Bad credit is expensive

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Credit scoring, demystified
Profile: Angel Smith
The problem:
Low credit score limits mortgage-financing choices.
The plan:
Boost score with auto bill pay and by zapping card balances.
Angel Smith

Angel Smith, 27, of North Carolina, is engaged to be married in October 2007 to the love of her life, Tyree. She has recently started a new position with a large supermarket chain and is looking forward to her new career.

Angel’s dream is to own her own home, and she is happily looking for something that she can afford. She has marginal credit, high credit card debt and little in the way of personal savings and retirement accounts.

She wonders if she will be able to get her finances in order, achieve her goals and start her married life out on the right financial footing.

   The problem

Angel has a problem common to many young professionals. She is in the market to buy her first home, but her low credit score has been a big hindrance in obtaining conventional financing. Not only that but Angel has relatively little personal savings, and she has a problem with budgeting for her expenses. “I tend to spend whatever I have at the moment,” she says.

Angel believes that she will continue to earn a good living and she has planned to pay for her wedding with cash. She believes she can look forward to substantial earnings gains over her career. But right now she is pinched in her finances, and a few issues after college have damaged her credit score.

While she is not sure how she got in this position, what she does know is that just starting out in her new life, she has $12,000 of high-interest credit card debt spread out over four credit cards. This debt is about 75 percent of her credit limit. She is currently paying high rates because her credit score has not qualified her for preferred rates. In fact, three of the cards have rates of over 25 percent. This is her only current debt, as she does not have a car loan.

This report was prepared by Chartered Financial Analyst William Z. Suplee, CFP, CASL, ChFC.
Key issues
A low credit score limits her mortgage-financing options.
No emergency savings.
Does not live on a written budget. Spends as she wants.
$12,000 in credit card debt over four cards.
Paying penalty-type interest rates of more than 25 percent on three cards.
Credit card debt balance is already at 75 percent of her limit.
Several recent late payments on credit cards.


Late payments hurt credit scores
While she has a goal of improving her credit score to over 700, she needs some help with her payments. Angel recently was late on a couple of credit card payments because she lacks a systematic payment plan. Her credit report has also been hurt by an old outstanding dispute over a $500 medical bill resulting from a worker’s compensation claim.

She does have $15,000 in an IRA that she rolled over from her previous employer’s 401(k) plan. She is intending to use the first-time home-buyer exception and use up to $10,000 of that IRA to fund her down payment and closing costs on a new home. She is not eligible to participate in her employer’s 401(k) plan until August when she will receive a 100 percent match on the first 6 percent of her deferred income.

Mortgage loan choices
Angel is looking to buy her first home using an FHA loan. She has been prequalified and believes she can afford a home in the range of $150,000 to $175,000 with a 30-year fixed mortgage at 6.75 percent. She intends to make a maximum loan-to-value purchase of 97 percent and include her closing costs in the mortgage. While this will allow her to purchase her first home, she will be highly leveraged and still in need of budgeting and credit repair.

One area that Angel seems to have adequately covered is insurance: She is covered for renter’s, car, life, disability and health. The term life insurance will cover the home payments if something should happen to her after she is married. She is currently covered by her employer’s disability policy of 1.5 times her salary to protect her mortgage if she becomes injured or disabled at work.

Except for the money that Angel has saved for her wedding, she does not have an emergency fund. Instead she must rely on the remaining available credit on her credit cards to finance any emergencies that arise. This might be a last-gasp measure, as all of Angel’s cards are at very high rates. Angel needs to reduce this debt and build her savings as soon as possible.

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