Put home renovations on hold.
Between the original mortgage and the subsequent home improvement project, Phil and Stacey have taken a big bite with this house. As a result, making more than the minimum payments on the mortgage is tough to swallow. But starting now – no more shortcuts!
How do they manage this?
Start by postponing further home renovations. In addition to needing to ramp up mortgage payments in a big way, there are other more pressing needs such as the need to establish some savings cushion, and another $1,500 in tuition payments for Phil is coming due.
In looking at their monthly income and expenditures, there is a significant sum of about $1,700 per month that is disappearing through the cracks. They live frugally in many instances but if they want smooth sailing in their finances, they must plug this hole in the boat first. True, some of this has been for the ongoing home improvements. Putting that on hiatus for now will help cut expenses and shore up other areas of their finances. They currently do not have a good handle on what goes toward miscellaneous spending – things like clothes shopping; family activities and outings; birthday/holiday gifts for the kids, other family, and friends; vacations; charitable giving; and any other expense that doesn’t fall into another category.
If they can limit this category to say, $500 per month, this will help accomplish a few important milestones. It will enable them to refinance the first mortgage into a 30-year fixed-rate loan. Mortgage rates have remained low for borrowers like Phil and Stacey that have good credit, and they can currently lock in fixed rates of 6.5 percent or better if they shop around. This marks an immediate improvement from their current rate of nearly 7.5 percent. But transitioning from minimum payments to fully amortizing, principal-and-interest payments every month — which they absolutely must do — will mean an increase in monthly payments that devours the savings garnered by taking a hard line on the miscellaneous expenses.
- Track every dollar that comes in and goes out.
- Establish a savings cushion.
- Build equity by chipping away at the mortgage balance every month.
- Start saving for retirement.
- Adjust your taxes annually as needed.
- Maintain sufficient insurance coverage.
Check out current mortgage contract. Watch out for any prepayment penalty that may be in place on the existing mortgage. This may affect the timing of the refinance, but not the necessity. In the event there is a prepayment penalty to wait out, they must make at least the interest-only payment – and preferably more – every single month between now and the date they refinance. If they cannot make at least the interest-only payment on a monthly basis, then they are in too deep with this house.
The tax refund they expect to receive can be used to pay off the credit card with the zero-percent promotional rate that expires this month. Then put the card away and don’t use it! Paying off that card balance now will avoid a sharp increase in the rate and free up $100 in the monthly budget. Eliminating this credit card payment, plus the $164 monthly savings from the orthodontist payments that end this month, will enable them to ramp up payments on their credit card and pump some life into a savings account. Split that $264 right down the middle – $132 toward the credit card balances and $132 into savings. Of course, I recommend opening a high-yield account listed on Bankrate.com to get the best return on that money.
Be savvy with taxes to create retirement account. While they’re at it, they should sign up for retirement plans at work. How are they going to pay for this? By adjusting their tax withholding so their net pay is unaffected. It makes no sense to wait all year for that sizable tax refund while they’re borrowing at every turn. On the retirement plans, it may make sense to contribute only to Phil’s right now if that enables them to max out any employer match. Don’t leave any free money on the table! They must establish the habit of saving pronto.
Continue making the minimum payment on the HELOC for now. I’d like to see Phil and Stacey eliminate the debt on the two credit cards and demonstrate an ability to live within their means – which means adding to savings while paying down debt – before taking on more home improvement expenses. The only debt they should add in the next year is for Phil’s remaining tuition payments, which should be done via lower-rate student loans rather than credit cards.
The family has two life insurance policies that it pays to terminate, one on Stacey and one on their oldest son. Both of these policies have accumulated a cash value, but neither of these policies is necessary. For each, find out the surrender charge before terminating, but the remaining cash value can be used to boost savings and pay down debt. The monthly savings could be used to add an additional 10-year term policy of $150,000 on Phil since he is the family’s primary breadwinner, or investigating disability coverage, which they currently do not have. As with Phil’s existing policies, these should be paid for via payroll deduction.
Future looks bright
Once Phil graduates and secures a promotion, they can further accelerate the repayment of credit card debt, boost their retirement contributions further and dip their toes back into the home-improvement waters. But the key will be paying those renovation expenses out-of-pocket, rather than stacking it on the home equity line.
Other winds of fortune will blow their way in the next year. Orthodontist payments for the oldest son will stop in August, giving them a six-month reprieve before their daughter starts treatment. Also, Phil’s car will be paid off in another year, freeing up additional room in the monthly budget. Using those months to increase their savings cushion is vital in the event they incur any car repair bills or to make a down payment when they next decide to purchase a car.
The next 12 months could be very big for Phil and Stacey in terms of making financial headway, but it won’t be easy. It will mean some tough decisions on spending, and I know Phil won’t want to let the home remodeling project sit idle. The toughest part will be getting started. But if they focus, they will make significant progress. I look forward to revisiting their situation later this year. Good luck!
|1) Get on a budget.|
Tools: Use this work sheet to create a budget.
|2) Establish a savings cushion.|
Tip: Find high-yield savings account.
|3) Refinance into a 30-year fixed rate mortgage.|
Tip: Find best fixed rate mortgages in your area.
|4) Start saving for retirement.|
Tools: This retirement calculator will motivate you.
|5) Eliminate all credit card debt.|
Tools: What will it take to pay off my credit card?
|6) Change up life insurance policies.|
Tools: How much life insurance do you need?
This report was prepared by Bankrate Senior Financial Analyst, Greg McBride, CFA.
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