Freddie Mac released this report at the end of January stating that of all the refinance transactions done in the 4th quarter of 2010 46% involved some level of cash-in on the part of the homeowner which is the highest percentage on record.  During the height of the mortgage debt bubble cash-in refinances only comprised of 4% of all refinancing.  This trend follows a larger pattern across the economy of deleveraging which I had been blogging about frequently back in 2009.

This is different from forbearance in that when a student loan is deferred the student loan holder is not required to make monthly payments BUT the loan is still accruing interest.  In this instance the home loan applicant may be required to include the monthly payment in their debt-to-income ratios even though they may not be required to make payments for 12 months or longer.

In this morning’s WSJ this article is featured entitled “Drought of Credit Hampers Recovery“.  In the article the authors explain that consumer debt (i.e. auto loans, credit cards, loans for recreational equipment) has fallen significantly since the collapse of the housing market and subprime crisis.

This is not a surprise as households cut back on spending and banks cut back on lending.  But the article makes it sounds like this trend is a bad thing.

I guess it’s true that a reduction in consumer spending ultimately costs jobs.  BUT, isn’t it also true that the levels of debt we saw during the boom, especially consumer debt which is “unhealthy” debt because it’s either unsecured or secured by a depreciating asset, was unsustainable?

If so, then is this really a bad thing?  Call me old-fashioned but I tend to think that this is good news.

What are your thoughts?  Has your household cut it’s debt in the last year?  Tell your story in the comment section below.

I try to read it every year and was pleased that Buffett provided some commentary on the credit/ housing crisis in this year’s letter.  Here is an excerpt from the letter:

Finance and Financial Products

I will write here at some length about the mortgage operation of Clayton Homes and skip any financial commentary, which is summarized in the table at the end of this section. I do this because Clayton’s recent experience may be useful in the public-policy debate about housing and mortgages. But first a little background.

Clayton is the largest company in the manufactured home industry, delivering 27,499 units last year.  This came to about 34% of the industry’s 81,889 total. Our share will likely grow in 2009, partly because much of the rest of the industry is in acute distress.  Industrywide, units sold have steadily declined since they hit a peak of 372,843 in 1998.

At that time, much of the industry employed sales practices that were atrocious. Writing about the period somewhat later, I described it as involving “borrowers who shouldn’t have borrowed being financed by lenders who shouldn’t have lent.”
To begin with, the need for meaningful down payments was frequently ignored. Sometimes fakery was involved. (“That certainly looks like a $2,000 cat to me” says the salesman who will receive a $3,000 commission if the loan goes through.) Moreover, impossible-to-meet monthly payments were being agreed to by borrowers who signed up because they had nothing to lose. The resulting mortgages were usually packaged (“securitized”) and sold by Wall Street firms to unsuspecting investors. This chain of folly had to end badly, and it did.

Clayton, it should be emphasized, followed far more sensible practices in its own lending throughout that time. Indeed, no purchaser of the mortgages it originated and then securitized has ever lost a dime of principal or interest. But Clayton was the exception; industry losses were staggering. And the hangover continues to this day.

This 1997-2000 fiasco should have served as a canary-in-the-coal-mine warning for the far-larger conventional housing market. But investors, government and rating agencies learned exactly nothing from the manufactured-home debacle. Instead, in an eerie rerun of that disaster, the same mistakes were repeated with conventional homes in the 2004-07 period: Lenders happily made loans that borrowers couldn’t repay out of their incomes, and borrowers just as happily signed up to meet those payments. Both parties counted on “house-price appreciation” to make this otherwise impossible arrangement work. It was Scarlett O’Hara all over again: “I’ll think about it tomorrow.” The consequences of this behavior are now reverberating through every corner of our economy.

Clayton’s 198,888 borrowers, however, have continued to pay normally throughout the housing crash, handing us no unexpected losses. This is not because these borrowers are unusually creditworthy, a point proved by FICO scores (a standard measure of credit risk). Their median FICO score is 644, compared to a national median of 723, and about 35% are below 620, the segment usually designated “sub-prime.” Many disastrous pools of mortgages on conventional homes are populated by borrowers with far better credit, as measured by FICO scores.

Yet at yearend, our delinquency rate on loans we have originated was 3.6%, up only modestly from 2.9% in 2006 and 2.9% in 2004. (In addition to our originated loans, we’ve also bought bulk portfolios of various types from other financial institutions.) Clayton’s foreclosures during 2008 were 3.0% of originated loans compared to 3.8% in 2006 and 5.3% in 2004.

Why are our borrowers – characteristically people with modest incomes and far-from-great credit scores – performing so well? The answer is elementary, going right back to Lending 101. Our borrowers simply looked at how full-bore mortgage payments would compare with their actual – not hoped-for – income and then decided whether they could live with that commitment. Simply put, they took out a mortgage with the intention of paying it off, whatever the course of home prices.

Just as important is what our borrowers did not do. They did not count on making their loan payments by means of refinancing. They did not sign up for “teaser” rates that upon reset were outsized relative to their income. And they did not assume that they could always sell their home at a profit if their mortgage payments became onerous. Jimmy Stewart would have loved these folks.

Of course, a number of our borrowers will run into trouble. They generally have no more than minor savings to tide them over if adversity hits. The major cause of delinquency or foreclosure is the loss of a job, but death, divorce and medical expenses all cause problems. If unemployment rates rise – as they surely will in 2009 – more of Clayton’s borrowers will have troubles, and we will have larger, though still manageable, losses.  But our problems will not be driven to any extent by the trend of home prices.

Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures take place because borrowers can’t pay the monthly payment that they agreed to pay. Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they can’t make the monthly payments.

Home ownership is a wonderful thing. My family and I have enjoyed my present home for 50 years, with more to come. But enjoyment and utility should be the primary motives for purchase, not profit or refi possibilities. And the home purchased ought to fit the income of the purchaser.

The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.

Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective.  Keeping them in their homes should be the ambition.

By the way, I’m currently reading “The Snowball” which is a great biography of his life.  I should have the review done in the next few weeks.

However, our unabated use of debt lead us to where we find ourselves today.  In the midst of one of the worst financial crisis’s in our nation’s history.  As a result, the credit spicket has been turned off and consumers are being forced to deleverage their personal balance sheets.

Data supporting this trend was released today when the Federal Reserve reported that consumer borrowing declined last month for the first time in nearly 20 years.  In the long-run this is good news.

From the sounds of it the loan would work kind of like a reverse mortgage where the lender would make a loan collateralized by equity in a home.  But instead of collecting interest in the form of monthly payments or through negative amortization (interest accrued that is added to the loan amount) the lender would instead take a cut of the equity in the home when it is sold in the future.

I’m pretty skeptical of this one.  On the surface it sounds like another way for lenders to appeal to undisciplined consumers who like the idea of not having monthly payments much like the negative amortization loans did during 2004-2007.

There are legitimate applications for this type of loan but I would advise that consumers consult with a financial professional they can trust before signing the dotted line.

Additional links-

-WSJ.com article on “shared-appreciation” loans

Pillar 1: Creating a cushion

The first pillar in the 4 pillar system involves creating a financial cushion. It is important to have money on hand that is readily accessible for life’s little (or large) unbudgeted emergencies.  The purpose of this account is to allow a person to pay for these emergencies with cash instead of falling into the all too common habit of using credit.

In calculating how much a person needs to satisfy this first pillar we recommend that a person first estimate their “survival number”.  Their survival number is the amount that they spend each month on essential items in their budget such as housing payments, food, utilities, and minimum payments on credit obligations.  This amount would allow them to “get by” without spending money on discretionary items such as Starbucks, eating out, and other purchases which could be eliminated if need be.

Once this amount has been established a person can calculate how many months worth of survival reserves they’d like to have.  Most financial planners recommend that a salaried person have 3-5 months worth of survival reserves in a safe liquid savings account whereas a self-employed or commissioned earner keeps 5-7 months in reserve.

Pillar 2: Get Debt Free

Once a financial cushion has been established a person can now focus on the second pillar of cash management.  Reaching the second pillar involves eliminating all “non-preferred debt”.  Non-preferred debt is all debt which does not meet most, if not all, of the following criteria:

            → carries a reasonable interest rate

            → has tax benefits

            → is secured by an asset which is appreciating

            → has affordable payments

In general, non-preferred debt includes all debt that isn’t a mortgage (some exceptions apply).  That said, our focus is to develop a strategy that will help our client pay-off their non-preferred debt as quickly as possible. 

By eliminating these miscellaneous monthly obligations a person is able to free-up additional monthly cash-flow that can then be directed to savings & investment accounts.  The key to financial independence is for a person to have control of their money and then conserve it, instead of consuming it.

Pillar 3: Liquidity

True financial security comes with having liquid funds available at any time.  This next pillar is about having 1 year’s worth of a person’s income or more available to them for either good or bad reasons.

A good reason why a person may want this type of money available to them is to take advantage of a business or investment opportunity.  Most of the time when a person is presented with an investment opportunity a significant amount of capital is required upfront.  If a person has the money to be able to participate then they can do so, but most people are not in a financial position to take advantage of these opportunities when they come along.  

An example of a bad reason to use liquidity is in the case of a major interruption to a person’s income.  This may be due to an illness, sudden disability, job lay-off, or economic down-turn outside of a person’s control.  In this instance liquidity can help fulfill a gap of income and still maintain a comfortable life.  By the way, the number one cause of foreclosure in the United States is disability. 

Pillar 4: Pay-off your house

This is the point where it can really get exciting.  For most people, having their mortgage paid off is a far-off dream that may never come to fruition.  But, by focusing on strategies to effectively achieve the first three pillars of this system it can become a very realistic target. 

Most people define “having their mortgage paid off” as not having a mortgage on their house.  But, wouldn’t it also be true if a person had a $300,000 mortgage secured against their home and also had $300,000 in liquid assets?  After all, their personal balance sheet would show a $300,000 liability on one side and a $300,000 asset on the other. 

This topic raises some very interesting questions and opens up some powerful opportunities.  But, if a person has not yet addressed pillars 1 through 3 then does it even make sense to focus on down payments, principal payments, and home equity?  The bottom line is that an effective financial plan and strategy will do more for a person’s long-term financial well-being than most anything else. 

Would you like to share this model with others?  You may download this documents by clicking this link-evans-4-pillars-cash-flow-management-model-mti.

As always, I invite you to share comments below!

But I will admit that this website does have some good information presented in an easy to read format.  I do take issue with a couple of the comments made on the site:

-The break-even worksheet on the site does not account for changes in amortization schedules between the existing and new mortgage in determining the break-even period.  This means the result will favor refinancing more often than not because an existing mortgage will typically have greater principal to be paid in the near-term compared to new mortgage. 

-The site also states, “Many financial advisers caution against cash-out refinancing to pay down unsecured debt (such as credit cards) or short-term secured debt (such as car loans).”  When done properly using idle equity in a person’s home to pay-off unsecured debt can free up significant cash-flow to use towards savings and investment goals.  I don’t know too many financial advisors who believe that is an adverse plan. 

Overall the site is pretty good but I still think its most important for an individual to clearly establish their objectives for refinancing before making an ultimate decision.  Here is a blog I posted about the subject a while back.

I encourage you to make comments about this posting below.

Among my favorite- dust off the bike and ride to work which is something I’ve done over the past few weeks!  Thanks Tony and Jared!

Here's a picture of my SWEET bike!

During my twenties, I accumulated nearly $25,000 in consumer debt. I had a spending problem. With time, I was able to get my spending under control (mostly), but I still owned overwhelming debt. How could I get rid of it?

The personal finance books all suggested the same approach:

Order your debts from highest interest rate to lowest interest rate.
Designate a certain amount of money to pay toward debts each month.
Pay the minimum payment on all debts except the one with the highest interest rate.

Throw every other penny at the debt with the highest interest rate.
When that debt is gone, do not alter the monthly amount used to pay debts, but throw all you can at the debt with the next-highest interest rate.
This made perfect sense. By doing this, I would be paying the minimum amount in interest over the long term. The trouble was, my highest-interest rate debt was also my debt with the biggest balance (a fully-maxed $12,000 credit card at 19.8% interest). I’d plug away at this debt for several months at a time, but then give up because it felt like I was never getting anywhere.

This happened over and over. I’d start and fail. Start and fail.

Then I read about the Debt Snowball method in Dave Ramsey’s The Total Money Makeover. The Debt Snowball method is similar to the traditional approach except that instead of attacking high-interest rate debts first, you attack low-balance debts first. Why? Because you’ll get the psychological lift of pinging debts off in rapid succession. And if you’re like me, this makes all the difference. The Debt Snowball approach is:

Order your debts from lowest balance to highest balance.
Designate a certain amount of money to pay toward debts each month.
Pay the minimum payment on all debts except the one with the lowest balance.

Throw every other penny at the debt with the lowest balance.
When that debt is gone, do not alter the monthly amount used to pay debts, but throw all you can at the debt with the next-lowest balance.

When I read about the Debt Snowball method, I was skeptical. I knew it would cost me more in the long run, at least on paper. But I figured I had nothing to lose. I tried it. In four months I’d paid off most of my debts. I was shocked. I’d been trying and failing for years, and now I was able to make a huge dent in just months? It was all because I had changed my approach just slightly.

Humans are complex psychological creatures. They’re not adding machines. Many of us know what we ought to do but find it difficult to actually make the best choices. If we were adding machines, we wouldn’t accumulate $20,000 in consumer debt in the first place! It’s misguided to tell somebody so deep in debt that they must follow the repayment plan that minimizes interest payments. The important thing to do is to set up a system of positive reinforcement, and that’s exactly what the Debt Snowball method does.

Which method should you choose? Do what works for you. The first method can save you money in the long-run. But if you’ve tried it and failed, give the Debt Snowball method a shot. It might be the answer you’re searching for!