Get Intimate with Your Debt
You can get started right now with the first part of this step: knowing exactly what you owe. Dig out your credit card statements and loan paperwork so that you can list all your debts with the relevant details. You can use the form provided in Table 2.1 or a blank sheet of paper. If you're into such things, you can even create your own spreadsheet.
| Debt | Lender | Balance Owed | Credit Limit | Interest Rate | Fixed/Variable | Adjustment Date | Deductible? | Minimum Payment | Typical Payment | Prepayment Penalty? | |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Mortgage 1 | |||||||||||
| Mortgage 2 | |||||||||||
| Home equity line of credit | |||||||||||
| Home equity loan | |||||||||||
| Student loan 1 | |||||||||||
| Student loan 2 | |||||||||||
| Student loan 3 | |||||||||||
| Student loan 4 | |||||||||||
| Credit card 1 | |||||||||||
| Credit card 2 | |||||||||||
| Credit card 3 | |||||||||||
| Credit card 4 | |||||||||||
| Auto loan 1 | |||||||||||
| Auto loan 2 | |||||||||||
| Auto loan 3 | |||||||||||
| Other vehicle loan | |||||||||||
| 401(k) loan | |||||||||||
| Personal loan 1 | |||||||||||
| Personal loan 2 |
Make sure you include every debt you owe, including
Mortgages
Home equity loans and lines of credit
Credit cards
Student loans
Auto loans
Other bank or credit union loans
Money owed to check-cashing outfits or payday lenders
401(k) or other retirement plan loans
Debts owed to friends and family
For each debt, write down the following:
Current balance owed. At this point, it really doesn't matter what the original loan amount was; what matters is how far you have to go.
Whether the loan is an installment or revolving debt. Installment debts include mortgages, auto loans, and other debt where you have a set schedule of payments to make and a specific payoff date when the loan is expected to be retired. Revolving debt includes credit cards and lines of credit, where you have a credit limit that you can draw on—and pay off—repeatedly. Paying off revolving debt generally increases your financial flexibility because you can always draw on that freed-up credit line in an emergency. That may not be possible with an installment loan.
Current interest rate. You should find this on your most recent statements, typically listed as your “annual percentage rate.”
Whether the rate is fixed or variable, and when it might change next. Credit card rates typically are variable and can change month to month. Installment loans usually carry fixed rates, unless you took out an adjustable-rate mortgage. If you're not sure when the rate is scheduled to change, ask your lender.
Whether the interest is tax-deductible. This is actually more complicated than it might seem, but we'll get to that in a minute.
Minimum payment owed. Again, this is something you'll probably find on your latest statement.
Typical payment made. Ditto.
Whether there's a penalty for paying off the loan faster than scheduled. Prepayment penalties aren't that common. You'll find them on some mortgages and auto loans, but not all. If you're not sure, call and ask.
You can add one more step if you really like to play with numbers by trying to figure out your “after-tax” rate on your tax-deductible debts. Essentially, you need to subtract your tax bracket from the number 1 and multiply the result by the interest rate you're paying.
For example, if you're in the 25% bracket, you'd subtract .25 from 1 to get .75. Multiply that by a 6% interest rate (.06), and your after-tax rate would be 4.5%.
Some folks like to get even more precise and factor in their state and local tax rates as well. Someone in the 25% federal bracket who lives in California may pay an 8% state income tax rate. To figure the effective rate, you multiply the federal rate by the state rate and then subtract the result from the combination of the two rates. This reflects the fact that you can deduct your state taxes from your federal return. It works like this: .25 times .08 equals .02. Add .25 and .08, and you get .33. Subtract .02 from that, and you get .31, so 31% is the combined effective tax rate.
If you enjoy this kind of thing, have at it. But remember that these are still just estimates of what your rate will be over time. Tax rates change constantly, so your tax benefit may be more or less than you think, depending on what's on your tax return in any given year.
Which Debts Are Deductible?
The issue of tax deductibility confounds a lot of people, who assume a loan is either tax-deductible or not. The reality, like so many things in personal finance, can be far more complicated.
Mortgage interest may be tax-deductible—or it may not. Technically, you can write off the interest you pay on mortgages of $1 million or less, as long as you owe the money on your primary residence or a second home. But if you don't itemize your deductions—and two-thirds of the nation's taxpayers don't—you don't get any tax benefit from your mortgage.
About half the nation's homeowners get absolutely no tax benefit from their homes—either because they own their homes free and clear or because they're paying too little in mortgage interest and other potentially deductible expenses to justify itemizing. You had to have deductions worth more than $9,700 for itemizing to make sense in 2004 if you were married filing jointly, or $4,850 if you were filing single.
If you're not sure whether you itemize, check last year's return. If you just bought a house this year, you can use TurboTax or another tax program to see if you'll get a tax benefit from your mortgage, or you can talk to a tax pro.
Even if you do itemize, you may be getting only a partial benefit from your mortgage. If your interest payments, property taxes, and other deductible expenses total just $10,000 and you're married, you get an additional tax benefit of just $300. If you're in the 25% bracket, that means all your deductions really saved you only about $75. That's very little tax bang for all the bucks you paid in interest.
Home equity interest is usually deductible. If you itemize, you typically can write off interest on home equity lines of credit or home equity loans, as long as the amount owed is less than $100,000. If you owe more, you can't deduct the interest on the part of loan that exceeds that limit.
Your ability to write off your home equity interest can be limited even more if you fall under Alternative Minimum Tax (AMT) rules. This Byzantine system was originally designed to make sure the wealthy didn't exploit loopholes to escape paying taxes, but today it's snagging many far less affluent families who simply have lots of deductions—usually because they have a lot of kids, they live in high-tax states, or they got certain kinds of stock options from their employers.
AMT rules severely restrict the deductions you're allowed to take, including home equity interest deductions. If you borrowed the money for anything but home improvements—if you paid off credit card debt or bought a car with the money, for example—you can't deduct the interest.
You probably know if you've been hit by AMT rules, but if you're not sure, talk to a tax pro.
Student loan interest probably is deductible. Congress loosened the rules so that married couples with incomes of under $130,000 and singles with incomes of under $65,000 can deduct at least some of their student loan costs (up to a limit of $2,500 a year). (All these figures were accurate as this book went to press, but check with your tax pro, a tax guide, or www.irs.gov for updates.) There's no longer a requirement that the loans be within the first 60 months of repayment. Also you don't have to itemize to take advantage of this deduction—a real plus.
Interest on credit cards and most other debt typically isn't deductible. If you own a business and carry a balance on your business credit card, you typically can write off the interest. People who are self-employed also might be able to deduct some of the interest paid on auto loans for cars used in their businesses.
Otherwise, credit cards, personal loans, auto loans, and other types of consumer debt don't merit a deduction.
You also need to consider one more issue, as discussed next.
Am I Paying the Right Rate?
Most lending these days is based in part on your credit scores, the three-digit numbers that lenders use to help gauge your creditworthiness. Credit scores are a snapshot of your credit picture that tell mortgage lenders, auto finance companies, credit card issuers, and other financial institutions how likely you are to default on your payments. The most-used score is known as the FICO, after its creator, Fair Isaac Corp. (formerly Fair, Isaac & Co.).
Good scores will land you the best rates and terms; mediocre or poor scores can cost you tens of thousands of dollars more in interest over your lifetime.
Table 2.2 shows how much difference even a few points can make on a 60-month $20,000 car loan.
| FICO Range | Interest Rate | Monthly Payment | Total Interest Paid |
|---|---|---|---|
| 720–850 | 5.900% | $469 | $2,502 |
| 700–719 | 6.670% | $476 | $2,840 |
| 675–699 | 8.634% | $494 | $3,723 |
| 620–674 | 10.778% | $515 | $4,708 |
| 560–619 | 14.478% | $551 | $6,464 |
| Source: MyFico.com and Informa Research | |||
The use of credit scoring has even seeped into areas of your life beyond lending. Insurers use a form of credit scoring to determine premiums, and landlords use scores to determine who gets an apartment and who gets denied. Even employers can make judgments about whom to hire, fire, and promote based on personal credit information.
So much rests on your credit scores that you really need to know what yours are and how to improve them.
You may have heard that U.S. residents are now entitled to one free credit report a year from each of the three major credit bureaus. (You can order your reports at AnnualCreditReport.com or by calling 877-322-8228.) But those reports don't include a free look at your FICO credit scores. For that, you usually have to pay.
The easiest place to get all three credit reports and FICO scores is from MyFico.com, which charges about $45.
The three bureaus (Equifax, Experian, and TransUnion) sells scores to consumers for $7 to $15 each, although sometimes they push their own in-house scores over the FICO scores actually used by lenders. You may also get a free look at your scores by signing up for the bureaus' credit monitoring services.
Since your scores can vary significantly from bureau to bureau, it's best to get a look at all three. But you can get a rough idea of where your scores might fall for free by using the FICO score simulator at Bankrate.com.
Contrary to what you may have heard, checking your own credit reports and scores won't hurt your credit. In fact, it's something you need to do to make sure your reports are accurate and that you're getting the best possible rates and terms.
The following chapters show you what people with credit scores similar to yours actually pay in interest on their loans. Since rates can vary widely over time, you might also want to visit the MyFico.com site and use its Loan Savings Calculator, located in the Credit Education section, to get more up-to-date results for mortgages, home equity lending, and auto loans. Bankrate.com is another good source of information on prevailing loan rates.
If your scores are below 720 or so, you'll want to focus on getting them higher. I wrote a whole book about how credit scoring works and how best to boost your scores—Your Credit Score: How to Fix, Improve, and Protect the 3-Digit Number That Shapes Your Financial Future (2004, Prentice Hall). Here's the thumbnail version of the best ways to get your numbers up:
Fix any serious errors in your credit report, such as accounts that aren't yours or negative information that's more than seven years old (or 10 years old in the case of bankruptcy).
Pay your bills on time, all the time. Even a single late payment can devastate your score.
Pay down your debt. The FICO formula likes to see a wide gap between your credit limits and the amount of credit you actually use.
Exhausted yet? Well, get another cup of coffee because we've just begun.