I have lots of readers here in the central Iowa area, so it came as no surprise to me that when I began hearing an ad frequently on local radio advertising a particular mortgage product in terms that were a bit on the confusing side, I received an email about it. Jim writes in:

I just heard an ad on the radio offering a 3.99% mortgage. That makes sense to me. Where I’m confused is when the ad then mentions a 4.22% APY immediately after that. What does it mean? What interest rate will I actually be charged?

First, let’s break down the terms.

APR, or Annual Percentage Rate, defines the interest rate that is charged to the principal of the loan. You will be charged a total of 3.99% interest on that loan over the course of a year.

APY, or Annual Percentage Yield, describes the percentage of the principal of the loan that you’ll have to pay over the course of the year.

The trick here is to understand that we’re talking about two separate and somewhat different things. An example will illustrate this difference clearly.

An Example: Quarterly Interest
Let’s say you have a loan from a bank that has 3.99% with interest that is compounded quarterly. That means that every three months, your loan is charged 1/4 of the interest for the year, which would be 3.99% divided by 4, or 0.9975% interest.

Let’s say your loan has a balance of $100,000 at the start of the year, to make the math more clear.

At the first quarter, your $100,000 loan will be charged 0.9975% interest, or $997.50. This gives your loan a new balance of $100,997.50.

At the second quarter, your loan has a balance of $100,997.50 and that balance will be charged 0.9975% interest, or $1,007.45. This gives your loan a new balance of $102,004.95.

At the third quarter, your loan has a balance of $102,004.95 and that balance will be charged 0.9975% interest, or $1,017.50. This gives your loan a new balance of $103,022.45.

At the fourth quarter, your loan has a balance of $103,022.45 and that balance will be charged 0.9975% interest, or $1,027.65. This gives your loan a new balance of $104,050.10.

Over the course of a year, your $100,000 loan turned into $104,050.10, earning $4,050.10 in interest. That’s 4.05% of the balance of the loan, which is your APY.

Thus, this loan has a 3.99% interest rate, but a 4.05% APY.

In the United States, APY is legally defined as being the rate achieved when using daily compounding. In this case, that would give you an APY of 4.07%. So, where does the rest of that 4.22% come from?

The Other Parts of a Mortgage
What the radio ad isn’t telling you is that in order to get that 3.99% interest rate, you’ll have to pay some fees and possibly a discount point or two. These are up-front costs that add to the balance of the loan.

In this specific case, the fees and points will add enough to the balance of the loan to raise the APY from 4.07% to 4.22%. In other words, the total of the fees and points will be somewhere around $165 on a $100,000 loan, or about $817 on a $500,000 loan.

These fees will be rolled into the true APR that the lender has to give you (not that nominal rate given on the radio that doesn’t include these fees), and it’s that APR that you should be paying attention to if you’re intending to live in the house for a long time.

Another point worth considering is the fact that banks are allowed to advertise interest rates as much as 0.125% lower than what they’ll actually give you. In theory, this is done to allow for market fluctuation between the time you hear the ad and the time you sign on the dotted line, but lenders often push this so that they can advertise with seemingly incredible low rates.

What’s the moral of the story? Two things.

First, shop around. Getting a mortgage is a major financial decision, one that will have an impact on you for a long time. You owe it to your finances to shop around.

Second, get the APR on paper. Remember that APR takes into account most loan costs (points, most loan fees, mortgage insurance), but doesn’t account for some other charges, like application fees, title insurance, title examination, appraisals, document prep, and so on. You’ll likely have to come up with some additional cash for those when you move forward with the loan.

No matter what, never take out a mortgage based on an advertisement. This is far too important of a decision to do it based on a radio ad. Spend the time doing your homework and shopping around first, even if your favorite radio host is recommending a particular product.

Let’s say, hypothetically, I have $50,000 in cash just sitting in my savings account. I need to replace my car and I’ve decided on a model that costs $20,000. I can get a very low interest loan for that car from the dealership – 0.0% or 2.9% or something like that.

What do I do?

You can really make a compelling case for either just buying the car with cash or keeping the money in checking and using the low-interest loan. In fact, I often go back and forth on that very question, and you’ll see differing opinions on this from different personal finance folks, including answers that vary depending on the interest rate of the loan.

The issue comes down to one of personal finance philosophy: cash flow versus liquidity.

Cash flow simply means the amount of cash you have going in and coming out each month. Your income versus your expenses. The fewer expenses you have, the greater your cash flow and the easier it is to save for other goals or survive economic twists and turns.

Liquidity means that you have easy access to cash or the cash value of something. Your baseball card collection has really low liquidity. The home you’re living in has pretty low liquidity. On the other hand, the cash in your pocket is very liquid. Liquidity means you have flexibility because you have cash in hand.

The usual argument against improving your cash flow is that you have to sacrifice liquidity to get it. In other words, to buy that car, you have to sink $20,000 in cash into that car. Suddenly, you have a lot less liquidity. You have a smaller cash reserve to deal with emergencies that come your way.

The argument against liquidity is that it requires discipline to maintain it. If you had $50,000 in the bank, would you not be tempted to buy something that you wanted? If you did, you’ve lost that liquidity for something you don’t really need.

My belief is that liquidity is better if you assume that your future is full of positive opportunities. If tomorrow is going to bring opportunities to get ahead, investment opportunities, business opportunities, and the like, liquidity will open those doors for you.

On the other hand, cash flow is better if you see a future with significant risk. A future with significant risk translates into a future with reduced income or with increased expenses – in other words, a crunch on your monthly cash flow. A long illness. A job loss. A new child. An ill or dependent parent. Having collateralized debt – like a car loan or a mortgage – means that the item can be repossessed, leaving you not only with reduced cash flow, but without transportation or a roof over your head.

The problem? We can’t see the future. We do not know what’s coming in the future. Is it a future loaded with opportunity? Or is it a future with significant risk?

In the excellent book The Black Swan, the author, Nasim Nicholas Taleb, argues that we often use mental tricks to disguise the randomness of the past from ourselves, turning our very random lives into a coherent and understandable story. We often do the same thing with the future, imagining not the chaotic future we’ll likely have, but a smooth road leading to some destination.

Lately, I’ve found myself hedging my bets more and more. What if I become ill? What if my income level drops? The better my cash flow is right now, the more room I have in my cash flow to deal with these challenges.

My conclusion is this: once you have a certain size of emergency fund (I usually use two months’ of living expenses per dependent), your focus shouldn’t be on further liquidity. Your focus should be on improving your cash flow. Not only does this protect against longer-term problems, it also creates a future where you’re more able to tolerate the unexpected in your life.

In simpler terms, get an emergency fund, then shoot as hard as you can for debt freedom. That might sometimes involve additional savings (like saving up to pay cash for a replacement car), but the goal is to keep your cash flow as healthy as possible.

Coincidentally, just an hour before this article went live, I got into a Twitter discussion about this very topic.

Brian writes in:

I was at a local car dealership looking for a replacement for my truck. I only have about $8000 in savings so I knew I would have to take on some debt to buy. The dealer offered to sell me a new F150 for a good price and a 0% loan for 36 months for $589 a month car payments. This seems awesome and I am looking for any problems with it.

Over the last few months, I’ve received a few emails like Brian’s, where individuals were strongly enticed by 0% or other extreme low interest loans. Are they a good deal? Should they sign up for these loans before making a purchase?

The problem with such loans is that they don’t eliminate what I consider to be the chief problem with all debt. Yes, they have spectacular interest rates and, yes, they’re often sold as being “free money.”

However, all debt – including 0% debt – has a strong negative impact on your future cash flow. By signing up for this debt, Brian, you’re agreeing to pay $589 a month for the next thirty six months.

That means, for each of the next thirty six months, you’re going to have to come up with $589. It doesn’t matter whether money is tight that month. It doesn’t matter whether you have a job or not. None of that matters. Come up with the $589 per month or they’ll repossess your truck. Add on top of that the vehicle registration costs, the insurance costs, and the maintenance costs and you’re marking off at least $700 a month for this new vehicle each month.

That’s a pretty big responsibility to throw onto your future self. For the next three years, you’re making a commitment to $700 a month without knowing what the future may hold.

Does your future hold steady employment – or is a pink slip around the corner? Will your health be perfect in three years? In three years, will you find yourself in a situation where an F-150 doesn’t meet your needs?

Even if everything goes perfectly, there will still be months when $700 from your monthly budget will really hurt in the form of missed opportunities. Some will simply jump on board those opportunities anyway in the form of credit card debt, further mortgaging their future self.

If I’ve learned anything over the years, it’s that relying on your “future self” to do things you want right now is a quick route to failure. Our future selves are unreliable for the reasons I listed above: job loss, change of heart, illness, life changes, and so on.

Debt is always a challenging choice because it relies on that inherently unreliable “future self” to pay it off. The fewer commitments you put on your future self – and the more commitments you just take care of today – the easier you’ll find your life getting as time goes on. That means more freedom in the future, not less. That means a greater ability to go in whatever direction life leads you, not less.

I won’t say explicitly that a debt-free lifestyle is the best choice. There are times where debt is the preferred option or the only option. For example, if you’re living in a situation where the cost of renting housing is comparable to that of taking out a mortgage to purchase a home, the purchase may be the better choice.

In most situations, though, debt merely allows you to put big burdens on your future self in exchange for something you don’t need today. Brian, do you really need the shiny new 2011 F-150? Or would a used model work for now, putting less of a burden on your future self, while you save up the cash for the vehicle you really want down the road?

Kelli writes in:

My husband and I are sitting on a thirty year mortgage (with twenty six years left to go). We still owe $330,000 on our home. A week ago, a very similar home to ours two blocks away sold for $220,000, so we’re under water by at least $100,000. We are thinking of just walking away from this mortgage and renting an apartment for a while until our credit clears up. What do you think?

First of all, there’s a strong personal moral element to this type of decision. Is it morally wrong to walk away from a mortgage? You’ll get strong, impassioned answers on both sides of the question. Some will argue that if you make an agreement with another entity, you’re obligated to stick to it to the best of your ability. Others will argue that banks know what they’re getting into with a mortgage and that foreclosure is a risk they accept in the agreement, so you’re just doing something within the bounds of the agreement.

As with most morality questions, I can’t tell you what to think. I personally feel walking away from your agreements when you have the capacity to fulfill them is morally wrong, akin to lying. If I were a lender, I would never lend to someone who walked away from a mortgage because I would simply view them as too big of a risk. But I’m not a mortgage lender.

Aside from that moral concern, though, is it really a good financial choice? I think it can be, but it depends on the other choices that the person makes.

First of all, walking away from a mortgage will drop your credit rating by 150 points and it will take several years to recover. Such a drop has a huge impact if your credit is good, but a much smaller impact if your credit is already bad.

What kind of impact? It will become incredibly difficult to get a car loan or another mortgage with any sort of competitive interest rate. Lenders will look at your credit score and if your score is low, they won’t offer you a prime loan (if they offer you one at all). You have to accept that you’ll either be paying for cars and homes in cash for the next several years or you’re going to be taking out loans with incredibly painful interest rates and down payments.

If you’re going to do this, your best approach is to make sure you have housing and automobiles lined out for the next several years before your credit collapses. If you’re going to get a mortgage on a second home, do it now and get a fixed rate mortgage while your credit is still good. If you’re going to rent, get your rental agreement set up now before you walk away. If you’re going to need a car in the next seven years, you might want to make the move now (unless you’ll have the cash to do it later).

Another impact is that many other services use your credit ratings to determine what to charge you and whether to do business with you. Insurance is one example of this – most insurance companies regularly do a “soft pull” of your credit and use declining credit as a reason to raise your rates. Many upscale renters will do the same thing and not rent to people with poor credit, which may limit the places where you can rent your housing. Potential employers often pull your credit (I’ve had two employers in the past do this) and use that as an element of their hiring decision, often leaning towards people with good credit over people with poor credit. These are all serious additional costs of walking into foreclosure.

In the end, I don’t think Kelli should walk away from her mortgage as a first response. She should try several other avenues first that would preserve her credit and perhaps even allow her and her family to remain in the home.

First, I’d simply talk to the lender. Explain your situation and discuss options available to you. It’s often easier for a lender to just refinance with you (sometimes even removing some of the principal) than it is to put the homes in foreclosure. Many lenders are currently focused on refinancing in this way rather than taking on more foreclosed homes, so it’s certainly an option.

Second, I’d look at the extra financial costs of what will happen if you do foreclose. Run the numbers carefully here. Include all the extra costs – a serious bump in your insurance rates, for example – and make sure you also include some estimate of the cost of the risks mentioned above – the extra cost of a new car or the challenge of finding a rental home or a new job. Those things have serious financial costs if they occur – or they might have no cost at all. A good way to appraise it is to figure out the cost if it does happen, then estimate the odds of it happening. So, if something has a cost of $100,000 and has a 40% chance of happening, it’d be a $40,000 cost.

You might be surprised to find that staying put is the best option, even if you happen to be underwater in your mortgage. If you still find that abandoning is the best option. then it becomes the moral question discussed above – and moral questions are things we all have to decide for ourselves.

Archie writes in:

In our marriage, my wife and I have agreed not to open financial statements addressed to each other. We supposedly did this so that we would be able to hide things like gift purchases from each other. Whenever we talked about our finances, we just talked about balances on accounts and didn’t worry about individual items on each other’s bills.

Over the last few years, I’d noticed more and more bills from various banks sent to my wife, but I hadn’t really thought too much about it. Yesterday, we received a call from someone from Citi who wanted to speak to my wife about her account and made it clear that the account was overdrawn and past due.

I was frustrated and worried, so I dug through the mail and found her most recent statement from Citi, which was unopened. I opened it. She had a balance of over $7,500 on it. I was just shocked, so I opened some of the other statements with her name on it that I could find. From just what I could gather in a few minutes, I found that she has $30,000 at least in credit card debt.

I put all of the statements in my bedside table for now. I don’t know what to do next. We certainly don’t have $30,000 to pay these off right now and even the minimum payments are difficult. It looks like my wife has been juggling accounts a lot because there aren’t many payments on our recent bank statements.

What do I do next? I don’t know what to do and I’m afraid of the big fight we’re going to have.

I originally included Archie’s note in my reader mailbag for this week, but I had enough to say about his situation (and I figured readers would, too) that I decided to devote a whole article to it.

First of all, this isn’t just about your discovery of the credit card debt. There has been a long history of dishonesty here – and that’s what I would call it, dishonesty. Marriage is a union based on trust and $30,000 in credit card debt is a pretty strong violation of that trust. It is going to take a lot of work to dig out of that debt.

In short, my suggestion would be that you seek marriage counseling, first and foremost. You’re in a situation now where you’ve both violated the trust in the marriage – your wife has been hiding tens of thousands of dollars in debt and you’ve opened up private correspondence to her. You have a perfectly good reason to feel that your trust has been violated and to feel upset. So does your wife.

This means your marriage has some very serious trust issues that you need to work through in order to be able to move forward successfully with a financial plan.

Why? A financial plan in a marriage only works if you can fully trust one another. You need to be able to trust that your partner is actually working towards the same goals with the same methods as you are and that if either of you run into trouble, you’ll work it out together. If you can’t trust each other, then a financial plan cannot work.

The first order of action, then, is to re-establish the trust.

If you’ve reached a point where you feel that you can trust each other again, then turn your eyes to your financial situation. View the past as water under the bridge; instead, focus on where you’re at now and how you can make your situation better from your current position. What-ifs don’t help with the here and now.

The first step to recovery would be a mutual commitment to spend less than you earn. Remember, of course, that part of your required spending is the debt repayment and also remember that you (as a couple) are spending far beyond your means (witness the $30,000 in credit card debts). Thus, this will be a lot harder than you might think. This step will take some serious work on its own. You’ll both have to face your spending head-on and make some difficult choices. But you have to get that spending under control.

Second, you need to create a debt repayment plan. A debt repayment plan is easy to set up and helps you develop an orderly method for paying your debts down.

Finally, and most importantly, the two of you need to discuss goals together. What do you want for your mutual future? Where do you see yourselves in five years or ten years or twenty years? What exactly will it take to get there? Obviously, getting control over your spending and getting rid of your debts are two big steps, but those are just two steps. You need to work together to figure out what comes next and how to get there.

Good luck.

Yesterday, I heard a very interesting story on NPR that focused on Dave Ramsey looking at Greece’s debt situation through a personal finance lens. Without going into the politics of it, Dave made the astute observation that if a person behaved in the same way that Greece (or any other nation verging on default) behaved, they would be in a deep, deep personal crisis.

The story ended with a very interesting line:

Ramsey says the data from his world of personal financial advice is not encouraging: Most people who consolidate their debt are back in trouble within two years.

This statistic isn’t surprising to me in the least. Zero-interest balance transfers, home equity loans, and the like can go a long way toward turning high interest debt into much more manageable low interest debt.

Most of the time, debt consolidation is used merely to give a person enough breathing room to continue their life as usual. It’s just another way to move around bills in the short term to extend the party a bit.

Of course, some of the time, debt consolidation can be a great tool for getting your house in order.

The difference between the two groups isn’t measured in dollars and cents. It’s measured in whether or not the debtor is actually committed to financial stability or if they just want an easy route to more short term stuff and long term problems.

Here’s the real truth. If you are in a situation where debt consolidation looks appealing to you, it won’t help even a little bit if you don’t get your spending under control. In fact, it’ll probably make things worse over the long run.

To get into that situation, you have to be spending more than you earn. In order to get out of the situation, you have to be spending less than you earn. If you’re not committed to making the changes it takes for that, then you’re just shifting the dirt around to dig yourself a deeper grave without the walls collapsing in on you. You’re reducing the interest rate on some of your debt, which gives you enough monthly cash flow to start racking up more debt, which is completely in accordance with your lifestyle.

Before you consider consolidation, get your spending under control. If you can’t go more than a paycheck or two without spending more than you earn, then debt consolidation will do nothing more than make the long term problem worse for you (simply because it enables you to get into even more debt).

The key is to get your spending under control, not finding a great debt consolidation program. Using debt consolidation as a means to extend your overspending ways is, as Dave puts it so nicely, an “orbital of stupid.”

Most of the time, when I talk about the implications of various debt repayment options on The Simple Dollar, I utterly ignore tax deductions.

This is not an oversight. Usually, it just makes a situation needlessly more complicated and takes the “simple” out of The Simple Dollar.

As is often the case, astute readers email me about this. John, for instance:

Your advice about ordering debts is really way out of line. You should pay off your home mortgage last so you can take advantage of the tax deduction.

Yes, tax deductions can be useful in some situations. Most of the time, though, they’re not much of a help and if you overvalue them, they’ll end up costing you in the long run.

First of all, most people don’t do deductions at all. 70% of tax filers simply use 1040EZ or 1040A for their tax returns, which means that they’re simply taking the standard deduction on their taxes.

If you’re doing that – and 70% of you are – then you’re not claiming a tax deduction for your mortgage or for a lot of other things. The tax implications of whether to pay your mortgage off first or another debt off first means nothing at all.

Beyond that, some of the 30% who do file the full 1040 do so for self-employment reasons and still claim the standard deduction, putting them in that group that is unaffected by deductions.

In a nutshell, if you take the standard deduction, you’re not counting your home mortgage as a deduction, and most Americans are taking the standard deduction.

Second, even if you do claim the deduction, it’s not as enormous as it’s often made out to be. Let’s look at the projected income tax brackets for 2010 and also assume that we’re talking about the average American family, bringing in $66,000 this year with two adults and two children in the household.

This income level puts that family in the 15% tax bracket. This means that if the family were to file long form and itemize their deductions, they would only deduct 15% of their annual mortgage interest from their taxes. In other words, the effective interest rate on their mortgage drops by only 15% when you take this into consideration. A 6% mortgage effectively becomes a 5.1% mortgage, in other words.

But it’s even worse than that.

To actually get that full 15%, you have to actually have other itemized claims that add up to more than the standard deduction for your family. The standard deduction for that family is $11,400. So, to get the full value of that 15%, a family filing with itemized deductions has to top $11,400 in deductions before including their home mortgage at all.

Let me show you what I mean. A couple filing jointly has a standard deduction of $11,400. They have $3,000 in various deductions and $10,000 in mortgage interest, so they’re going to file long form and itemize.

In the end, though, they’re only deducting $1,600 more than they would have with the standard deduction ($13,000 vs. $11,400). Even if you’re generous and say all of that money came from the mortgage, that’s still only a small deduction. If they’re in the 15% tax bracket mentioned above, they’re only saving $240 by filing long form. That’s the equivalent of dropping their 6% mortgage rate down to only 5.856%.

Here’s the truth. For almost all families, cash flow is much more of a day-to-day concern than tax deductions. It’s much more important that you have a low monthly debt load than it is to maximize your tax saving. With a high monthly debt load, you run the risk of going into more debt because of emergencies, and even a little bit of consumer debt taken on to handle those emergencies can quickly devour your “savings” from your deductions (and a lot more).

So, unless you’re very well off and have a strong monthly income, worrying about tax deductions and their impact on your day-to-day life is a bit of a moot point. It doesn’t save you all that much even if you do everything perfectly, and if doing everything “perfectly” means having a lot of monthly debt payments, you’re introducing a lot of risk into your life for relatively little reward.

Of course, credit card and mortgage marketers prefer that you’re in the latter situation. The more debt you’re in that you can handle and keep making the payments, the better off those big banks are because they’re just sitting back and collecting the interest off of you. Thus, they’ll talk up the tax advantages of various debts as much as they can, trying to make them sound like the greatest thing in the world.

You’re far better off having a small debt load and perhaps missing a deduction or two than having a high debt load and getting those deductions. The latter situation puts your whole financial house at risk because if an emergency occurs, you’ll have a very hard time meeting the monthly bills.

If you have a strong income, and are in a situation where you’re claiming lots of deductions anyway, it does become a factor, but if you’re in that situation, you’re in a very lucky and rather small minority of the American public.

One of the most common questions I get is whether or not a person should cosign on someone else’s loan – a car loan, a student loan, or so on.

I have a single response that I always give to this type of question:

You should only co-sign a loan that you’re perfectly happy paying off yourself.

If you would be unhappy with being forced to pay for the loan yourself, then you should not be cosigning that loan.

Here’s why.

First, the reason a lender wants a cosigner on a loan is because they believe that the person they’re lending to has a high likelihood of not paying back the loan. Usually, a person that needs a co-signer is a person with poor credit or, in some cases, a person with no credit history at all. This means that either they’ve never dealt with the ins and outs of paying a loan back before or they’ve attempted it and failed to pay back their obligations.

Second, if that person who the bank has deemed untrustworthy proves the bank to be correct, you’re left holding the bag. Co-signing isn’t just a way to help a friend. It essentially means that you’re hung with the debt if the primary signer decides not to go through with actually repaying the debt.

Third, when you turn a personal relationship into a financial one, you introduce a lot of strain in the personal relationship. If they default on this loan, what will that do to your relationship? It will be very, very hard for the two of you to be as close as you once were.

These three things together make for a dangerous mix. They put your finances at significant risk without any direct benefit to you. You’re betting that someone is reliable when someone else who is not involved has looked at the evidence without emotions clouding their judgment and came to the opposite conclusion.

To put it simply, you’re saying, “Sure, I’ll take on more risk than the bank.” You know, those paragons of financial stability who were quite willing to hand out adjustable rate mortgages like candy and almost tanked the United States economy.

“But I really want to help!” This is often the reason that people use to talk themselves into such large amounts of risk. The person asking for their help is someone who they genuinely want to help and so they let their emotions cloud their judgment and sign away.

Here’s the thing: you can usually help quite a lot without signing on the dotted line.

Offer resources that you can give them. If you want to financially help someone, don’t do it in a way that puts you at risk and don’t enter into a financial arrangement with them that could damage your relationship. Instead, make it a gift. Give them some cash to buy a beater to get back and forth to work or to put a deposit on an apartment. Let them live in your spare room for a few months. If they want to pay you back, let them, but make it clear that you don’t expect repayment.

Offer intangibles. Invest your time in them by driving them to job interviews or taking them around to buy a car. Invest your contacts in them by calling someone you know who can help them get a job. Listen to what they’re talking about and going through and offer your advice and whatever else you can offer.

In other words, offer all the help you can without introducing unnecessary risk into your life. Don’t co-sign, but offer help in every other way you can.

From my perspective, there is one exception to this. I think that the intangibles related to a parent co-signing on a student loan for their freshly graduated child likely add up to more than the risk of signing such loans. In that case, a parent is often a fairly good judge of the situation and if they view the risk of co-signing in this situation as acceptable, it seems to me to simply be an extension of the risks of parenthood.