student loans as the investment vehicle that allowed you to increase your future potential earnings. Whether we think college is too expensive or not, the fact is that having a college degree does increase your salary potential. A Business Insider survey found that the earnings gap between high school grads and college grads is smallest in Nebraska, but college grads still earn 38% more there. That’s the lowest earnings gap. Washington DC, New York, and California all have earnings gaps over 100%. That means college grads in those states are averaging more than double the salaries of non-college grads. Over their lifetime, college grads will earn an average of $1 million more than non-grads. So, stop hating so much on your student loans. Think of them as an investment.

How to Use Student Loans the Right Way

While student loans are a great tool to help you get a college degree and increase your future earnings, there are important things to consider when taking out student loans. When looking into what degree you’ll be pursuing, you should consider your future starting salary and your future debt payments. If you’re expected to earn $30k a year at graduation and you want to go to a private school in New York City, your future salary probably won’t justify the cost of your tuition. On top of your tuition, how are you planning to pay for housing and books? If you’ll be taking out more loans to pay for those things, you need to factor that into your cost vs expected salary evaluation as well. If you really want to cut down your student loans, the best way to do that is by picking a cheaper school, or by applying for scholarships and grants.

Car Loans

Cars are a depreciating asset. That means that their value decreases over time. Do you know anyone who has sold their car for more than they bought it for? Probably not. The only exceptions to this are for some restored, historic, or rare vehicles. I hate to break it to you, but your Honda Accord doesn’t fall into that category.

When you take out an auto loan you have to pay interest on that loan, so the price you end up paying for the car is actually higher than the sticker price due to the interest you’re charged. The only way to justify the additional cost of interest is to, at minimum, recoup the interest expense when you sell at a later date. Since the price of your car is declining, that will never happen. Therefore you’re just paying more for the car than it was worth.

How to Use an Auto Loan the Right Way

Unless you need a car right now because yours was totaled or stolen, you shouldn’t take out an auto loan. Instead, you should look at what the trade-in value is on your current car, what the price of the car you want is, and start saving for the difference. A great way to save for this is to use a high-interest savings account, so you can earn interest on the money you’re saving. (See this post for more info on opening a high-interest savings account.) Once you have enough money saved, you can trade your car in for the new one, and pay for the balance in cash. That way, the price you end up paying is for the true value of the car and you won’t pay additional money in interest.

Mortgages

Millennials are at the age where many of us have recently purchased, or are looking to purchase our first home. Most people consider buying a house an investment because houses are an appreciating asset. That means that unlike cars, their value goes up over time. If you buy a house now and want to sell it in the future, you should be able to sell it for more than the price you purchased it for. Since houses appreciate, taking out a mortgage isn’t a bad idea, but what most people fail to do is to save for a large enough down payment for their house. The median down payment on a home for first-time homebuyers is 7%, but the recommended down payment is 20%. While you can qualify for loans with a down payment of as little as 3%, that doesn’t mean you should buy a house with only 3% down. If someone buys a house for $200k with 3% down, their mortgage will be $194k. The average interest rate for a mortgage is around 3.5% and the most common loan length is 30 years. With only $6k down, this person will end up paying an additional $119k in interest over the life of their loan, meaning their house will cost them $319k by the time their loan is paid off. If they had put down 20%, or $40k on the same home, they would only end up paying $98k in interest. With 20% down, they would have paid $21k less than the buyer who only put down 3%. On top of the additional interest expense that comes with making a lower down payment, you may also have to pay mortgage insurance, which will make the cost of your home even higher.

$21k may not seem like the biggest deal to you since you’re expecting the value of your home to increase, and appreciation will cover that right? Not necessarily. The more you spend on things like interest and mortgage insurance, the more your home will have to increase in value in order to cover these costs. There is no guarantee that your home will appreciate enough to cover these additional expenses, and if it doesn’t, you will end up losing money on your home even if you sell it for a higher price than you paid for it initially.

How to Use a Mortgage the Right Way

The first thing you need to do is evaluate your current financial situation and how much debt you have from the previous 3 debt types we’ve discussed. You should calculate your debt to income ratio (DTI) to see if you’re financially able to take on more debt. (See this post to learn how to calculate your DTI.) Once you’ve done that, you should open a high-interest savings account and set up automatic deposits to begin saving for your 20% down payment. It may take you a few more years before you can buy your house, but it will put you in a much better position to use your house as an investment that makes money instead of loses it. You should also use a mortgage calculator to see how much you will actually end up paying for your house with interest included, and evaluate if you think you will be able to sell the house for more than your total cost in the future.

Personal Loans

Unlike other loans like a mortgage or auto loan that you take out for a specific item, personal loans can be used for pretty much anything. This ranges from consolidating other types of debt to paying for your wedding. As we know, loans come with an additional cost in the form of interest, but loans are also financial obligations. That means that you must always make your minimum payment or you run the risk of defaulting on your loan. Taking out a personal loan to pay for something you want, like an extravagant wedding, will leave you paying more for your wedding than you intended and make you less financially stable.

How to Use Personal Loans the Right Way

Personal loans can be great refinancing tools. As we discussed at the beginning of this article, credit card interest rates are SUPER HIGH. If you have a lot of credit card debt, taking out a personal loan with a lower interest rate to pay off your credit cards could end up saving you a lot of money and shorten the length of time it takes you to pay off your debt.

While student loans are often thought of as having low-interest rates, that isn’t always the case. Taking out a personal loan with a lower interest rate may help you save some money on your student loan interest. However, student loans also have other tax and repayment benefits, so you should do a lot of research to make sure it’s actually more beneficial to use a personal loan over your student loan before making the switch.   

So there you have it! Debt can be beneficial if used wisely, but it can also be detrimental when used improperly. Since we use debt for so many things, it is important to understand the advantages and disadvantages of any debt you have or are considering taking out. Banks and lenders are in the business of making money off of your money; so don’t take their word for it when they tell you they have the best option for you. Do your research and thoroughly understand if you should finance your purchase with debt, and if so, find out where you can get the lowest cost debt.

Citations

How Much More College Graduates Earn Than Non Graduates in Every State – Business Insider

Do College Grads Really Earn More Than High School Grads – Cornerstone University

The 20% Mortgage Downpayment is Dead – NerdWallet

Posted on 11 Comments

Do You Have Too Much Debt?

Millennials love debt. We have a lot of it, and we can’t stop acquiring more. Our largest source of debt as a generation is credit card debt, which few people realize. On average, each of us has $33k in student loan debt. We may have an auto loan, and we’ve probably just purchased or are considering purchasing our first home and taking on a mortgage. Even though we turn to debt to reach all of our life goals, few of us actually know how much debt we have, and even fewer of us know how much of our income goes toward paying for our debts. But it’s important to know these things because having too much debt is risky and expensive. If used properly, debt can help you build wealth, but if used improperly it can devastate your finances. So how can you tell if you have too much debt?

A Little Bit About Debt

Debt is an amazing tool for wealth building. It allows you to purchase things that would otherwise take you a lifetime to save for, like a house. When debt is used to purchase things that appreciate in value or go up in price over time, it can build great wealth. Debt can also get you into a lot of financial trouble though. That’s because debt is a financial obligation. That means that you have to pay it back no matter what. Lose your job? Like the honey badger, debt don’t give a f**k. When in a bind, you can cancel other things like Netflix or your gym membership, but you still have to figure out how to make all of your debt payments. The more of your income that goes to pay for your debts each month, the more vulnerable you are to getting yourself into financial trouble that leaves you unable to make your payments. If you can’t make your payments, you could default on your loan. If you default on your loan, your credit score will drop dramatically, any collateral backing your loan like your car or house will be seized by the bank, and in the worst-case, you will have to declare bankruptcy. To avoid ending up in one of these scenarios, it is important to know how much debt you have, and how much of your income goes toward your debt payments. The best metric to determine if you have a healthy debt amount is the debt to income ratio (DTI).

How to Figure Out Your Debt to Income Ratio

The best way to determine if you’re over-leveraged, aka have too much debt, is to calculate your DTI. This is a good ratio for you to know to understand how much of your income goes toward paying off your debt, but it’s also good to know because this ratio is used by banks and lenders to see if you qualify for a loan. Lenders will often use your gross DTI when you are applying for a loan, but your net DTI gives you a clearer understanding of how much of each paycheck goes to debt payments. We will discuss the importance of each, and how to calculate them below.

Calculating Gross DTI

To calculate your gross DTI, you first need to calculate your total minimum monthly debt payment. To do this, list out all of the debt you have, and what your minimum monthly payment is for each loan. This will include your student loans, car loans, mortgage, personal loans, etc. You want to list the minimum payment because this is what you are required to pay. If you are paying extra each month (good job!) and get into financial trouble, you can always cut back your payment to the minimum amount required. If you’re married, I suggest you include both partners’ debts. If you have credit card balances that will not be paid off in full on your next payment, you also should include the minimum payment for those. Once you have all of your loans and minimum monthly payments listed, add them up to get your total minimum monthly debt payment. Below is an example of how Patricia calculated her minimum monthly debt payment.

Patricia’s Monthly Debt

  • Student Loans – $250
  • Car Loan – $300
  • Mortgage – $1,000

Total minimum monthly debt payment

           $250 + $300 + $1,000 = $1,550

Now that you know your total minimum monthly debt payment, you need to calculate your monthly gross income or your before-tax earnings. This is your quoted salary, not your take-home salary. If your company quotes your salary as $50k/year, that is your gross income. Divide your salary by 12 to get your monthly gross income. If you have income from other sources like freelance work, include that as well. For variable income, you should look back at your earnings over the last 6-12 months and take a monthly average. If your pay varies because you are paid hourly, you can find your year to date (YTD) gross earnings on your pay stub. Divide that by the number of paychecks you’ve received YTD to get your average gross income per pay period, then multiply that by the number of times you’re paid in a full year and divide that by 12. Again, if you’re married, include both partners’ incomes. Once you have listed all of your income sources and the monthly income they generate, add them up to get your total monthly gross income. Patricia’s example is continued below.

Patricia’s Monthly Income

  • Annual salary from job – $50k
    • Monthly – $50k/12 months = $4,167
  • Freelance photography income – $200/month

Total monthly income

$4,167 + $200 = $4,367

With both components of your gross DTI calculated, you can now divide your total minimum monthly debt payment by your monthly gross income to get your gross DTI. Our example continues below.

Gross DTI = total minimum monthly debt payment/monthly gross income

Patricia’s Gross DTI

  • Total minimum monthly debt payment – $1,550
  • Total monthly gross income – $4,367

Gross DTI ratio – $1,550/$4,367 = 35.5%

So what does your ratio tell you? The lower your ratio, the better. A lower DTI means that you are more likely to be able to pay your debt obligations on time because less of your income is allocated to them. While debt is considered a financial obligation, people will pay for other necessary expenses like food and medicine before they pay their debt. If too much of your income goes toward paying for debt, you’re more likely to miss a payment if you run into any financial problems. Banks want to make sure you can pay them back, and this ratio is a great way for them to evaluate your ability to do that.

If you are looking to take out a mortgage, the highest gross DTI ratio the bank likes to lend to is 36%. That includes your future mortgage payment for the loan you’re seeking. Banks will often still approve you for a loan if your DTI is up to 43%, but they may add some additional provisions to the loan. If your DTI is higher than 43%, the risk of lending to you is high. In this scenario, you will often only be offered a subprime loan, which will carry a much higher interest rate. A subprime loan will end up costing you a lot more money in interest and increase your chances of defaulting on the loan. If your gross DTI is higher than 43%, it is better to pay down your other debt first, and then apply for a loan once your DTI has improved. Based on our example above, you can see that Patricia is just under the acceptable 36% DTI threshold.

Calculating Net DTI

Since your gross income is not your actual take-home pay, to determine how much of your spending money goes to pay off debt, you can calculate your net DTI. Banks won’t use this to determine if you qualify for a loan, but you should use it to determine your financial health and make future financial decisions. Again, the lower the ratio the better.

To calculate your net DTI, you will use the same minimum monthly debt payment amount you calculated earlier. We will continue with Patricia’s earlier example.

Patricia’s minimum monthly debt payment – $1,550

Next, you’ll need to calculate your net income. This is your take-home pay, not your quoted salary. It is the amount of money that is deposited into your bank account and that you can actually use to buy things. If you receive a salary from your employer, this is an easy number to calculate. Just look at the biweekly amount that is deposited into your account and multiply by 26, then divide by 12 to get your monthly take-home pay. If you have variable pay, you will need to take an average of your previous 6-12 month deposits. If you are self-employed or do contract work where taxes are not taken out before you’re paid, I would suggest using 50% of your gross income. Your net income is probably higher than that, but this is a good conservative estimate. Patricia’s monthly net income is calculated below.

Patricia’s Net Income

  • Net income from salary – $1,250 biweekly
    • $1,250 x 26 / 12 = $2,708 monthly net income
  • Freelance photography net income – 50% of $200 gross income
    • $200 x .5 = $100 net income

Total monthly net income

           $2,708 + $100 = $2,808

To calculate your net DTI, you will use the same formula we used earlier, but you will replace your monthly gross income with your monthly net income.

Net DTI = total minimum monthly debt payment/monthly net income

Patricia’s Net DTI

$1,550/$2,808 = 55%

Your net DTI will tell you what percentage of your monthly take-home pay is used to pay for your debt. Keep in mind that you also still need to eat, get gas, etc. to function, so you’ll need to earn more than your net DTI to survive, and meet your minimum payments. If you are married, evaluate how much of your income comes from each partner. If the higher earner loses their job, will you still be able to meet your obligations and eat? The higher your net DTI, the harder it will be to meet your basic needs and financial obligations if you hit financial difficulties.

What to Do with Your DTI Ratio

After calculating your gross and net DTI, you may find that you’re over-leveraged. If you’ve taken on too much debt, you can use a payment calculator like this one to figure out how much longer you have until you can pay off each loan. If some of your loans will be paid off in the next year, calculate your DTIs after those are paid off to see if you will be in a better position. If you still have a significant amount of time before you’ll pay off any of your loans, it is critical that you set up a payment plan and stick to it. If you’re really anxious about the amount of debt you have, start making larger monthly payments if you can. This will reduce the length of time it will take you to pay off your loan. Another option is to sell something that you have a collateralized loan on. However, this scenario isn’t usually helpful because most of millennials’ debt is in credit cards and student loans, not collateralized loans like mortgages and car loans.  

If your DTI is in the healthy range, congrats! You can now feel some relief over your finances. If you haven’t bought a home but want to, you can use your DTI calculation to look at different mortgage payments and how they will affect your DTI. If you find that you can afford a mortgage payment of $1,500 and still maintain a healthy DTI, you can use that to figure out the highest home price you can afford. Knowing your DTI will allow you to keep making healthy financial decisions and build wealth in the future with less risk of defaulting on your loans.

Whether your DTI is in the healthy range, or higher than you expected, you now know one of the most critical components of your personal finances, your DTI ratio. Debt can be an amazing tool, but when trying to build the life we want, we can end up over leveraging and putting ourselves at risk. Continuing to track your DTI in the future will keep you financially healthy and allow you to use debt as a wealth-building tool and become a rich bitch.

Posted on Leave a comment

You Can Save Over $1,000 if You Keep Paying Off Your Student Loans Right Now

Since our friend, the novel coronavirus, crashed our longest economic expansion party several months ago, we’ve seen the worst unemployment rates since the Great Depression. Millennials have been especially hard hit by the job losses the coronavirus has caused because young people make up the majority of service workers, which have essentially been eliminated due to social distancing and travel restrictions.

As job losses continue, millennials are faced with another problem, the staggering $497.6 BILLION they carry in student loan debt. High job losses and student loan debt are the two ingredients needed to create a millennial financial disaster. Luckily, the government stepped in and decreased federal student loan interest to 0% and suspended loan payments through September 2020. This move was critical to helping unemployed millennials survive until they’re able to find work again. However, if you’re one of the lucky millennials who are still employed and able to continue paying off your student loans, this loan suspension is a great opportunity for you. Here is why you should keep paying your student loans off during the suspension if you can.

How Loan Payments Work

Your loan payment is a pre-determined amount that you agree to pay each month until you repay the principal amount you borrowed, as well as any interest you are charged over the term of the loan. Your payment first covers any interest you are charged that month, and the remainder of your payment is used to pay down your principal. Each month as your principal balance decreases, the interest you are charged also decreases, so a larger portion of each payment goes toward paying down your principal. Since this is confusing AF to understand by reading about it, take a look at the table below to see an example of how this works.

We’ll use the current average student loan debt, interest rate, and monthly payment in our example.

  • Average Student Loan Debt (Principal) – $33k
  • Average Federal Student Loan Annual Interest Rate – 4.45%
  • Average Monthly Student Loan Payment – $393
MonthPrincipal BalancePayment$ Applied to Interest$ Applied to Principal
1$33,000$393$122.38$270.62
2$32,729.38$393$121.37$271.63
3$32,457.75$393$120.36$272.64
4$32,185.11$393$119.35$273.65
5$31,911.46$393$118.34$274.66
10$30,527.92$393$113.21$279.79
50$18,488.29$393$68.56$324.44
100$701.11$393$2.60$390.40

As you can see in the example, as your principal lowers, so does your interest, and therefore the amount of your payment allocated to paying down your principal increases. During the term of your loan, more of your payment will be allocated to paying interest in the beginning, and almost all of your payment will be allocated to your principal as you near the end of your loan. Now that you understand the basics of loan payments, I’m going to tell you why continuing to make your student loan payments during the suspension will save you money and help you pay off your loan faster.

Why You Should Keep Paying Off Your Student Loans Now

As part of the Covid-19 relief that the government passed to help reduce the financial strain caused by the massive economic shutdown, federal student loan payments were suspended and interest was reduced to 0%. If you’ve recently lost your job, this reduction in monthly spending makes an enormous difference. The $393 you were using to pay off your student loans can now be used to pay rent or buy groceries. If you aren’t unemployed right now (lucky you!) this may seem like a great time to use this extra money to complete a home project or buy an expensive item you’ve been wanting. It doesn’t matter if you keep making your payments since you aren’t being charged any additional interest or penalties, right?

WRONG!

Continuing to pay off your student loans if you’re able to will benefit you enormously. Why? ALL of your payment will go toward paying down your principal! You don’t have to sacrifice any of your payment to interest. This helps reduce your total loan balance, so when the government does start charging interest again, you’ll be charged less interest since your balance is lower. In the example above, the interest that you will pay over the length of the loan is $6,611. If you take advantage of the 6 months of interest-free payments offered by the government during the suspension, you will only pay $5,592 in interest. That’s a savings of over $1,000! Not only will you save money, but you’ll also reduce the length of your loan by at least a few months. If your student loan balance is larger than $33k, the impact on your interest savings and loan length will be even larger. Who doesn’t want to save money and pay off their student loans faster?! I know I do.

How to Check on Your Loan Payments

Since the government suspended loan payments for federal student loans through September, they have stopped accepting any automatic payments that were previously set up. My husband and I ran into this problem when we reviewed our finances this month. We were taking our debt inventory and realized that his federal student loan balance hadn’t gone down. After looking further into it, we saw that his automatic payments had been stopped.

If you check your account and realize this has also happened to you, you have two options. You can send manual payments through September when the loan payment suspension is scheduled to end, or you can call or email to have your automatic payments reinstated. No, there isn’t an easy option to just click something that says, “please keep taking my money”, but what else would you expect when dealing with the government?

We all want to pay off our student loans as quickly as possible, and you’ve just been given a leg up on doing it. If you’re still employed and able to, capitalize on this moment. Continue making your loan payments and drive down your principal. We may not all agree on the government’s response to the coronavirus, but I think we can all agree that crossing the debt-free finish line sooner while saving lots of money is an awesome plan. Now go give that letter to reinstate your automatic loan payments to your carrier pigeon so she can fly it to Sallie Mae asap.

Citations

A Look at Millennial Student Debt – Forbes

Here are 3 Reasons Why Millennials are Being Hit Especially Hard Economically by the Coronavirus – CNBC

Coronavirus and Forebearance Info Students, Borrowers, and Parents – Department of Education

Posted on 2 Comments

Your Credit Score Can Save You Over $100K

I recently listened to Earn Your Leisure’s podcast episode 84 on Jamila Davis. Jamila was working her ass off as a young woman and had a goal of buying a Lexus GS 300. Once she did, she had a lot of people asking her to help them get expensive cars. She began making money by helping other people get their dream cars, and she quickly realized she could make even more money with real estate. After a short time, she was helping some of the top rappers get their hands on their dream homes.

Many of her rapper clients had a problem when they tried to buy their first mansion though. They had no credit history. They would get famous, start making millions, but not be able to get loans to buy homes due to their lack of credit history. When I heard this, I thought this was an insane problem! The banks knew the rappers had the income, but since they were newly rich, they wouldn’t lend to them. (We won’t get into the racial discrimination involved with this problem, but just know that it isn’t lost on me.) It showed me that it isn’t only about the journey to get the money in the bank, but that you need to be building trust on the back end to be able to buy the things you want in life. The way you do that is by building credit.

Your credit score impacts your life in so many ways. Some of the ways you’re probably familiar with your credit score being used are to determine the interest rate on your loans, to check your ability to pay your rent when you submit your rental application, to get approved for credit cards, things like that. What you may not be aware of is that your credit score is also used to determine your insurance premiums, your cell phone plan rates, and your utilities deposits. If you have a good credit score, you will get better rates on ALL of these things. A bad or mediocre credit score, on the other hand, can cost you an excess of $100K over your lifetime. That is A LOT of your hard-earned cash. For many of you, this exceeds your annual salary. That means you would need to work several years just to pay the higher payments caused by your poor credit score.

So How Do They Come Up with Your Credit Score?

Your credit score is a number ranging from 300-850. The higher the number, the better your score. This number is used to help a lender determine the probability the borrower will repay their loan on time. The higher your credit score, the less risky you are to lend to. There are several credit scoring systems, but the most commonly used is the FICO score.

Your credit score is based on your payment history, credit utilization, length of credit history, types of credit, and new credit. Your payment history makes up 35% of your credit score and tells the lender whether or not you pay your debts on time. 30% of the score comes from your credit utilization. You want to have a low utilization percentage. For example, if you have a credit card limit of $10K and have used $2K of that, your credit utilization will be better than someone who has used $6K of their $10K limit. Length of credit history accounts for 15%. If you opened a credit card when you were 18 and never use it, still leave the account open. All of your history with that credit card will add to your length of credit history. The longer your history, the better. 10% of your score comes from the types of credit you have like your credit cards, mortgage, car loans, etc. This factors in if you have installment credit such as mortgages and car loans, as well as revolving credit such as credit cards. The final 10% looks at any new lines of credit you’ve opened, and inquiries into your credit score. Having a lot of credit inquiries will damage your credit score.

What Makes a Credit Score Good?

In the previous section, you learned that credit scores range from 300 to 850. Borrowers with scores under 640 are considered subprime. These borrowers are often offered subprime loans. Subprime loans have higher interest rates because the borrowers are deemed riskier. (Credit scores are not the only factor considered when deciding to offer subprime loans. Read our post on the racial wealth gap to learn how race also plays a factor.) These higher interest rates can end up costing you a lot of money over the term of the loan. A person with a credit score near 620 will end up paying $65K more on a $200K mortgage than a person with a credit score over 760.

A credit score of 700 or higher is considered good and borrowers can be offered better interest rates at this level. Scores of 800 or above are considered excellent. A more comprehensive FICO score range is shown below.

  • Excellent: 800 – 850
  • Very Good: 740 – 799
  • Good: 670 – 739
  • Fair: 580 – 669
  • Poor: 300 – 579

How Can You Improve Your Credit Score?

If you have a low credit score or no credit score, there are three ways you can improve it. Since your payment history makes up the largest portion of your credit score, this is where you should start. If you are trying to repair your credit score, start by taking a debt inventory. In an excel spreadsheet, Word doc, or notebook, log every open credit card and loan you have and the current balance and due date for each. Also log the credit limit and minimum monthly payment for all of your credit cards. If possible, set up automatic monthly payments. This will ensure that you never miss a payment. If your income is sporadic and automatic payments won’t work for you, set up due date alerts for all of your payments. If your payment due dates are all over the place, you can call the lenders and see if they can change the due dates. If you get everything due at the same time, it will be much easier to make sure everything gets paid on time. After about 6 months of consistently making all of your payments on time, you should see an improvement in your credit score.

If you are trying to establish credit, I would suggest opening a credit card. Do your research to make sure you’re getting one that will suit your lifestyle. If you love to travel, the Capital One Venture card gives you a lot of points that you can use later to cover travel purchases. The American Express Blue Cash Preferred card offers great returns for gas, groceries, parking, and subscription purchases. Nerd Wallet allows you to compare a lot of credit cards, so you can start there. The key to your success with your credit card will be to pay off the entire balance every month. I purchase everything on my credit card and pay it off in full every month. This allows me to get all of the benefits of using the card, build a great payment history, and not pay any interest on my purchases. Interest is only charged on balances you keep for over a month on your credit card. If you’re worried about overspending on your credit card, start by just buying a few things, like groceries or gas, and paying those purchases off every month. This will still allow you to get the same benefits I listed above, and you can build your comfort level with using your credit card and add purchases over time. 

After you’ve set up your payment plan, the next way to improve your score is to improve your credit utilization. This makes up the second-largest portion of your credit score, and it is simple to improve. If your credit limit is $10K and you’re purchasing everything on your credit card each month for a total of $6K, your credit utilization rate will be high because you are using 60% of the credit you have available. To improve your credit utilization rate all you need to do is increase the credit available to you. You can do that two ways. The first is to call your current credit card company and request to increase your credit line on your current credit card. The second is to open a new credit card. Pretty simple.

The last way to improve your credit score is to never close an account. Closing a credit card account affects both your credit history and your credit utilization. Even if you’re no longer using a credit card, keep the account open. All of your previous payment history with this card and your credit limit will help keep your credit score up.

Negotiating Interest Rates 

Many people aren’t aware that you can negotiate the interest rate on your credit card. If you are currently maintaining a balance on your credit cards, you can call your credit card company and try to negotiate a lower rate. It will be important to show that you are making all of your payments on time, so make sure to first follow the steps above to improve your payment history if it isn’t great right now. After you’ve established your payment plan, call and ask for a lower rate. A lower rate will decrease any of the future interest you are charged on your current balance until you can pay it off. If you currently have a $10K credit card balance and an annual percentage rate (APR) of 25%, you will accumulate $2,500 in interest this year. If you call your credit card company and can reduce your rate from 25% to 15%, you will only accumulate $1,500 in interest this year. That is a savings of $1,000 for a 20-minute phone call!

Credit cards are amazing tools for building credit, but they can easily end up costing you a lot of money. Whether you’re building credit or repairing it, following these rules will make sure that you always maintain a high credit score and save money.

1. Never carry a credit card balance. Credit card companies charge extremely high-interest rates. You carrying a balance allows the credit card company to makes returns of double or triple what the stock market returns.

2. Always make at least your minimum payment on time on all of your debts. Your payment history makes up the largest percentage of your FICO score, so make it a priority to have a good payment history.

Citations

Investopedia – Credit Score

Investopedia – Cut Credit Card Bills by Negotiating a Lower Rate

Nerd Wallet – Why Your Credit Score is Important

Posted on 2 Comments

Maximizing Your Ass-ets

One of the biggest misconceptions I see around the current views of millennials’ finances is what assets are good to acquire using debt. We are constantly bombarded with the notion that taking out debt to get a college degree will leave us forever paying off our student loans, and therefore we will never be able to get ahead. But no worries, it is totally fine to take out that $25,000 loan to buy that new car you really want. These messages are completely wrong, and here’s why.

Taking out a student loan to get a college degree is usually a good investment. Sure, you need to review the tuition you’ll be paying against your potential earnings, and avoid taking on extra debt to pay for a really cool apartment, but it’s a good decision more times than not. This is because a degree from an accredited university is an appreciating asset. An appreciating asset will gain value over time. I think college degrees are overlooked assets because they are intangible, or an asset you can’t touch, unlike a house. However, getting a college degree usually affords you a higher starting salary out of college, and sets you up to make more money in the long run. You get more opportunities for promotions, and the ability to advance your career by applying for jobs at other companies that you would otherwise not be qualified for. Therefore, since the trajectory of your income should increase over time, and outpace the income growth of a person without a university degree, I would argue that this is a great use of debt. You will incur interest on your loans, and could be paying them off for many years, but with proper planning your potential earnings increase should outweigh the total loan and interest you will end up paying.

Unlike with student loans, I never hear the argument that people shouldn’t take out a car loan. Instead, I constantly hear commercials saying that I can go get a car today with $0 down! But unlike college degrees, cars are depreciating assets. Cars lose value over time. If you use debt to buy a new car, your car will end up costing you the loan amount, plus the interest. While you’re paying more money for your car than the sticker price, your car will be losing value until it is only worth the value of its scrapped parts. By taking out a car loan, you are agreeing to pay more for your car, and never make any money on your new, shiny, depreciating asset. If houses did this would you still take out loans to buy them? You’d take out a home loan for $250,000, end up paying around $350,000 in total on the loan with interest, and then you could only sell your house for the scrap value of the drywall. I bet this seems like a horrible investment. So why would you do this with a car?

As a basic rule, if the asset will depreciate, debt is the wrong choice of financing. Instead of opting for a car loan, open a savings account and begin saving up to buy yourself a new car. With proper due diligence, debt can be a great tool to build wealth. Debt can also leave you paying much more for something than you intended, and having little to show for it. In the words of my husband, “play the game to win, not to play.”