The Perils of Plastic

Millions of credit card borrowers are about to face larger monthly payments, a change that represents both good news and bad for consumers.

Under new guidelines suggested by the federal government, starting in January minimum monthly payments for credit card debt will generally increase. Many mortgage lenders will no longer require payments equal to 2 percent of the debt, an amount that includes interest and fees. Instead most will now require a payment equal to 1 percent of the debt plus fees, interest and charges. Altogether, the new payment will be more than 2 percent of the borrower”s outstanding debt in many cases.

This is the good news. The higher monthly payments will reduce overall interest costs and force people to borrow less with credit cards.

The bad news? It will reduce the ability of many consumers to obtain a mortgage.

According to the most recent Federal Reserve report, we now have $799.1 billion dollars in outstanding credit card debt. That”s about $2,681.54 per person: For a household with four people, average credit card debt amounts to almost $10,750.

Such debt would not be a problem if it were offset by equally robust savings. Unfortunately, the Bureau of Economic Analysis says our saving percentage was -.2 percent in both October and November. Instead of putting money away, in those two months alone we spent $37.4 billion more than we earned.

Credit card financing is unsecured debt — a form of financing that”s especially risky for mortgage lenders. More risk means higher interest, and in the case of credit cards interest rates between 18 and 28 percent are well known.

Let”s imagine a household with $10,000 in credit card debt. Imagine also that the interest rate is a modest 18 percent and that a monthly repayment equal to 2 of the outstanding balance is required. If you borrowed no more this loan would take 7.8 years to repay and interest over time would amount to $8,622. Increase the required monthly payment to 4 percent, the same debt could be repaid in 2.7 years and interest would amount to $2,628 — a plump savings of almost $6,000.

The new repayment standards for credit cards will reduce credit card debt for millions — but the higher minimum payments will also impact mortgage applications.

When mortgage lenders look at mortgage applications they consider many financial issues. Of particular interest is what borrowers spend each month, spending divided into two general categories: Housing expenses and consumer expenses.

Housing expenses are typically seen as mortgage interest and principal plus property taxes and insurance — “PITI” in lender jargon. Consumer expenses include PITI plus such things as required monthly payments for credit card bills, auto payments, student loan pay, etc.

Expenses are described as a percentage of monthly income. If your household has a monthly income of $8,000 and monthly PITI is $2,240 then your “front” ratio is 28 percent. If overall required expenses are $2,880 then the “back” ratio is 36 percent. Overall, lenders would say the ratios are “28/36.”

As it happens, to qualify for given mortgage loan programs you must meet certain front and back ratios. The ratios for loan programs vary, so if you do not qualify for one program you may qualify for others. For instance, there are different ratios for conventional loans (28/36), FHA financing (29/41) and VA loans (effectively 41/41). Adjustable rate mortgages often use 33/38 ratios while other loans have even more liberal standards, some with a back ratio above 50.

Now go back to the new payment standards for credit cards. If your required monthly payment goes from $200 to $280, that”s good for reducing credit card debt — but your monthly required payment has increased. For instances, monthly expenses may go from $2,880 to $2,960. No a big deal in terms of cash or in the cost of a household with a monthly income of $8,000, but now the “back” ratio is 37 percent.

Whoops. That higher credit card payment means some borrowers will no longer qualify for certain mortgages. They monthly costs are above the guidelines.

What to do?

First, start with the realization that paying non-deductible, high-cost credit card charges is not a magical path to great wealth. To get the best possible mortgage, and to simply save more money, reduce credit card use.

* Look at your credit situation and get rid of credit cards you don”t use and don”t need. Keep one for emergencies.

* Speak with underwriters. Ask if it is possible to get an “exception” to the guidelines.

* Start saving. People save enormous sums of money with such basic steps as putting aside all singles found in their wallet at the end of the day or all coins in their pockets. Eat-in more often, bring lunch to work, keep safe cars longer and cut back on fashion and frills.

* If you have credit cards, always make full and timely payments and keep balances at zero.

* Instead of credit cards, use debit cards — with a debit card you”re simply using money already in your checking account. Using cash on hand instead of credit means you”re likely to buy less.

* Get over-draft protection (a line of credit) for your checking account or link savings to checking accounts. Both can help prevent over-drafts and excess fees.
So the next time you pull out that credit card think about your real goal — a new sweater or a new fireplace, a fancy dinner or a better kitchen, higher monthly payments or less. In no time it will be easy to keep the plastic out of sight and out of mind.