21 Surprising Tips To Know Before Buying A House

21 Surprising Tips To Know Before Buying A House

 

things to know before buying a house

Are you getting ready to buy a home? 

Your first (or even fifth) house purchase is a huge decision. It seems like there are a million things to know before buying a house.

From figuring out how much you can afford to hire the right home inspector, there is a lot to keep in mind.

In order to help you with your home-buying checklist, I interviewed 21 different experts on the top thing they wish they knew before buying their first house. Their answers uncovered a few surprising things even I hadn’t considered!

Read on for the top 21 tips for new home buyers.

1. Hire a Home Inspector

Ryan Luke from Arrest Your Debt says:

A good home inspection will cost you several hundred dollars. When you are already spending so much money, it may be difficult to write another check for a professional to inspect your home.

However, not inspecting the home professionally can have costly consequences. Home inspectors come into the property and take a deep look at everything — the landscaping, wiring, appliances — plumbing, and the roof — before you sign the contract.

Home inspectors can find these problems, and you can either have the seller fix the problems or pull out before you’re stuck with a problem property.

2. Keep the Hidden Costs in Mind

Melanie Allen from Partners in Fire says to think about the hidden costs:

The cost of a home is far more than the purchase price. I wish I would have taken into account how expensive everything else is when budgeting for my first home.

I didn’t think about how much homeowners insurance would add to my monthly bills, or that I would have to furnish my first home from scratch. Remember to consider things like moving expenses, furnishings, closing costs, insurance, taxes, HOAs, and any other hidden expenses of buying a home when first creating your budget.

This will prevent you from getting a nasty surprise that you can’t afford when you should be excited about your new home.

3. Renting Back Isn’t Always at Market Rate

Monica Fish from Planner At Heart warns about lease-back agreements:

In a competitive real estate market, buyers are doing all they can to become “The Chosen One,” including allowing the sellers to stay in the property and rent it back from the buyer for a set amount of time after closing. While you want to make your offer as competitive as possible, keep in mind it’s customary to charge a daily pro-rated portion of your PITI payment (Principal, Interest, Taxes, and Insurance), not the market rate.

So if your PITI is unusually low due to a large down payment or they’ll be renting from you for months, you might want to consider a separate rental agreement based on current rental rates in your neighborhood. We certainly wish we did.

4. Be a Stay at Home Landlord

Brian Thorp from WealthTender wished he had thought about his purchase as an additional income stream:

Mortgage payments can feel intimidating, but especially if you’re buying a house while living alone, it’s easy to offset your mortgage (or even make money each month) by renting a room or your entire house on Airbnb during major events.

I wish I had subscribed to a few real estate blogs before buying my first house as I would have discovered ideas like this one sooner to save money or even pay off my mortgage early.

5. Home Improvement is Expensive

Jeff Cooper from Have Your Dollars Make Sense learned some lessons about home improvement costs:

Many people will buy a fixer-upper when buying a home to save on the initial cost thinking they can simply put money into the home when they can. It is a solid strategy, but many fail to realize how much home improvement can be. Most of us want to fix everything quickly, but fail to realize how much even the smallest of updates can be.

When buying a fixer-upper make sure there isn’t too much to fix!

6. Think About the Future

Derek Carlson from The Money Family suggests thinking about your future plans before buying a home:

Consider your future plans and if this home fits in with them, or if you’re willing to move in 5 – 10 years. If you’re planning on starting a family or changing jobs, will this home fit into those plans? Or will it require you to relocate to another part of town with a different commute, different school district, etc.?

Selling a house and buying a new one is expensive. By planning now for a house you can grow into you can save a significant amount of money down the road.

7. Aggregate Your Paperwork

Sanjana Vig from The Female Professional says:

There are many things to consider when buying a house. While I did all my calculations before taking the leap, I underestimated the amount of paperwork that would be required for the bank.

For example, I had, over time, transferred my down payment into my main checking account. For each transaction, I had to explain where the money came from. In retrospect, I wish I had done the transfers earlier, or in one lump sum so that I could have avoided the headache of phone calls, paperwork, and explanations.

Do yourself a favor and tee up all of your accounts so that you can skip the questions. You’ll save yourself a lot of time and stress!

8. Ask About Warranties

Jessica Bishop from The Budget Savvy Bride wishes she had collected more information on appliance warranties:

Before you buy a home, you’ll want to learn about the history of all the major appliances and if there are any existing warranties. From kitchen items like your refrigerator, oven, and dishwasher, to laundry machines, or even your HVAC unit or water heater, you’ll want to know what’s still within a warranty period and what’s not.

It’s also helpful to know the age of your water heater or air conditioning unit in particular because these costly items generally have to be replaced at regular intervals. If you’re coming close to the 10-year mark on a water heater, you might just find yourself hit with a major emergency plumbing expense right after you move in, so it’s good to be aware of any potential risks ahead of time.

9. Know How Much You Can Offer

Riley Adams from The Young and the Invested offered this advice:

My wife and I recently purchased our first home together, and we, fortunately, decided to contact a lender out of an abundance of caution to understand what our budget would be.

Initially, we thought a larger home with a higher price tag was within reach, however, after learning about the rules for measuring your debt to income ratio, not all of our income would count in that equation. Banks, who tended to be more conservative during the pandemic, only counted certain types of income, making variable income not receive credit in that metric. As a result, we had to lower the range we could afford on a home.

Thankfully, we still found our dream forever home and it didn’t hold us back too much. If anything, it added discipline to our ability to bid. If we had more firepower, we may have opted to use it. We knew buying a house would be one of the best assets to invest in for our part of the country and wanted to find the right one for us to settle down and see appreciation over time.

10. Your House Is Not a Part of Your Retirement Fund

Jesse Cramer from the blog The Best Interest wishes he had considered the impact of his home on his retirement plans:

I was excited to buy my first home because I saw it as a vehicle to build my wealth. And that’s largely true. Real estate is a significant stepping stone in building the average American’s net worth.

But wealth is not the equivalent to your retirement savings, and that’s where I messed up. You cannot both live in your house and sell it as part of your retirement nest egg. Duh! I know, I know, but it’s a mistake I made.

The truth is that you should only count real estate as part of your net worth if it’s not your primary home or if you plan on downsizing prior to retirement. Otherwise, you’re selling yourself a false dream!

11. Consider Furniture in Your Closing Costs

Kevin from Just Start Investing gave the following advice:

Furnishing a home can cost a lot of money, and oftentimes that is an overlooked expense when buying a house. It’s important to consider your furniture budget when looking at your overall housing budget, keeping in mind are needs vs wants.

Remember, you don’t have to fill your entire house right away. Be realistic with your budget and stay within your means.

12. Take Advantage of First-Time Home-buyer Loan Programs

Jonathan from Parent Portfolio added:

Some loan programs allow first-time homebuyers to make a down payment as low as 3% to 5% of the purchase price. Instead of buying a single-family home, consider purchasing a duplex or another multi-unit.

Homeowners can house hack by living in one unit and rent out the other unit(s) to tenants. The rental income can cover the mortgage payment and allow a homeowner to live mortgage-free.

Usually, real estate investors have to pay a 20% to 25% down payment for non-owner-occupied properties. Therefore, a 3% to 5% down payment is a great deal with the benefits of living for free and making extra income.

13. Purchase Price Should be Based on Monthly Affordability

Tawnya from Money Saved is Money Earned advises that the monthly payment is more important than the purchase price:

If you are financing your home, which most are, there are several factors that can drastically affect your monthly payment.

These factors include property taxes, mortgage insurance, homeowners associations fees, and the interest rate you’re able to secure. While your interest rate will likely be the same for each house you consider, the other factors can swing your monthly payment several hundred dollars one way or the other.

Instead of setting a budget at the purchase price of a home, you should instead set a monthly budget when determining the affordability of a house. If you’re pre-approved or working closely with a lender, have them give you a rough estimate of the monthly payment for each home you’re considering to ensure your monthly budget isn’t overstretched.

When I was looking for a home there were several that were within my overall purchase price range that ended up being outside my monthly affordability due to property taxes or one of the other factors discussed.

14. Hidden Fees Add Up

Adam from Wallet Squirrel says to pay attention to the hidden fees:

There are some hidden fees on top of the property taxes and insurance we didn’t know about when we bought our first home.

One example is the sewage and storm-water fee. This isn’t huge because it is only about $250 a year but it is another check to write. I wish I had known to check with the county and city for fees like that.

I would recommend talking to your real estate agent about any county or city fees that might sneak up on you. They should have the resources to help you research.

15. Remember to Budget for Legal Advice

Tim Thomas offers some advice on understanding legal fees in the buying process:

Here in the UK, when it comes to legal advice concerning buying property, the quality of the service you receive and the fees they charge can vary significantly.

In hindsight, we were lucky in finding someone for our first purchase who we used for future purchases, but he wasn’t available on our last house buy. The costs for this last purchase escalated significantly from the initial quote, and it was for things that our preferred lawyer wouldn’t have charged us for.

So get a clear handle on the legal fees you’ll be charged and what is and isn’t included in that price.

16. How to Budget for Maintenance

Josh Hastings from Money Life Wax emphasizes the importance of budgeting for regular maintenance:

Truth be told, when I bought my first home I had no clue that within a few years my A/C unit, washing machine, stove, and dishwasher would all need replacing.

I wish I had budgeted for all of these big-ticket items. After talking to my financial planner, his recommendation was to save 1% of my home value per year for home improvement and maintenance costs. For example, a $300,000 house means you want to set aside $3,000 a year to be safe.

This will help for even bigger projects such as siding, plumbing, or windows.

17. Get Your Finances in Order Before You Buy

Marjolein from Radical FIRE recommends doing a financial check-up before you start looking for a house:

Before you buy your home, you want to make sure that your finances are in order. You can do that by making sure that you’ve paid off your high-interest debts, and you want to have an emergency fund, to name a few examples. Getting your finances in order looks different for everyone, so think about what it means for you and start to take action.

I was in a situation where I wanted to buy a house, and I was in the process of talking to the bank. That’s when I found out that I couldn’t afford the home because of my debt. There are regulations in place in the Netherlands, where your debt influences the amount of mortgage you can get. It didn’t matter that I had a high average net worth in the Netherlands.

If I knew that before, I would’ve started by paying off my debt, and I wouldn’t have wasted my time. Get your finances in order and you’ll be able to buy a home with peace of mind.

18. The Value of Adding Value

Tyler Weaver of Relentless Finances says you should consider ways to add value to get the most bang for your buck:

When buying my first house, I was looking for something of great quality that was ready to go.

As I learned more about real estate, and myself, I realized I prefer to buy a house that needs a little work. On my second house, I took on a much more extensive renovation and was able to capture a lot more equity.

Building equity through renovations is a core principle to the BRRR method which I now do on rental properties.

19. Don’t Overlook Your Wish List

Amanda Kay from My Life, I Guess reminds you not to compromise on your wish list just because of a hot market:

Although I am still a renter, I kind of hate where I live. Not being able to move somewhere better used to really bother me, but as my husband and I are getting closer to buying our first home, I see it as more of a blessing.

I know exactly what I would change about our current home, and my wish list is ready for when we start looking. More importantly, though, is the list of deal-breakers that I have been able to pinpoint and will avoid, so I don’t end up stuck owning a home that I don’t want to live in.

20. Shop Around for Insurance

Robyn from A Dime Saved says:

Insurance costs and needs vary wildly from state to state and area to area. Ask neighbors of the house you want to buy about approximate insurance costs and consult with an insurance agent to find out if you are in a listed flood or zone.

Even if you are not required by the bank holding the mortgage to purchase special supplemental insurance (fire, flood, hurricane, earthquake, etc) you may want to look into purchasing them for your own peace of mind.

Make sure to have enough money in your emergency funds to cover your insurance deductible so you are covered in case of an emergency.

21. Be Aware of Your Own Biases

Linda from The Cents of Money says self-awareness is key in the buying process:

The most reasonable people may become irrational when buying their first home. Biases like the confirmation bias may cause you to be swayed by an eager real estate agent doing their job. As they highlight the best features during the home search, you may overlook negative factors that are more crucial to you, like the tiny kitchen, cracked walls, or low ceilings.

Make sure to revisit the house at different times and honestly appraise what may later become significant problems.

Final Thoughts

There are a lot of things to know before buying a house. By being aware of these tips, I hope it helps you become more prepared for your own home purchase.

Educating yourself before jumping into a big purchase will help you make a better decision, and be more confident in the outcome.

Thank you for reading! What are your best tips for first-time homebuyers? Let me know in the comments!

This article originally appeared on Wealthy Nickel and has been republished with permission.

How To Buy A Home With Bad Credit

How To Buy A Home With Bad Credit

Is it easy to buy a home with bad credit? No, but it’s not impossible to do so. Before engaging in a search for a home, you should find and review your latest credit report and credit score. There is quite a financial difference in the thousands between paying a monthly loan based on a bad credit score and an excellent one.

You want to know where you stand as a potential creditworthy borrower. There may be errors on your credit report that you can be easily correct.

By itself, it is overwhelming to buy a house. The home buying process can be intense and emotional between buyers and sellers, brokers, inspectors, lenders, and attorneys. Having bad credit adds a significant hurdle. Unless you have substantial liquidity and pay cash for the house in full, you will have to rely on a lender who will provide a mortgage.

Can You Buy A House With Bad Credit? Check Your Credit Score

A credit score reflects your creditworthiness based on an analysis of your credit information provided by the three credit bureaus, resulting in your credit report. The FICO scoring system ranging from 300-850 remains the predominant model used by financial institutions. Your creditworthiness increases with the higher the score.

Various people may ask for your credit report and credit score. They are lenders, landlords, employers, cable companies, utility providers or even to obtain a smartphone, a prospective business or life partner. Your creditworthiness reflects your attitude on your finances and paying your bills on time.

What Is Considered A Bad Credit Score?

Generally, there is no stated specific minimum credit score that all lenders will universally accept you and give you a loan. The lower your credit score, the higher the risk for the lenders to view you as a borrower. They may lend you money, but you will be paying a higher monthly loan amount. Others may pass on giving you a loan.

All lenders have different requirements. Once you accept the probability of paying a higher interest rate, recognize that you can improve your credit score and refinance your mortgage later on. It may be challenging, but it will be financially worthwhile to make this one of your priorities.

Some lenders may accept a larger down payment (e.g., 20% or more of the home’s price) to offset a lower credit score. Typically, you will have more borrowing opportunities in the 670 or higher range than below 580, where it will be pretty challenging. You will be able to buy a house with bad credit but be open to options provided by the lenders.

FICO Credit Score Ranges Per Experian:

  • 800-850 Exceptional
  • 740-799 Very Good
  • 670-739 Good
  • 580-669 Fair
  • 300-579 Poor

 

 First, let’s talk about how the FICO Scores formula works using information from your credit report. They use five criteria that are proportionally different in value.

Payment History  (35%)

 Payment history accounts for 35% of your credit score. It carries the most significant weight in your score. This is one area in which you have considerable control. Lenders want to know if you have paid past credit accounts on time. Any late payments will dent your score on this critical factor. You need to exhibit an excellent track record of not missing payments for the length of any credit outstanding.

Those who are new to being approved for their credit cards need to show a consistently positive pattern. 

Amounts Owed  (30%)

Amounts owed reflects on your credit utilization. Lenders do not want you to use a significant amount of your available.

A significant influence on your credit score, credit utilization is the ratio of your total outstanding revolving credit balances divided by full available credit. Revolving credit refers to your credit cards and credit lines you may have but does not include your car loan (unless on your credit card) or your mortgage.

The utilization ratio is known as the balance of debt to available credit or debt-to-credit. It measures how much credit you have used for the amount available to you. You don’t want to “max out” your credit cards.

Having a  30% or higher utilization ratio tells the lender you are using too much credit, impacting your score. I would stay in the mid-20s range so as not to hit the 30% level. To an extent, you have more control over this factor, like payment history. 

 Length of Credit History (15%)

How you handle credit is essential to lenders. The length of time of your oldest credit account and the average age of all of your accounts determine your credit history. When you are just getting your credit card and borrowing, your credit history is short and out of control. The older the account, the better your credit score. If you are new to obtaining credit, it will take time to benefit from showing up in your score.

Don’t Close Any Accounts

You should not do some things, such as closing an account because of not using them actively. Closing a credit card can negatively impact your score in two ways. First, the longer your credit history, the better, so you don’t want to close an older card. At the same time, you will take away the available credit on that card, raising your overall credit utilization rate. Rather than closing your account, leave the card in a drawer where it will do little damage.

 Credit Mix  (10%)

Lenders favor some variety of borrowing in your mix of credit. A borrower handling different kinds of debt products may reflect less risk to lenders. When you don’t yet have a credit card, you may be at higher risk. Don’t go out and apply to get different kinds of loans for the sake of improving your mix. 

New Credit (10%)

When you apply for new credit, a creditor will review your credit file to assess how much risk you pose as a borrower. As such, it results in a “hard” inquiry on your credit report for up to two years. Hard inquiries can negatively impact your credit score, particularly if you are making multiple inquiries. However, don’t let it stop you from doing comparison shopping for the same type of loan.

A soft inquiry occurs when you are checking your credit score or report. Soft inquiries do not generate negative hits. Avoid getting new credit simply because you lack credit history. Over time, you should apply for what you need. 

 How Much Of A Difference Does A Credit Score Make On Your Loan?

According to the following credit scores, using myFICO Loan Savings Calculator,  here are national 30 year fixed mortgage rates with a $300,000 loan on May 26, 2021. The higher the score, the lower the monthly payment. The difference between $1,204 and $1,469 may not seem that vast for one month. However, over 30 years, these costs have become significant. 

      Scores              APR                  Monthly Payment

  • 760-850    2.624%                 $1,204
  • 700-759    2.846%                 $1,240
  • 680-699    3.023%                 $1,269
  • 660-679    3.237%                 $1,303
  • 640-659    3.667%                 $1,375
  • 620-639    4.213%                 $1,469

 

Besides your credit score, lenders will consider your debt-to-income, loan-to-value ratios, and cash reserves as indicators of your overall financial health. They are looking for clues to inform them how comfortable you are with paying down your debt. 

Debt-to-Income Ratio

The debt-to-income ratio or DTI compares how much you owe each month relative to your monthly earnings. Specifically, it’s a percentage of your gross monthly income before taxes that covers your monthly bills, including monthly rent or mortgage, student loans, car payments, credit card payments. Divide the total amounts by your gross monthly income. The lower the DTI, the less risky you are to lenders. Most lenders would prefer a DTI below 36%, with a DTI of 20% is considered excellent.

Loan-To-Value

The loan-to-value (LTV) ratio is typical ratio lenders use to express that amount of borrowing to the appraised value of the asset purchased, such as a home.

High LTV ratios indicate that the borrower is putting a lower down payment on the home they are buying. The calculation is straightforward: divide the loan amount by the asset’s appraised value, which secures the loan as collateral to the lender. A typical LTV is 80%, meaning you are putting 20% down on your home. It means that you own 20% equity in your home. If you can put down more than 20%, that will give a lower LTV than 80%, which is excellent. It is not unheard of for people with excellent credit to have a 50% LTV.

The higher the down payment towards the purchase, the less risky the loan as the borrower puts “more skin in the game” since they own more of the property. If you have poor credit, you can target a higher down payment, which can help you get approved for a loan.

A borrower putting too low a down payment may need to buy mortgage insurance to cover the lender against potential loss if the borrower can’t pay the loan. Federal loans may not require a substantial down payment.

Cash Reserves

Having readily available cash reserves that can cover six months of your basic living needs when you face emergencies is essential. Bankers want to see you have the ability to pay for six months of mortgage payments and prefer you to have some cash reserves on hand.

Homebuyers can apply for a conventional loan from private lenders or government loans, depending on their circumstances regarding their credit scores, ability to put a down payment, and other criteria.

 Conventional Loans

It may be challenging to qualify for a conventional mortgage if your credit score is below 640. Lenders may require a higher down payment of at least 20% to offset your lower score. Most private lenders will require private mortgage insurance (PMI) when borrowers put less than 20% down on their home loans.

You should continually improve your credit score to get a better interest rate for your loan. It takes time and patience but raising your credit score is possible. If a conventional loan is out of the question, you can either work on improving your score or apply for a government-backed loan. 

Government Loans

For those borrowers with bad credit, you can apply for federal government-backed loans. You may have more flexibility on the credit score and require a lower (or even a zero) down payment. However, each entity may require its respective mortgage insurance (similar to PMI) when down payments are less than 20% of the home value.

Federal Housing Administration or FHA Loans

An FHA loan is one of the more lenient options for buyers with bad credit, may have gone through bankruptcy, foreclosure, or first-time homebuyers who may not have saved a large enough down payment.  Created in 1934, the FHA guidelines for borrowers are:

  • A FICO credit score of at least 580  requires a 3.5% down payment.
  • If your credit score is between 500 and 579, you need a 10% down payment.
  • Borrowers will need to buy a mortgage insurance premium (MIP) if down payments are below 20%.
  • The debt-to-income ratio must be less than 43%.
  • The home has to be the borrower’s primary residence.
  • The borrower must show steady income and proof of employment.

All FHA loans require borrowers to buy a mortgage insurance premium (MIP). This insurance protects lenders from losing money should the borrower default on the loan. Mortgage insurance requires an upfront fee of 1.75% of the original loan amount. There is a recurring monthly fee varying from 0.45% to 1.05% of the loan amount. The fee percentage depends on the size of the loan, down payment, and the number of years financing.

An  Example On The Mortgage Insurance Fee

Let’s say you are buying a $200,000 home, with a 10% down payment of $20,000. Your original loan is $180,000. The upfront mortgage insurance fee of 1.75% x $180,000 is $3,150. You will also have a recurring payment, using the fee of 0.45% to 1.05% of $810 to $1,890 in the first year.

Veteran’s Administration (VA) Loans

VA home loans are non-conventional loans available to veterans, those serving in the military, or eligible surviving spouses seeking to become homeowners. Private lenders are the issuers of the loans, but the VA determines who qualifies for the loans and is the guarantor.

If you are qualified for a loan, there is no minimum credit score, and you may buy a home with no down payment. Although you don’t pay private mortgage insurance, there is an upfront VA loan funding fee of 1.4% to 3.6% of the loan amount if you put less than 5% down payment on your home.

USDA Loans

The USDA loans are for rural borrowers who may qualify for a mortgage directly from the US Department of Agriculture or a USDA-approved lender. The loan has specific home requirements, and its location must be in a qualified rural area.

You may not need a minimum credit score if you are getting the loan directly from the USDA. However, to qualify for such a loan when using a USDA-approved lender, you will need to have a minimum credit score of 640.

You don’t need to put any down payment for the USDA loan. However, like private mortgage insurance for conventional mortgages or MIP for FHA loans, borrowers of USDA loans pay mortgage insurance via two fees. There is an upfront guarantee fee equal to 1% of the loan amount and a recurring fee of 0.35% of the loan.

Home Loans From Fannie Mae And Freddie Mac

Fannie Mae and Freddie Mac were government-sponsored entities, transitioning out of conservatorship. Neither entity originates or services its loans but buys loans from private lenders who require PMI if down payments are less than 20%. Their respective loans are designed for low income first-time or repeat homebuyers with limited cash for down payments:

Fannie Mae HomeReady Mortgage requires a 3% down payment with a 620 minimum credit score. They may use alternative data with a lower score. Borrowers will need private mortgage insurance when putting less than 20% down.

Freddie Mac Home Possible loan requires  3% down with a minimum of a 660 credit score. Without that score, borrowers require a 5% down payment.

Final Thoughts

Buying a home with bad credit is possible. Before searching to buy a home, you should understand your credit report and score. Consider improving your creditworthiness so you may get a favorable interest rate. If you are still getting your own home, there are several government-backed options for qualifying for a home loan if you have bad credit. You can buy a home with bad credit, but you need to take more steps.

You will likely be paying higher interest rates than those who have good-to-excellent credit scores. You will have to pay some kind of mortgage insurance if you cannot put a down payment of 20%. As you improve your credit, consider refinancing your loan.

Thank you for reading! If you found this article of value, please visit us on The Cents of Money and consider subscribing to receive other articles and our free newsletter.

This article originally appeared on Partners In Fire and has been republished with permission.

 

 

 

How To Save For A House: 10 Ways To Make Your Biggest Purchase Ever!

How To Save For A House: 10 Ways To Make Your Biggest Purchase Ever!

Buying a home may be the biggest purchase a person can make. And, with home prices rising, it can also feel intimidating or even impossible, especially for a first-time home. However, there is no need to fret. If you’re wondering how to save for a house, you’re in the right place!

Before you start looking for a real estate agent, take some time to self-reflect on your current financial situation to develop a plan for success. Here are ten ways to help you save for a house and make your biggest purchase ever.

What Are the Costs When Buying a House

According to the National Association of REALTORS, the median existing-home sales price for March 2021 was $329,100. Unless you have hundreds of thousands of dollars to spend, you most likely will work with a bank to finance your home purchase. Thus, the two main costs you need to save up for are down payment and the closing costs.

Down Payment

A down payment is an out-of-pocket expense a homebuyer will pay when financing a purchase. The amount is usually a percentage of the purchase price, which can vary depending on the type of loan.

For example, a 10% down payment for a purchase price of $200,000 is $20,000. Therefore, a homebuyer would need to bring $20,000 when signing closing documents while the bank will finance the remaining balance of $180,000.

Closing Costs

When financing a home purchase, there are several closing costs, such as an appraisal fee, termite inspection, and escrow fee. However, unlike a down payment, a homebuyer won’t know the exact dollar amount due until a few weeks or days before closing on the property.

Therefore, as a safe estimation, the closing cost is usually about 2% to 5% of the loan amount. For instance, homebuyers with a loan amount of $180,000 can estimate to pay about $3,600 to $9,000 in closing costs.

Moving Expenses

Although moving expenses are not as large as a down payment, it is still a cost that buyers should save up for. If you have a small family and only have small items, you can save a lot of money by transporting your family’s personal belongings in your car or a friend’s truck.

However, if you have larger and heavier items, you can rent a moving truck or hire a moving company. According to Moving.com, the average cost of a local move is $1,250 and $4,890 for a long-distance move.

How Much is Down Payment?

The down payment amount is usually a percentage of the purchase price. However, depending on the loan program, the percentage can vary. Determining which loans you qualify for is one of the first steps on how to save for a house. The requirements can change every year. So, be sure to check with a mortgage professional to get the latest details.

FHA Loan

The federal government insures a Federal House Authority (FHA) loan. However, the government doesn’t provide the loan to homebuyers. Instead, this program allows lenders to offer a low down payment requirement. The government will ensure the loan in case the borrower stops paying.

According to U.S. Bank, the minimum required down payment for an FHA loan is only 3.5% of the purchase price. Therefore, a 3.5% down payment for a $200,000 purchase is $7,000.

203k Loan

A 203k loan is a subset of an FHA loan based on section 203(k) of the National Housing Act. This program follows the same rules as an FHA loan and includes rehab expenses as part of the loan. Thus, homebuyers can buy a distressed property in need of significant improvements but at a meager purchase price.

VA Loan

The U.S. Department of Veteran Affairs created the VA loan, which is similar to the FHA loan. This loan’s critical difference is exclusively for U.S. service members, veterans, and eligible surviving spouses.

A VA loan doesn’t require any money down nor private mortgage insurance. Additionally, a VA loan allows a seller to pay 100% of the closing costs, unlike an FHA limiting a seller to 3%. Therefore, a homebuyer who qualifies for a VA loan doesn’t have to save up for a down payment.

USDA Loan

A USDA Loan is short for the “USDA Rural Development Single Family Housing Guaranteed Loan Program.” Like a VA loan, this program also allows a homebuyer to fully finance a home purchase, which means a down payment isn’t required.

The property must be a rural single-family home and low to moderate-income homebuyers based on the county’s median income to qualify for this program. Speak with a mortgage professional within your area to check your eligibility.

Conventional Loan

A conventional loan is a loan that is not part of a specific government program. The down payment ranges from 5% to 15%. Therefore, a 5% down payment for a purchase of $200,000 is $10,000.

Why Do People Want a 20% Down Payment?

Home borrowers that make a down payment of less than 20% are typically required to pay for private mortgage insurance (PMI). This insurance is not the same as home insurance. Instead, the purpose of a PMI is to protect a lender if a borrower defaults on their payment.

Thus, on top of the mortgage payment, property insurance, and property taxes, some homeowners will also have to pay for PMI. However, some homebuyers don’t mind paying the PMI because they prefer a lower down payment.

Some loan programs don’t allow you to remove the PMI. On the other hand, some programs will allow PMI removal when the balance is 80% of the original purchase. Homeowners can make extra payments towards the principal balance to accelerate the debt service payment. Alternatively, homeowners can refinance the property and take advantage of the house’s appreciation.

How Much Can You Afford?

Before you start looking at potential houses to buy, it’s essential to know how much you can afford. The general rule of thumb is that the mortgage payment should be no more than ⅓ of your monthly household net income. For example, a person with a monthly net income of $2,500 should aim to have a mortgage payment of no more than $833 a month.

Although this rule of thumb is a quick and easy way to calculate a rough estimate of how much you can afford. Any homebuyer needs to review their financial situation in detail thoroughly. Mortgage payments can easily vary due to property taxes and home insurance and can quickly increase your monthly expense.

Where to Save Your Money

It’s best to save money in a high-yield savings account, such as a money market account. Your account may not accrue a lot of interest. But, you avoid risking your savings by not putting it in an investment account, such as stocks or REITs.

10 Ways to Save For a Down Payment

1. Track Your Expenses

Before you can start putting away money for your down payment, you first need to identify and track all your expenses. Whether the cost is paying for utilities or entertainment, track it all.

 

With the help of online banking, you can see all your transactions in one place. Reviewing your expenses might even surprise you with some items you were unknowingly paying for. Knowing how much you spend on expenses will give you an accurate idea of how much you will have leftover from your paycheck.

2. Create a Budget

After you track all your expenses, it’s crucial to create a budget. A budget does not mean taking the fun out of your life. Instead, a budget is the best way to make sure you have enough money every month. For example, you budget $100 a month for dining out. If you already have exceeded that amount for the month, you will have to postpone any dining plans until next month.

3. Automate Savings

Creating a budget is a great way to be fiscally responsible. However, it can be tempting to spend your paycheck once it hits your checking account. To help overcome this temptation, you can set up automatic transfers to your savings account.

Talk to your payroll department to have them transfer a certain amount or percentage to your desired account. As another option, you can set up an automatic transfer with your bank. Automating your savings is a simple way to keep you honest with your savings.

4. Reduce Expenses

If you don’t have much money, an easy way to start saving is by reducing your expenses. For example, instead of buying lunch when you’re at the office, consider bringing your lunch.

Also, get rid of unnecessary expenses. That’s fantastic you signed up for a gym membership after the new year. But, if you’re not using it, you’re better off canceling it to keep more money in your pocket.

Consider living stingy and downsize, if possible. You’re not cheap. Instead, you are more intentional with your money. For example, you can trade-in your car for a more affordable vehicle or change your cell phone plan. Or move into an apartment with more affordable rent while you work on building up your down payment.

5. Increase Your Income

Aside from reducing your expenses, another way to save for a house is to increase your income. One way to accomplish this task is by requesting a raise from your employer. However, be sure to back up your request with data to justify a promotion.

If you’re unable to get a substantial raise from your main hustle, consider a side hustle to create a second income stream. Depending on your current career, you can leverage that to your advantage to make money in your spare time.

Additionally, if you have an extra bedroom to spare, you could house hack your current residence and rent out the room for extra income. Be sure to consult with your landlord before advertising for a roommate.

6. Postpone Major Activities

You might call me a killjoy, but another option to save for a house is to postpone significant activities or events, such as a family vacation or concerts. Saving on travel alone can save you hundreds and even thousands of dollars.

Remember, I said “postpone” and not “cancel.” There will always be another opportunity to live that experience. At least once you have your house, you can hang those memories in your new home.

7. Get Rid of Debt

Getting rid of debt is another excellent way to help you buy a house. Not only does it reduce your monthly expense, but it can also make you favorable in the eyes of your lender.

According to Experian, two of the four significant factors mortgage lenders consider are payment history and credit utilization ratio. Lenders want to make sure potential borrowers have a good track record of paying on time. Consider raising your credit score by following these steps.

Also, lenders use the credit utilization ratio to determine how much a borrower’s balance is compared to their credit limit. The lower the ratio, the more favorable a borrower, is to a lender. Therefore, it pays to pay down your student loans and credit card debt.

Additionally, lenders will also check a borrower’s debt-to-income ratio (DTI). This ratio compares how much a person owes to how much they earn a month. The better your DTI, credit utilization ratio, and other factors will help qualify you for a loan program to your advantage.

8. Save Your Windfall Income

There will be moments you’ll unexpectedly receive extra income, such as bonuses, gift money, tax refunds, and stimulus checks. Instead of splurging that surprise money on consumer products, save that extra cash in your separate savings account to help you get closer to your goal.

9. Sell Your Things

Another way to boost your savings is to sell items you no longer use. For example, if you’re no longer planning on having kids, you can sell that Spectra S2 to another mother in need. Not only can you make extra money, but you’ll also be reducing your belongings, which can have a positive effect on moving expenses.

A few options to sell your items are holding a garage sale or listing items for sale on Facebook or Craigslist. Aside from selling your TV or video game console, you can go as far as selling your barely used vehicle.

10. Pause or Reduce Retirement Contribution

It’s essential to make regular contributions to your retirement account, especially when you’re young and have time on your side. However, if you need a little more capital to save up for a down payment, you can temporarily pause or reduce your contribution to your 401k or IRA.

Keep in mind that you’ll lose the tax benefits of not contributing to these retirement accounts. Thus, it’s crucial to weigh the pros and cons of pausing or reducing your contributions. You may find more profitable avenues to save more money or may just need to extend your timeline when you can reach your savings goal.

Final Thoughts

Owning a house is a great way to create generational wealth. So, as early as now, start reaching out to various mortgage professionals. A seasoned mortgage lender can help you navigate the financing process and help identify mortgage loan programs that work well for you. They can also let you know what credit score to work towards to get a better interest rate.

While you work on saving up for your down payment, also practice budgeting for monthly payments. So, once you’re ready to make an offer and buy a home, you’ve already developed a habit.

This article originally appeared on Your Money Geek and has been republished with permission.

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9 Ways To Avoid Lifestyle Inflation With A Savings Plan

9 Ways To Avoid Lifestyle Inflation With A Savings Plan

Lifestyle inflation happens when our income rises, we increase our spending.

Like a balloon that gets larger, we tend to spend our expanding pocketful of extra dollars.

When we get our first job after college, we begin to earn money, get raises, bonuses, or change jobs for more pay. We conjure up what we had considered buying before this newfound financial freedom and spend it too quickly. Instead, we should be using this money wisely.

To avoid lifestyle inflation or lifestyle creep, we need to make a reasonable budget when we start our first job and throughout our career.

9 Ways to Use Our Savings

  • An emergency fund.
  • Set up a budget.
  • Spending limits.
  • Pay down debt.
  • Pay down student loan repayment.
  •  Retirement savings.
  • We leverage the power of compound interest.
  • Diversify your investments.

College Students Are Probably Better Budgeters

When we go to college, we become frugal out of necessity.

College needs for money for the academic year are housing, meal plans, public transportation or car costs, including insurance, gas, repairs, parking permit, textbooks/supplies; cellphone/cable/streaming; clothing, food outside of meal plan, entertainment, clubs/ activities; clothing, computer, travel, laundry, and personal items.

Parents may share or pick up school-related costs such as housing, meal plans, car insurance, clothing, textbooks, travel, and computer. Students may also have their mobile phones and streaming through shared family accounts. Parents may provide their kids a monthly allowance or an emergency fund for miscellaneous expenses.

Students will most likely pay for lifestyle needs like meals and alcohol off campus, gas or public transportation, extra clothes, entertainment, gifts, personal items, and belong to clubs.

Working Through College Helps

The average full-time college student makes $195 per week and may stay on for winter break or summer. Many college students may work 30 hours per week or more at various jobs on and off-campus.

The majority of college students make between $7,500 to $42,000 per year while in school, according to Bizfluent. The wide gap is likely due to hourly differences for full-time and part-time students who may work full-time jobs.

According to a Digest of Education Statistics (NCES), working students comprise 43% of those going full-time and 81% of part-timers in 2018.

What College Students Think About Money

LendEdu survey illustrates attitudes held by college students about personal finance topics.

Current financial situation:

  • 49% of students were in fine shape versus 51% barely making ends meet.
  • 42% were saving money monthly, 58% were not.
  • 71% were saving some part of their income, while 29% were saving zero.

Budgeting/Emergency Fund

  • 59% were very knowledgeable or moderately knowledgeable about budgeting.
  • 57% were budgeting either using an app or doing it by hand.
  • 43% were not tracking their monthly spending.
  • 19% had an emergency fund, while 81% did not.
  • Their most significant monthly expense, the most prominent categories were: food (38%), rent (29%), alcohol/drugs (25%), and clothing (8%).

Knowledgeable about Personal Finance

  • 51% were very knowledgeable or moderately knowledgeable about the need for saving for retirement.
  • 34%  took a personal finance course in college, 21% hadn’t but planned to, and the rest have no interest in taking such a class.

Personal Finance Goals: 29% want to pay off student debt, 19% start saving for retirement, 23% plan to build good credit, and 20% want to save for a vacation or a unique vacation.

This survey indicates that college students need to learn how to manage their money as they start their careers. After college, they are prone to lifestyle inflation, spending more of their income than they should. Instead, they should seek financial security and freedom long term. 

First Job Post College Leads to Lifestyle Inflation

A college student with fewer funds is more budget-oriented. They may have accumulated some cash while in school or parental contribution, but they use it sparingly.

Once getting their first job, a $50,000 plus annual income feels pretty sturdy in former students’ hands and quickly disappears. Their college life of squeezing dollars seems to dissipate soon. If they are living at home, they may feel even more prosperous.

The latest average salaries for your first job after college will probably be in the $50,000 per year range according to Indeed. Salaries will be higher for majors like aerospace, software, or mechanical engineers.

Your gross monthly income is $4,167. However, you will be paying your bills with your monthly take-home pay, net of taxes, of about $3,173. Budgeting is easier when you are younger and have fewer bills to pay. Start early and get into the groove of budgeting by finding a free mobile app (e.g., Mint, Personal Capital).

 Related: A Guide For College Grads On Your Company Benefits

Start A Budget As Soon As Possible

The monthly income may seem like a lot of money to someone just out of college. However, it needs to support many fixed monthly bills, including rent, utilities, student loan debt, public transportation or car payments, gas, and health insurance payments.

You should start a budget, using your current income, and add your fixed monthly payments such as rent, utilities, and groceries. Remember to pay yourself an amount that reflects savings to target money for your retirement, an emergency fund, and investment accounts.

There are variable expenses, mainly for discretionary spending. These costs include food (groceries at home and eating out), clothing, entertainment, personal care, and services. Track your spending on your mobile app or via credit card bills. 

With that in mind, we can calculate average monthly expenditures for major categories by age group drawn from the Bureau of Labor Statistics (BLS) Consumer Expenditures Survey of 2017. This survey tracks the average American as well as provides respective demographics.

Post-College Demographics Consumer Unit

After a few years in the workforce, the post-college graduate falls comfortably in the “25-34 years” group, with the age of the reference person being 29.8 years old. As such, there are 2.8 people in this consumer unit, including a child under 18 years old.

This household has 1.5 earners with 1.7 vehicles. Of this group, 75% went to college.

The 25-34 year reference person earns $61,145 aftertax annually or takes home about $5,095 per month.

Average total expenditures are about $4,610, falling into the following:

Housing is the most significant expenditure category at $1,660 per month

When you are just out of college and working at your first job, you will likely be renting an apartment with two or three other people. However, as you move through your 20s, you will want your place for privacy and, potentially, a family.

Where you live will have implications on not just your housing costs but your overall living costs. Living in an urban market like New York or San Francisco is much more expensive than living in Boise, Idaho, regardless of whether you buy or rent.

Roughly 59% of this age group are renting, while 41% are homeowners. Of this age group, 33% have mortgages.

Housing accounts for 36% of total expenditures. However, housing costs vary whether you own your home, pay a mortgage, or are a renter.

This broad category includes utilities, mortgages, maintenance, insurance, repairs, telecom, mobile, household supplies, furnishings, furniture, flooring, appliances, and household equipment.

On its own, utilities ( including gas, electric, water, telecom, and mobile services) are 8% of your total housing costs. Your utilities may part of your rent. Many homes have cut the cord and use mobile which may not work in some rural areas.

Be Cautious About Housing and Related Expenditures 

You should keep your housing costs to 25%-30% of your total spending budget. Lifestyle inflation is going to play a significant role in your housing costs getting out of control. If you want the most prominent house in the high consumption neighborhood to “keep up with the Jones,” your costs could quickly spiral out of control.

The house is often the least of the problem. Add in the decorator and furnishings, the luxury cars, the private schools, cruises, and the country clubs, and other items adding to your conspicuous spending tally.  Suddenly your six or seven-figure income is drained from spending and higher debt.

Food: $616 per month

What we spend on our food is dependent on the type of household we have. Our reference household of three, including a young child under 18, eats home 54% of the time and 46% away from home. Food accounts for 13% of total expenditures.

As we all know, and I can attest in our household, eating out is far more expensive, especially when you add beverages.

It is good to do comparison grocery shopping, use coupons wisely, eat out more prudently to save more. Food should account for 10%-15% of your budget, especially if your household has four people.

Transportation: $760 per month

This category amounts to about 16% of total spending. It matters if you live and work in an urban market with access to an excellent public transportation system or need a car(s).

While NYC is super expensive, monthly MetroCards are among its few bargains at $127 for a 30-day unlimited pass if you depend on the train. On the other hand, buying a new or used car, net of trade-in,  car insurance, finance charges, gas/oil, and repairs can be costly. You can eliminate about $58 per month if you are handy with cars.

You should aim to keep transportation below 10%-15% of your spending.

Gas, fuels, and oil cost $168 per month in 2017, lower than previous years, and can significantly swing. Shopping around for a used car that you buy outright and comparing vehicle insurance costs can reduce your monthly burden.

Cars are often a big part of our conspicuous consumption. For some, it is a functional device to transport us from place to place. For others, the “dream” car has to go with the “dream” house. Resist spending that may go with your success and higher income.

Budgeting Is For Everyone, Even Millionaires

In one of my favorite books, “The Millionaire Next Door,” authors Stanley and Danko portray the differences between the self-made millionaire and the typical wealth inheritor.

The one who became rich by working hard often bargain shops for low-key used cars, saves and invests wisely. On the other hand, the classic wealthy person who has accumulated wealth through legacy tends to be a big spender for the sake of image. The last exhibit similar traits to those in the early stages of lifestyle inflation, ramping about debt quickly.

Healthcare: $264 per month

This category is 5% of our total spending and is associated mainly with health insurance.  If you are fortunate, your employer substantially pays for the plan. Medical services, medical supplies, and drugs account for the rest. As your family grows and especially ages, healthcare costs rise for the household.

You should target these costs to stay at the 5%-10% level.

Apparel: $170 per month

Apparel is just under 4% of total spending and certainly is a variable annual cost. You could always use a rule of thumb of 2%-4% of your total expenditures for budget purposes.

More likely, families will spend seasonally or back-to-school and special events. For young families with young children, clothes could amount to more significant expenditures because of outgrowing (sizing out) or fashion-conscious teens. Shopping wisely really matters, whether in the mall or online, to keep spending down.

Entertainment: $220 per month

We entertain differently depending on our age, household, hobbies, video, sports, music, and pets. These variable costs are something we can exercise some control over. It may be more challenging when we have children, however.

Here, entertainment is a tad under 5% but may increase if you count eating out as part of the entertainment.

Personal Insurance and pensions: $549 per month

Your social security payments are your contributions deducted from your paycheck and in this category. Also, there are life insurance, railroad retirement, government pensions, private pensions, and retirement programs for the self-employed. This category accounts for 12% of your monthly expenditures.

Education: $102 per month

Education is part of “Other Expenditures” but deserves its mention. It includes tuition, fees, and supplies for all levels of private and public schools, including colleges.

The relatively low amount may not fully reflect the burdensome student debt. Typically, students pay their loans over a ten-year or longer time frame. Some students may accelerate their payments to get rid of their debt. Others pay just the monthly minimum, which could be as low as $50 per month. Others make late payments.

Other expenditures: $269 per month

These are miscellaneous items, primarily personal care products, magazines, credit card memberships, legal fees, tobacco, donations,  and alimony. This category amounts to 5.7% of total spending.

Those that can give to their favorite charities should donate higher amounts. We have used a rule of thumb of 10% of spending though recognizing that is not possible for every year and everyone.

 Related: 10 Ways To Better Manage Spending

Related: Saving For Retirement in your 20s

What Does Your Budget Look Like?

Monthly income of 5,095 less total expenditures of $4,610 for the average 25-34 year household leaves $485 or almost 10% of net income.

Boost your “monthly savings” of $485 or $5,820 a bit, especially if you can keep your housing costs to 30% of total expenditures or less. Certainly, if you are renting or buying a modest home and getting an affordable mortgage, your savings will have room to grow.

Monthly Savings Should Be at least 10% Of Your Earnings

To combat the likelihood of increased spending as your income grows, you need to have a financial plan in place: 

#1 Pay Yourself First

Allocate at least 10% of your earnings to go savings and allocate to paying off debt, emergencies, retirement accounts, and investments.

#2 Establish An Emergency Fund

Establish an emergency fund for at least six months of necessary expenses such as rent, student loan payments, transportation, utilities, phone, food (even pizza). You may be living on your own or with roommates, and they’ll be expecting your monthly contribution.

#3 Set Up A Budget

Put a budget plan in place once you know your take-home pay, you should think about your fixed and variable expenses. Keep your housing costs from expanding as you grow your family. Consider a used car and paying cash. It is not unusual to quickly ramp up spending for entertainment, eating out, clothing for work, and play as your earnings grow.

#4 Spending Limits

Spend within your means by tracking and limiting purchases. The problem is that the new freedom you have to enjoy more things with your latest paycheck, the more likely you will spend more than you should. You want to live well within your means so you can grow savings. Bargain hunt and consider ways to avoid impulsive shopping.

#5 Pay Off Debt

If you are living home initially after college, that is a great time to put some savings away to pay off debt. Reduce your high-cost debt by paying your bills in full. Credit card balances grow fast on high interest rates. Instead, pay your credit card balances in full. If you can’t, stop spending with your cards.

#6 Student Loan Repayment

Have a plan for your student loan repayment. This has to be an essential part of your priorities. The Consumer Expenditures Survey may be underestimating education costs or in other categories. Your household may have higher student loan repayments closer to the national average of $304-393 per month.  Pay your fully monthly bill, not just the minimum for student loans.

#7 Consider Increasing Your Loan Payments

When you have extra savings or your income rises, pay down your student loans. You may decide to pay more than your current student loan bill if you get a bonus or substantial raise. If you can handle paying back your federal and private (if any) student loans sooner, that may be good. Look to pay the higher cost of debt first, usually the private loans.

If you buy your home or condominium, consider a shorter term for your mortgage, say 15 years versus a 30-year mortgage. The latter is a higher total cost because of the higher over interest costs.

#8 Retirement Savings

 Jumpstart saving for your retirement when you start your job by contributing to your 401K plan, especially if your company has a matching contribution. There are tax-deferred savings benefits. You need to save up to the amount that will trigger your companies’ matching contribution. At the same time, allocate some savings for an IRA/Roth IRA.

#9 Leverage The Magic of Compounding Interest

Get familiar with the benefits of compounding to grow your money faster. Regular contributions in your 20s amount to substantial savings for your retirement decades later through compounding interest. A monthly amount of $800 for 30 years at an 8% rate produces savings of $1,203,223.29. Not too shabby! The earlier you invest, the better your retirement grows.

#10 Diversification Is An Essential Investing Strategy

When investing money,  you should diversify your investments among different financial instruments and asset classes, such as real estate. That strategy will help you reduce your risks. 

By diversifying, you can reduce risk by buying different kinds of stocks in various industries, even in foreign markets (the US versus emerging markets). You can never eliminate risk or loss, but you never want to put all your eggs in one basket.

11. Taking Advantage of Retirement Savings: 401K and Roth IRA

In 2021, the maximum contribution you can make to your 401K is $19,500, likely a steep amount to make if this is your first job. Make some arrangements for some percentage of your paycheck to be withdrawn for your 401K. It is a good habit and essential to start as early as possible, given the benefits of earning on a compounded basis.

You should also open up a  Roth IRA account to begin saving outside of work. In 2021,  the maximum amount allowed was $6,000 ($7,000 if you’re 50 or older). Maybe you received some graduation presents from your family, which would be perfect seed money to put into these accounts.

At an early age, post-college, you can learn how to reduce spending, save more to pay down debt, create an emergency fund and invest in your future. What has worked for you when you are budgeting? What ideas have you tried that worked for your household? We would like to hear from you!

 Final Thoughts

Avoid lifestyle inflation by carefully budgeting your spending so it doesn’t get out of control. Spend within your means and allocate your savings with care. Sure, you deserve treats in life but you want to make sure your costs don’t spiral out of control so you are constantly borrowing. Financial security and freedom are desirable goals so that you can achieve financial success and enjoyment in life.

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The Pros And Cons of Credit Cards

The Pros And Cons of Credit Cards

“Once you get into debt, it’s hell to get out. Don’t let credit card debt carry over. You can’t get ahead paying eighteen percent.”

Charlie Munger, Vice-Chairman, Berkshire Hathaway

 

For me, credit cards have always been a double-edged sword, a fight between good and evil, or in Biblical terms, a blessing and a curse. Growing up, my parents predominantly used cash, using their retail business’s checking account to pay bills. I was the first in my family to go to college and the first to have a credit card. My parents celebrated the former and not so much the latter. They only accepted cash from their customers, refusing to believe in the benefits of the credit card. That’s where I probably get my reluctance to use credit cards instead of cash at times.

They may have been onto something though it may have been something else altogether. My mom, I still believe, may have been irked by the fact that women, on their own, could not get their cards until the passage of the Equal Credit Opportunity Act of 1974. Before that, women needed to have a man (husband or father) cosign for a credit card. How was it fair that my Dad, not my Mom, the brains behind all our finances, could get a credit card? Just saying why I think my Mom, until the day she died in 2000, never had any interest in a credit card (pardon the pun!).

The Credit Card Landscape

Credit cards are a financial tool. But like buying a new buzz saw, you need to use it with care. Some people collected credit cards like baseball cards when I was growing up. That seems like a formula for disaster to me. Clearly, we are not yet a cashless society with nearly 1 in 4 people unable to get approval for a credit card due to lack of credit history or discipline. Roughly 33 million people in the US are unbanked or underbanked, meaning they largely use financial products outside the banking system.

When COVID hit our shores in March 2020, new card applications dropped 40%. Inquiries for all kinds of loans–auto and mortgages–dropped substantially as our priorities changed during the pandemic.  The irony is that the use of credit cards increased out of necessity due to fear of touching cash on the risk of getting a coronavirus-related infection. That behavior is just another example of the strange happenings in 2020. Growth in new card applications should resume in 2021. 

Credit Card Statistics:

  • About 176 million or  67% of Americans have a credit card with about 3.1 cards per person.
  • The average card balance is $5,897 per person end of 2020.
  • Roughly 58% of cardholders carry some kind of balance.
  • The average FICO score for credit cardholders was 735.
  • The current credit card interest rate averages were 14.58%, but for those with fair credit scores, the rates rise to 23.13%For new credit cards.
  • The average rate was 17.87%.

 

Advantages of Credit Cards

 

1. Convenience

Compared to cash, credit cards are a suitable financial product. Before COVID, retail businesses were increasingly not accepting cash from customers. Credit cards provide fast payments, transfers between accounts, and withdrawals.

There are far more shopping options with a card. It is easier to make, change, and cancel travel, hotel, and car rental arrangements.  When traveling overseas, credit cards allow you to realize currency conversions automatically.  Let’s face it, carrying a lot of cash is hard –bills and change– around in your pockets, jingling around. That said, I do like window shopping without my wallet, so I don’t feel tempted to spend money unnecessarily.

2. Build Up Your Credit

For those who lack credit history, like young people, becoming an authorized user on your parents’ credit card is a rite of passage. This is an excellent way to build up a credit history so long as your parents’ credit scores are strong. Otherwise, it won’t help your credit situation at all.  Most states do not have minimum ages for your child to become an authorized user. I’d suggest you teach your kids about the responsibility of using a card safely and responsibly first.

Getting a new card may be a second chance to improve your credit score. You have missed payments, hurting your credit score in the past. If you are ready to be responsible, you should consider getting a secured card, putting some cash on account. You don’t need a massive number of cards to strengthen your payment history and length of credit history. Understand common credit mistakes and how to avoid them.

Related Post: 6 Ways To Raise Your Credit Score

3. Easy To Track Spending

You should regularly review your credit card bills helps you track your spending. It is easy to do (except when you know you spent a lot of money) and an excellent way to improve your financial discipline. Although spending cash is the best way to feel pain immediately, regular examination of the amounts you are consuming is a realistic way to correct yourself. The credit bills provide a purchase record when making returns.

One particular month, I recall seeing a very high bill with several items that seemed uncharacteristic of me. It was a posh store with a great salesperson.  Looking around,  I realized that the dress  “I had to have” was still in the bag with the tags on along with new shoes. Who did I buy that for? Not me, apparently so I returned those things and stayed clear of that salesperson.

4. Automate Your Payments

Paying your bills, especially credit cards, are so much easier when you use the automation feature. Most cards have this feature that you can set on or before the due date so you are not late on your bill payments. Also, consider paying more than once a month if the lower amounts feel better to digest. As payment history accounts for 35% of your credit scores, automating payments is one way to help you not miss the due date.

5. So Many Perks

Having a credit card may entitle you to perks. Typically, the card use may provide perks such as cashbacks, rewards, airline points, merchant discounts, hotels, travel insurance, welcome bonuses, access to tough-to-get tickets, and free museum passes. Before signing up a specific perk, make sure it aligns with your needs. One time I ordered four tickets for Hamilton on Broadway for my family, only to realize they were preview tickets for the opening in LA, 3000 miles away. The issuer reimbursed us and waived the fees.

6. Protections For Consumers, Not Necessarily For Businesses

Credit cards offer several features for consumers. When you lose cash, it is gone forever. The good news is that money is typically not attached to your personal information, like the loss or theft of your credit cards. Some cards provide zero-liability fraud protection. In a fraud situation, just notify your issuer to cancel your card. Alternatively, the issuer can get you a new account number at no charge. Safety is important.

Typically, when you lose your credit card, your losses are capped at $50 so long as you let the issuer know promptly. There may be a higher fee and responsibility for any charges that aren’t yours if you delay reporting them. I once thought I lost my card, I called the card company quickly to find that my card fell out of my wallet into a nook in my bag. Paying the fee was a fine for a lesson learned to at least look for your card first.

Cards often have spending limits. Occasionally, you may want to lift the limit if you know you may be spending more for an overseas trip, for example, where you plan to shop for jewelry. A cardholder can let their issuer know that they want to “opt-in” to allow for transactions that may put you over your credit limit. You can let them know the specific dates you’ll be traveling. Spending limits are a good feature, especially if you’re prone to overspending.

The Credit CARD Act of 2009 enhanced more protections for consumers that do no apply to businesses. With this law, issuers need to notify consumers of significant interest rate hikes at least 45 days beforehand. Also, fees, previously hidden, must be better disclosed clearly. There are some other practices that improved with the CARD Act discussed here. Still, it is always important to read the tiny fine print, especially when it comes to credit cards.

Disadvantages of Credit Cards

 

 

1. Overspending Leads To Higher Debt

Spending beyond your means can be the root of all evil related to your finances. Credit cards enable people to shop impulsively.  Having a card rather than a finite amount of cash gives you the ability to borrow more than you should. Overuse of your card leads to carrying high-cost debt on your balances. Paying double-digit interest rates on these balances can be overwhelming.

The convenience of using credit cards as compared to cash may encourage higher spending, according to studies. In the now-classic MIT study by Drazen Prelec and Duncan Simester, MBA students held an auction for tickets to sporting events. One event was a desirable basketball playoff game, and the other was a regularly scheduled baseball game. Those participants were encouraged to buy tickets using credit cards spent up to 100% more than those paid in cash. They called this the credit card premium.

Other studies seem to validate the MIT findings that we tend to spend more with a credit card than cash. For me, spending cash for purchases gives me an immediate pain instead of a nearly month delay of having to pay my credit card balance.  to me, mental accounting bias and overspending

2. Irresponsible Use of Your Credit Card

When you pay your card bill in full every month, you don’t pay any interest. Your credit card provides a lot of benefits without the pain of paying high interest costs. Unfortunately, many people just pay the minimum amount due at the end of the month, carrying a balance forward. The issuers prefer cardholders to carry balances as it is a lucrative income stream for the companies. 

At an average balance of $3,000 with an average interest rate of 16%, it can take 16 years to pay off that balance at the monthly minimum rate, roughly 3%-4% using a credit card interest calculator. That assumes that you haven’t used a credit card during those years. It is a vicious cycle. The magical powers of compounding that work so well when investing or saving for retirement works against you when you are paying interest charges on interest accumulated. If you cannot use your card responsibly, you should work hard to reduce your spending. Some people have too many credit cards, maxing out their limits, losing control of their spending.

Watch out for the particularly punitive penalty interest charge when you are late on your credit card payment. The penalty interest rate could be as high as 29.99%, above your regular interest rate, and may stay in place for some time.

3. Lower Your Credit Score

Just as you may raise your credit score, misuse of your credit cards can destroy your score. Missing payments, applying for credit too many times, and using more than the 30% limit of your available credit all can hurt your scores. Even closing a credit card account, you don’t use will result in a decline in your score. Your credit score reflects your creditworthiness to lenders, landlords, and other professionals and could negatively impact you.

4. Read The Fine Print

Just like any contract you sign, make sure to read the terms and conditions of the credit cards you are considering. Despite legislation to protect consumers, issuers are well known for hiding information about their perks, fees, charges, and other liabilities from consumers. In recent years, consumers have been able to compare credit cards more quickly. Among my favorite sites are WalletHub, NerdWallet, and CreditCards.com, which have a ton of good information on credit card features.

Be aware that you are usually subject to mandatory arbitration if you have a dispute with your card issuer. This has been relaxed in recent years but is still in the terms and conditions. It is one of my pet peeves and a project I assign my law students to look at the fine print. The average consumer can’t fight the legions of arbitration attorneys that support card issuers.

Exercise Financial Discipline By Using These Rules:

  1. Shop wisely for a credit card, finding the perks that most suit you.
  2. Read the terms and conditions carefully even after you made your selection.
  3. Pay your credit card bill in full, so you don’t carry a  balance.
  4. Have an ample emergency fund, so you don’t put high unforeseen costs on your card.
  5. Spend below your means always and make savings and investing a priority.
  6. Don’t close any credit card. Instead, cut your card in a million pieces or simply put it in a drawer.
  7. If you have multiple cards, decide how to use them for different categories and don’t max out their limits.
  8. Avoid cards with annual fees unless they have essential features you will use.
  9. Don’t get addicted to credit cards. Limit the number of cards you have.
  10. When it comes to paying your card bills, automate and don’t procrastinate. The penalty rate is punitive for a reason.
  11. If your child is an authorized user of your credit card, teach them how to use the card wisely and safely.
  12. Be aware of behavioral biases of spending more when using your credit card instead of cash.
  13. Review your credit card bills for errors, poor judgment on your part, or correct impulsive spending.
  14.   Use cash for some of your discretionary spending.

 

Final Thoughts

Credit cards serve an essential purpose as a financial tool in an increasingly cashless society. Used wisely, the advantages of credit cards will outweigh their disadvantages. Practice financial discipline in all aspects of money management. We have had our druthers about using credit cards, learned a hard lesson or two.

Thank you for reading! If you found some value in this article, please share it with friends, family, and colleagues. Consider subscribing to our growing community at The Cents of Money!

 

 

 

 

Getting Stimulus Money? Spend This Money Wisely

Getting Stimulus Money? Spend This Money Wisely

The third and possibly final stimulus check from the federal government is on its way. Most people will get their stimulus money via direct deposit to tens of millions of bank accounts. If you and your family qualify for the most extensive distribution, you likely have some immediate or future needs. Whatever you decide to do, strategize to spend this money wisely.

Stimulus Checks And Extended Unemployment Benefits

Did you get your stimulus check yet? The maximum tax-free amount is $1,400 per individual ($2,800 per married couple if jointly filing), and $1,400 per dependent, including those ages 17 and up. The federal government extended unemployment benefits with a $300 additional supplement to state benefits through September 6, 2021.

Typically, unemployment benefits are fully taxable. However, the IRS gave a tax break by allowing taxpayers to exclude up to $10,200 ($20,400 for married couples filing jointly) benefits on their 2020 taxes for those who made less than $150,000 in adjusted gross income (AGI). As stimulus checks were going out to households, the IRS announced tax returns are now due on May 17 this year instead of April 15.

How To Use Your Money Depends On Your Needs

Every household varies as to their need for this money. For instance, lower-income families are more likely to devote much of their spending to living necessities.

In a June 2020  US Census study,  adults in households with income between $75,000 and $99,999 were more likely to use their stimulus money to pay off debt or add to savings compared to households overall. In contrast, 87.6% of adults earning $25,000 or below planned to use their stimulus payments to meet their expenses.

The stimulus money is part of more considerable fiscal support targeted to boost consumer and business spending. As the economy grows, more people will work.

The Fed has accommodated our weak economy with low-interest rates and continued liquidity. These efforts will stimulate our economy and help our financial markets, but they may cause higher inflation. Fears of higher inflation have added volatility in the stock market.

Some believe higher economic growth and inflation may be transient, causing some stock market opportunities ahead. Chair Powell seems to be staying on course of a stimulative monetary policy and will tolerate higher inflation over the 2% target. 

Is This A Financial Windfall?

Merriam Webster  defines windfall as “an unexpected, unearned, or sudden gain or advantage.” A windfall can range from being a sum of $1,000 to something far more significant. This money may result from an inheritance, legal settlement win, salary bonus, or a winning lottery ticket.

A small windfall, newfound money, or stimulus money can serve a similar function by bringing you a step closer to your financial goals. That is a win for you whether you direct the money to help you with your day-to-day expenses or cushion your retirement nest egg.

Strategize What You Need Now And For Your Future

Strategize before spending your additional money by paying what is most urgently needed now.  The funds should improve your financial situation. Most people receiving checks have had a difficult time making ends meet. They may have lost their jobs, had their hours cut, or their job remains in jeopardy.

You may need to shore up your finances now. Are there holes in your budget that need mending that you can take care of first?   Pay your bills, reduce your debt to manageable levels, eliminating high-interest credit card debt. Should you have money left over, save for emergencies.

On the other hand, if you have little to no debt, devote your extra money to where you can catch up on retirement savings and investing.  Allocate where you can boost your financial future–replenish your emergency fund, retirement, investing– by adding to where the money can potentially grow.

Our Recommendations For Spending The Money Wisely  

 

1. Prioritize Your Everyday Bills

If you have outstanding household bills for your rent, mortgage, or utilities that need attention, consider negotiating with your providers. Ask if lower rates are possible or stretch out due dates. You want to avoid being late paying bills and affecting your credit score. It never hurts to try to do that at a time when people are most understanding.

Staying current on your bills can relieve the angst. And you don’t want to pile on late charges and add to your debt load.

2. Paying Off Your High-Cost Debt First

When you carry a lot of debt–credit cards, car, mortgage, student loans, or personal loans–can be overwhelming. Your stimulus money may not stretch that far. Interest rates are low for mortgages, car, and student loans, so your best bet is to reduce your credit card balances. Card issuers typically charge 15%-16% interest rates, and the compounding effect makes that balance grow faster.

It may be tempting to spread the cash proceeds around to all of your loans but target the most detrimental cost first.

3. Neglecting Any Car Repairs?

During COVID, you may be using your car less. If you are not following through with tune-ups, you can damage your vehicle in the long run. Do you have any car repairs you postponed but now can bring into the shop? Your repair guy will likely welcome you back.

4. Replenish Your Emergency Funds Or Start One

Many people have withdrawn money during the past year. They may have had to close businesses, leave jobs to take care of their family, or lost their jobs. It is time to reassess your emergency savings. Refill this fund so you can cover six months of your basic living needs should something unforeseen happen. A job loss, pet surgery, an unexpected illness, or car accident can mean higher costs beyond your budget.

Replenishing these savings can give you peace of mind. Those unexpected events do happen, as many of us learned the hard way last year.

Make sure to keep this money in liquid assets such as a higher-yielding savings account that is readily accessible. These days there is very little income to earn from low yields. But, economists are expecting higher interest rates as the economy strengthens. Therefore, use short-term securities like CDs so you can roll this money into higher yields when they are available.  

5. Add To Your Retirement Savings

Whenever you have extra money from a bonus, overtime, or raise, consider adding some of this money to your retirement savings. Notably, a 401K employer-sponsored plan or an IRA and Roth IRA makes sense. If you don’t have a retirement account, this is a good time to do so. 

Technically, your tax-free stimulus payment is unearned income. As such, it may be tricky to deposit money into your Roth IRA directly. Therefore, you may want to substitute earned money from other accounts, replacing those dollars with your stimulus money.

It is worth the effort to do so. Putting some money into a Roth IRA makes it a triple tax-free win. You aren’t paying taxes upfront. The contributed amount grows tax-free, and when you withdraw money after your turn 59.5 years.

Be Aware of Contribution Limits

You can have both a 401K and an IRA, but there are IRS contribution and income limits you need to be aware of so you can get the full deduction. Be mindful of those income limits for traditional IRA and Roth IRA for 2020 and 2021. They vary according to whether you are the single or head of the household, married, filing jointly, a retirement plan at work covers one or both spouses.

Contribute generously up to the maximum amount allowed:

The 2020 and 2021 limits are $19,500 for 401K and most 400 plans, and with a catch-up limit, $26,000 for employees aged 50 or over.

Total contributions for 2020 and 2021 are limited for all traditional IRAs and Roth IRAs to $6,000 or $7,000 if you’re age 50 or older.

6. 529 Savings For College

These accounts have federal tax benefits, like retirement accounts. Open a 529 savings account to set aside some money for your children’s college fund. Earnings on investments grow on a tax-deferred basis and tax-free when you withdraw money for educational costs. Generally, there are no contribution limits except for the $15,000 cap to qualify for the annual gift tax exclusion.

Each state has its own plan, and you don’t need to reside in the state to use their program. You may think that they are young and it is too early to think about their future, let alone college, if they are still at the crawling stage. The truth is that time goes by quickly, and before you know it, they are in high school. Don’t let this valuable time slip away without putting money into this fund. It will help your children to avoid borrowing heavily for college tuition.

7. Allocate Your  Savings To Investing

In a perfect world, all of your extra money should go toward investing. If you have a strong financial foundation with manageable debt, you should invest the money. Add to your investments or opening up an investment account for you or your kids.

Any savings you have from stimulus checks to a significant financial windfall should go to your investment accounts. That is if you have taken care of other needs. Invest early and have a plan in mind which considers your risk tolerance, timeframe, and diversification. 

When you are beginning to invest, you may not know where to start. Buying individual stocks can be very rewarding but can be risky. Consider low-cost index mutual funds or exchange-traded funds (ETFs) if you are uneasy purchasing individual stocks. Buying a pool of stocks is a popular way to own securities with diversification, avoiding concentration risk.

Professional portfolio managers actively manage mutual funds. They are constantly evaluating and choosing securities for the fund’s specific investment approach. Mutual funds are available for stocks, bonds, precious metals, other securities, varying risks,  and varying geographic markets. 

Active managers earn annual fees or expense ratios of your investment and are responsible for the fund’s performance. If you invest $1,000 in a mutual fund with a 1% expense ratio, you pay $10 per year towards the fund’s expenses.

Active Versus Passive Investing

Investors who buy actively managed funds pay higher expense ratios than passively managed index mutual funds that track a market-weighted portfolio. The latter index fund replicates the S&P 500 index via computers for a fraction of the fees, averaging 0.20%-0.50% expense ratios, below the typical 1%-2.5% costs of active managers.

You can buy a low-cost index mutual fund or an ETF consisting of a basket of securities, such as money markets, stocks, or bonds depending on your risk appetite. ETFs are similar to mutual funds but tend to be cheaper and more liquid. If both are available, I usually buy the ETF version. There are many funds with terrific choices, such as Vanguard, who pioneered indexed funds.

8. Give To Others

It is always a good time to give charitable donations to others. We always target giving 10% of our income to charitable contributions, but we have done more to offset the time we couldn’t do so. Everyone has their reasons for giving what they can and may stem from religious or ethical sources.

The minimum of one-tenth of one’s income belongs to God per measure handed down from the Patriarchs. As Jacob himself said to God, “Of all that You give, I will set aside a tenth to You” (Genesis 28:22). Giving 10% of your net income every year is a desirable goal—those who can do that.

Giving, like expressing gratitude, is among the most worthwhile healthy emotions to feel. Being grateful can even help us with our finances.

As part of 2021 $1.9 trillion American Rescue Plan, Biden extended the favorable tax deduction treatment in 2021 that was available last year. Taxpayers who take the standard deduction rather than itemize their tax deductions may set aside $300 (or $600 if you are married and filing jointly). The IRS suspended the typical limit of 60% of adjusted gross income for the amount of the charitable deduction made in a year.

The IRS has temporarily suspended limits on charitable contributions for those who itemize deductions on Schedule A. Check with your accountant whenever it relates to your taxes. 

 

Final Thoughts

Use your stimulus payment or windfall by spending the money wisely to improve your financial situation. It’s a personal decision based on your needs now or in your financial future. Strategize before spending this additional money so you can get the most of it. Hopefully, you are turning the corner to better times.