12 Debt Myths That Trip Up Consumers
As posted on February 25, 2013 on www.wsj.com
By Rachel Louise Ensign
Avoid debt if you can.
If you can't, borrow carefully and conservatively.
So the conventional wisdom goes. But if you follow it blindly, you may miss out on key nuances of dealing with debt.
For instance, consider store-brand credit cards. They often offer no-interest financing, and rewards on store-bought products. Sounds great. But did you know those attractive financing terms can come back to bite if you carry a balance after a promotional period?
Then there's mortgage debt. A big down payment may be a great way to steer clear of a huge home loan. But if you get the money for the down payment from relatives, lenders may scrutinize your financials closely.
As many people look to rebuild credit or land loans, it's crucial to know when the conventional wisdom makes sense—and when it doesn't. With that in mind, here are some top myths that consumers fall victim to when borrowing today.
1. Once you marry, you're responsible for your spouse's debt.
Many couples think marrying each other means merging their debt loads, but that generally is not the case. While many couples opt to pay down debt together, neither spouse is usually legally obligated to pay off debt that the other incurred before marriage, says John Ulzheimer, president of consumer education at credit-monitoring service SmartCredit.com.
However, be aware that a spouse could lose that protection. If you refinance a loan with your significant other and put your name on the loan's promissory note, or add yourself as a joint account holder of a credit card, you'll likely become responsible for those debts, even if your spouse took them on before marriage, he says.
Know also that you may be responsible for debt your spouse takes on after you wed, even if your name isn't on the account.
2. Credit cards from your favorite retailers are a good deal.
The pitches for store-branded credit cards can sound enticing, with lures like interest-free financing and rewards. But the deals may be much less appealing if you tend to carry a balance.
Some of the cards operate like payment plans where borrowers make a purchase from the retailer on the card and then have a number of months to pay it back, interest-free. But if you don't pay off the whole balance in the allotted time, you'll typically have to pay interest on the entire amount you initially charged retroactively—often at a higher rate than a typical credit card, says Odysseas Papadimitriou, chief executive of credit-card comparison website CardHub.com.
For instance, Apple offers customers up to 18 months interest-free on purchases on a card from Barclaycard US. But if you don't pay off that specific purchase in the interest-free period, you'll face a variable annual percentage rate that's currently about 23%, according to the Apple website.
Other cards don't offer deferred interest, but come with fairly high rates, says Ben Woolsey, director of marketing and consumer research at CreditCards.com. "Even somebody with excellent credit will be paying 20-plus percent," he says. For instance, the two cards offered through Banana Republic have variable rates recently at 24% and 25%, higher than the recent average rate of 15% on all variable-rate cards.
3. You're too rich for federal student loans.
Some well-off families figure they won't qualify for federal aid and don't apply. But that means they may have to turn to private loans instead. In recent years, as many as 41% of families earning $100,000 or more didn't file the Free Application for Federal Student Aid, or FAFSA, which is necessary to land federal loans, according to a Sallie Mae survey.
But passing up on that chance can be a mistake.
For one thing, well-off parents and students can get federal loans, as a number of them have no income limits. And private loans can come with higher rates than federal loans, or variable rates that could very well rise in coming years. Another key drawback: Private loans generally don't offer the flexible repayment plans, tied to a student's income, that federal ones may.
If that's not convincing enough, consider that even private lenders recommend that you consider federal loans in the college-funding process, no matter what your income. "We encourage students to explore Stafford loans, which may have lower rates, and to compare options, such as PLUS loans and private loans, to fill any remaining unmet need," says Patricia Nash Christel, a spokeswoman for Sallie Mae, the largest private lender.
4. Dutifully paying off your mortgage each month will do wonders for your credit score.
The typical scoring model from FICO, standard bearer of the credit score, will cut your score for missing mortgage payments. But don't expect to get a lot of points added to your score for making those monthly payments on time.
That's because, in FICO's models, missed payments say more about your riskiness than regular on-time payments do.
"Negative information can be very influential, positive information helps your score more incrementally," says Frederic Huynh, senior principal scientist at FICO.
5. Money from a family member makes an easy down payment on a home.
Even if people don't buy a home entirely with cash, they're being more careful to put down big down payments. And often that means turning to family members for money.
But those kinds of gifts may set off red flags for lenders. With much tighter lending standards than before the crash, banks are looking closely at where the money for your down payment came from, says Erin Lantz, director of real-estate firm Zillow's Mortgage Marketplace.
Some lenders want to see that any gift for a down payment has been in your bank account for a significant period of time, and most want to see that its origin is documented, says Ms. Lantz. "What the lender would ask for is the whole path of that money. Where did that money come from? How did it come into your account? What has it been doing in your account? Has it been sitting there?" says Ms. Lantz. You'll also want a letter from the person who gave you the money, stating it was a gift.
And make sure you have documentation showing the money going from one account to the other, says John Prom, a mortgage banker at Real Estate Mortgage Network Inc. in New York.
6. Today's tight lending criteria apply to auto loans too.
Lending criteria for mortgages remain tight. But standards for car loans are comparatively looser. A January Federal Reserve survey of senior bank-lending officers found 16% reporting they had eased standards for making auto loans in the preceding three months—compared with 6% for prime residential mortgages.
That's in part because auto loans come with lower delinquency rates and are therefore less risky, says Greg McBride, senior financial analyst at Bankrate.com.
"For most people, the rates are the lowest they've ever been. Anyone with decent credit is going to get a loan at a lower rate than they've ever seen before," he says. But you'll want to shop around, as rates can vary widely, even for those with good credit, he says.
7. If you agree to separate your debt in a divorce, it's separate.
While a legally binding divorce decree is an important step in separating marital debts, it does not alter your agreements with lenders, says Rod Griffin, director of public education at Experian. "People think: I went through the divorce, I have the decree, why is [the joint debt] still there?" he says.
What you'll need to do is call the lender and figure out how the joint debt—whether it's a credit card, student loan or mortgage—can be placed in the name of only one ex-spouse.
Sometimes, a lender will require you to close the joint account and transfer the debt balance into a new account held by one individual. Other times, an ex-spouse may need to refinance the mortgage or other loan independently, obtaining the new loan based on his or her own financials, he says.
8. A high income and credit score means you'll be pitched the lowest interest rates on credit cards.
Credit-card companies and issuers are currently sending bevies of offers to affluent people with good credit. The rewards on some of those cards—like cash back and airline points—can look appealing. But they often come with higher interest rates than the lowest-rate cards, with or without rewards, says Mr. Woolsey of CreditCards.com.
The lowest-rate rewards cards go for around 11%, while the typical higher-end rewards card, like the Visa Black Card, carries a rate around 15%, says Mr. Woolsey. Plus, the higher-end cards usually have annual fees.
Meanwhile, the lowest-rate cards without rewards go for between 7.25% and 8.00% APR, says Mr. Woolsey. Of course, affluent folks can qualify for those low-interest cards—but card companies and issuers won't usually pitch them as hard.
9. If you've looked up your credit score, you know your credit score.
You know one credit score. The problem is that lenders may be looking at a different credit score than you are—and there's no easy way for you to know if it's better or worse.
Consider the widely used FICO score. There are actually 60 slightly different iterations of FICO, and lenders may pull a different score depending on what kind of credit you're applying for, says Mr. Huynh.
If you're applying for a mortgage backed by Fannie Mae or Freddie Mac, lenders typically pull three FICO scores available directly from each of the three major credit bureaus. But if you're applying for an auto loan or credit card, the company will likely pull a score tailor-made for that kind of credit product, says Mr. Ulzheimer.
While the various FICO scores are usually in a similar range, that's not always the case. For instance, certain scores ignore collections below $100. In some cases, a person's FICO score that falls into this category could be 100 points above a score that doesn't ignore such collections, says Mr. Huynh.
10. A late credit-card payment will damage your credit.
Late payments can bring fees and interest charges—but unless you're really late, they may not put a dent in your credit.
"There will be consequences, but they won't be on your credit report," says Mr. Griffin of Experian.
It comes down to standard practice in the credit-reporting business: companies usually don't report a late payment to a credit agency until your payment is 30 days past due.
It takes time for other kinds of late payments to hit your credit report, too. Medical debt, for instance, usually won't show up until the bill goes to collection, says Mr. Griffin.
11. All mortgage and home-equity interest is deductible.
Deducting interest is one of the big appeals of a home loan. But if your mortgage is too big, you won't be able to deduct all of the interest you paid.
The federal government has set a cap on the mortgage-interest deduction: You can generally only deduct interest on mortgages up to $1 million. So, if your mortgage is $2 million, you can typically deduct only half of the interest paid.
The typical threshold is even lower on home-equity debt: $100,000.
But if you're using some of that home equity for significant home improvements, that portion usually falls under the $1 million cap for mortgage interest instead, says Jeremy Kisner, a certified financial planner and president of SureVest Capital Management in Phoenix.
12. Buying a home with cash is the best option, if you have the money.
Covering a home purchase with cash is in vogue. With the housing market heating up, the tactic may help a buyer win a bidding war—and the idea of not living under a mortgage can be appealing.
But going with cash isn't always the best financial choice. Mortgage-interest payments can be deducted on your tax return, which can save you a bundle.
Then there's the opportunity cost of handing over that much money. Some people prefer to invest the money they would have spent on the home purchase, betting it will earn a higher return than the interest rate on the mortgage when considering the tax deduction, says Jimmy Lee, a financial adviser in Las Vegas, Nev.