Live Debt-Free (Continued)

Page 1 | 2 | 3

The bigger-payment approach gets more complicated when it comes to your biggest-ticket debt item: the mortgage. Mortgage debt almost always carries lower rates than other types of debt, and the interest is tax-deductible -- if you have a 6% mortgage and occupy the 28% tax bracket, you effectively knock another percentage point or two off the cost of that loan. Jimi Ellis, a San Antonio real estate developer, recently considered paying off his home outright with the windfall from a business deal, but crunched the numbers and found he's better off sticking with a mortgage -- he figures the interest deduction will save him close to $4,000 a year in taxes.

Still, some borrowers may see some advantage in wiping the liability column clean sooner. If you start the process early on in your home-owning years, you can cut the overall cost of the home and free up some serious money for the savings account. But making only occasional extra payments is "like trying to move a mountain with a teaspoon," says Keith Gumbinger, a vice president with mortgage research firm HSH Associates. A better approach is to make it a regular affair: You could increase the size of each monthly payment by one-twelfth, for example, making the equivalent of one extra monthly payment each year. It doesn't seem like much, but if you start early, you can shave seven years off the life of a 30-year mortgage -- and, on a $400,000 loan, trim about $100,000 from the total cost. Paying off early could also benefit you once retirement comes: Your nest egg won't have to cover a home payment, and since you'll have 100% equity, you'll have an even bigger pool of assets to draw from should you ever decide on a reverse mortgage.

Fix It and Forget It
David and Yvonne Hernandez knew it would be a stretch to afford the four-bedroom house in Hayward, in the East Bay outside of San Francisco. But it was two doors down from Yvonne's parents, an important factor for their tight-knit family. So in 2003 they bought it by taking on an interest-only adjustable-rate mortgage (or ARM) for slightly more than $400,000. The interest rate opened at a reasonable 5.8%, but then crept higher by about a point per year. By last year, they were paying an extra $300 per month as the rate reached 8.9%. "It started to freak me out," Yvonne says. Alarmed, the couple started shopping for a fixed-rate mortgage--something to eliminate future surprises.

By now, housing-bubble headlines have made mortgage ARM-twisting all too familiar. While a fixed-rate mortgage provides for a steady interest rate throughout the duration of the loan, an ARM offers a lower initial rate, but allows for future interest to float with prevailing market rates. At the peak of their popularity in 2004, about 33% of all new mortgages were ARMs. Today it's closer to 20% and dropping, but this year about $400 billion in adjustable-rate mortgages are scheduled to reset for the first time, with another $1 trillion due next year.

Despite the bad press, ARMs are not always bad deals: Because they float with short-term interest rates, they can provide a way for homeowners to capitalize on falling rates without refinancing. But they also can turn costly when rates rise, as they have lately. And for borrowers like the Hernandez family who opted for an "exotic" or "exploding" ARM, trouble can mount even more quickly. These loans typically have too-good-to-be-true initial rates that result in too-high-to-stomach payments after the short teaser period. The increases are capped -- two percentage points annually and five or six total over the life of the loan are common terms -- but many borrowers didn't understand the dramatic impact those bumps can have. "I think they should be called 'scary' or 'totally unpredictable' or 'impossible to understand,'" says Kirsten Keefe, executive director of Americans for Fairness in Lending. For many who either bought too much house or gambled that they could profitably flip the property, the outlook could be bleak. According to a recent study by First American CoreLogic, 32% of those who started with low teaser rates will eventually face foreclosure.

Fortunately, interest rates remain relatively low for now, giving those with good credit and income a chance to get into a saner fixed-rate loan. The rate will likely fall somewhere between an ARM's teaser rate and its post-reset rate, but with no uncertainty about future market conditions. "You can always refinance if rates fall down the road," points out Gary Houle, a financial planner in Houston who, like most in his profession, vastly prefers to steer people toward fixed rates.

Many lenders will make you cough up some dough to refinance. On an ARM, the most common penalty is 1% of the loan value if it's paid back in its early years, usually the first five or so. Do the math to make sure that fee will pay for itself in lower monthly payments down the road; if you don't plan to stay in the home long, it may not be worth refinancing. But for the Hernandez family, it was. Well-armed with good credit and household income totaling more than $100,000, they were able to land a 30-year fixed-rate mortgage at 5.75%. On top of that, they added a second mortgage at 7.25% that allowed them to consolidate credit card debt they had incurred putting on a new roof and adding landscaping. All told, they will save more than $17,000 per year in interest charges alone, and deep into six figures over the life of the mortgage. "This is working out perfect," says Yvonne.

Mortgages aren't the only field where fixed rates offer big advantages. Home-equity loans are virtually always fixed -- more on those later. And while their issuers don't necessarily trumpet them, there are fixed-rate credit cards on the market. It takes a good credit score to get one, but in recent years their rates have typically been two to three percentage points below variable-rate cards. To find fixed-rate offers, check card-comparison sites like CardRatings.com.

Are There Pitfalls to Being Debt Free?



· Check Out: More Debt Management Tips