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(4 votes, average 4.75 out of 5)
Personal Finance - Credit Cards
Written by Omie Ismail   
Tuesday, 12 January 2010 05:36
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Debt: The Monthly Payment Trap
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Anybody who really wants to live cheaply needs to start by casting away some of the bad habits that banks, car dealerships, and real estate professionals have reinforced in the last 30 years. They are the enablers that sell consumers on the toxic 'monthly payment affordability' trap.  I'm sure you all have a relative or friend that shops for a house or aThe Monthly Payment Trap car with a sign on their back that says "I want a monthly payment of X."  Every time I hear that phrase, it makes me cringe.  The monthly payment mentality is probably the single biggest factor that leads to debt overload.  It starts innocently enough but can quickly spiral out of control.

For the average wage earner, the monthly payment mentality leads to an irrational thought process that goes something like this : "I make $3,500 a month in take home pay.  If all my monthly payments are less than $3,500 a month, then I can afford whatever I am buying."  If life were always kind, that might be the case. Unfortunately, most lives are tales of unexpected events: the unplanned emergency visit to the hospital, the layoff that disrupts your cash flow, the HVAC system that breaks down on the hottest day of the year, etc.  When life's unpredictable twists and turns throw you a curve ball and you've been living on a month-to-month basis without any cushion, things can get tough real fast.

But even without the speed bumps that disrupt most life journies, people that play the monthly payment game can still find themselves on the short end of the stick because they fail to pay attention to the terms of the  installment contracts they sign.  Their lifestyle seems affordable when they are paying 9.99% on their credit card, but when the interest rate jumps to 17.99% or their monthly minimum payment increases from 2.5% to 5%, they find themselves in a jam.  Or maybe they opted for one of those interest free programs from Best Buy or other retailers; they sound great if you pay on time for 18 months.  Unfortunately, when you miss a payment, you get saddled with a ridiculous interest rate that qualifies as usury.

Let's not forget that the now infamous variable rate NINJA  (No Income No Job) mortgages were largely responsible for the huge economic mess we're in. Once the initial teaser rates expired, the payments repriced  and the result was an avalanche of foreclosures. The table below demonstrates how horribly things can spiral out of control if  just a few things go wrong. In this example, we have a 7% reduction in take home pay, an increased payment for being late on a Best Buy zero interest loan for an HDTV and a similar increase for a late payment on furniture that was also purchased with a zero interest loan. In addition, we have an unexpected credit card minimum payment increase from 2.5% to 5.0% of  a $10,000 outstanding balance. Read your credit card contract - banks can change the minimum payments on a whim.

Monthly Payment Mentality and How It Easily Goes Wrong
Base Case Changed Case Change Amount
Take Home Pay $ 3,500 $ 3,250 $ (250)
Mortgage/Rent $ (1,500) $ (1,500) $ -
Car Payment $ (500) $ (500) $ -
HDTV Payment $ (75) $ (110) $ (35)
Food $ (500) $ (500) $ -
Credit Card Payment $ (250) $ (500) $ (250)
Furniture Payment $ (200) $ (275) $ (75)
Other $ (400) $ (400) $ -
Total Payments $ (3,425) $ (3,785) $ (360)
Net $ 75 $ (535) $ (610)


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Omiewon  - Great Question |2010-01-12 19:06:46
Borrowing to invest can be a potentially good idea but in a very limited number of cases with disciplined investors. The problem I have with advocating it is that people are always asking me for their blessing to take an advance on a credit card to invest in the next hot stock or some new restaurant. Those almost always backfire and leave the person in debt without any asset to show for it.

For those savvy people though who have access to super cheap financing, there are situations where you can virtually print money with the borrow and invest. Some of the opportunities that have existed in the last couple years:

1) Take a HELOC on your home for a big amount, say $100,000 at 2.75% (the lowest I can find) and invest it in a 5 Year CD Yielding 4.5% for a 1.75% spread or $1,750 a year. Current rates are not as favorable but the spread peaked at about 2.25% at one time. If the HELOC rates go up, you cover with the CD by breaking it and paying the penalties, but for the last few years this is a winner.

2) Buy a rental property that when the expenses are fully factored in, still produces positive cashflow. With the plunge in real estate values, and interest rates still hovering near record lows, you can make this happen more often. The risk: renters that stiff you, unforseen expenses, and higher than expected vacancy. Still, for the long run this is a great asset to get yourself into.

So in general, I would say steer clear of using debt for investments except for these cases. Better to build up your assets and invest them the old fashion way. In terms of borrowing to max out your retirement accounts, in general, I think that you should max these out especially if you get a match on the 401(K), but if you are incurring high rate debt, you are probably better paying down the debt first, then increasing your contributions. But make sure you get that debt paid down or it might be 10 years before you get around to socking money in your retirement accounts.
frugal nomad  - What about borrowing to invest |2010-01-12 13:33:16
What about borrowing to invest. I mean if you think borrowing for a house is not such a bad idea - why not borrow to max out your IRA or your 401 K. With interest rates so low, and housing deals all around, what's wrong with borrowing for a down payment to buy a rental.

 
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