Financial Consult for the Severely Anemic Resident Wallet Part 4: How to Reduce Your Debt

MAY 18, 2007
Wender Hwang, MD, Loma Linda University Medical Center, Loma Linda, and Erik W. Thurnher, MD, CFP, Kaiser Permanente Medical Group, Lakewood, and Physicians' Financial Advisors, Newport Beach, Calif
Wender Hwang, MD
Chief Resident
Department of Emergency Medicine
Loma Linda University Medical Center
Loma Linda, Calif

Erik W. Thurnher, MD, CFP
Emergency Physician
Kaiser Permanente Medical Group
Lakewood, Calif
Certified Financial Planner
Physicians’ Financial Advisors
Newport Beach, Calif

In the first 2 articles of this series we reviewed basic investment strategies and which to fund now. Last month’s article showed you how to use the tax code to minimize Uncle Sam’s cut of your meager paycheck. In this current installment we discuss strategies to reduce your debt, specifically focusing on your existing debts and spending patterns. All online links mentioned in this article can be accessed at www.residentandstaff.com.

Financial Disclaimer
Please consult your tax advisor or employer if a particular topic is right for you. Side effects of learning about or using the tools outlined here may include increased wealth, early retirement, thicker wallet, or sounding educated at a cocktail party.

Reduce Your Debt
We are not going to tell you to stop overspending. Instead, we are discussing how to manage the inelastic debts you carry, including ways to reduce your student loan obligations and payments by consolidating wisely, understanding and improving your credit score to qualify for lower interest rates, and a hodgepodge of ways to save here and there.

Student Loan Consolidation
Recently, the interest rate for in-school/grace period student loan consolidation jumped from 2.77% (an all-time low in 2004-2005) to 4.70% (2005-2006) to 6.54% (2006-2007). The rate changes every year in July, based on the 13-week T-bill in May. Despite this increase, loan consolidation is still your best long-term option for paying off student loans, because of lower monthly payments, longer repayment terms, billing convenience, fixed rates, and loan discounts (Table 1). The most critical element is timing—lock in your interest rate during the grace period because it increases by 0.6% when the grace period expires. Most companies will let you mail in your application and specify when to process the consolidation (to maximize your grace period but still get the application done early).

If you have student loans at more than one bank, you can consolidate with any company you want. If you have only one lender, you must consolidate with that company. Even if you are subject to this one-lender rule, consolidation still saves you money because of loan discounts, as explained below. We do not go into it here, but there is a loophole that allows you to get out of the one-lender rule.1

Calculating your consolidated loan interest rate
The interest rate on any of your loans is calculated by a weighted average of the interest rate for each individual loan, rounded up to the nearest 0.125%. The maximum term of the loan depends on your total student loan debt, including the loans you are not consolidating (Table 2). You may not want to consolidate small loans with high interest rates, because they may bump your interest rate up significantly and make you pay more over the long-term.

Let’s say you have 3 loans, and you want to consolidate only loans 2 and 3, because the higher interest rate on loan 1 will throw off your weighted average (Table 3). Rounding up to the nearest 0.125% yields a consolidated loan of $57,000 at 3% interest for 30 years and a nonconsolidated loan of $8500 at 5% interest. Of course, you will pay off the 5%-interest loan as soon as possible, and drag out the consolidated low-interest loan as long as possible. Your paid interest over 30 years will be $29,514.11 for both your consolidated and unconsolidated loans. If you had consolidated all 3 loans, the loan principal would have been $65,500 at 3.25% interest for 30 years, with $37,121.68 interest paid.

To find the interest rate of your loans, visit the National Student Loan Data System (at www.nslds.ed.gov) or your lenders’ websites.

Loan discounts
The best part about consolidating is loan discounts. Most consolidation companies offer the same incentives:
• 0.25% interest-rate reduction for direct debit billing, plus
• 1% interest-rate reduction after 33 to 48 on-time payments (variable), or
• 1% to 2% rebate on original loan amount after 1 to 4 years (variable).

Some companies call incessantly and send junk mail claiming that they will save you more money, yet all lenders offer essentially the same discounts. Most offer a combination of the first 2 rate reductions mentioned. Do not consolidate with a company that offers the one-time rebate if you have a choice of another company that offers interest-rate reduction. Larger debts and longer-term loans save more with rate reductions. Although a 2% rebate seems like a lot, you will save more money by having a lower interest rate over 15+ years:

Consolidated loan discounts Total interest paid
None $29,514.11
0.25% direct debit and 1% after 36 on-time payments $15,481.05
0.25% direct debit and 2% rebate up front $23,507.98

To run your own calculations on loans, visit www. finaid.org/calculators/loandiscounts.phtml. FinAid online has a great loan discounts calculator.

With most companies, the interest-rate reduction does not affect the monthly payment. Instead, less interest accumulates each month and more of your payment is applied toward the principal. Your loan is paid off slightly quicker (approximately 5 fewer years) and you save a lot of money on interest with loan discounts.

Instead of spending your time sorting through the junk mail or browsing endless websites for the best consolidation discounts, read the discussion thread at www.fatwallet.com/t/52/596894.

Buffing Your Credit Score
Your credit score will have a substantial impact on your future financial life. Financial institutions are relying on these scores more than ever to determine who is a good credit risk and who is not. A high credit score can save you thousands of dollars in interest by helping you secure low interest rates on mortgages and other loans. Credit scores are increasingly also being used by employers to evaluate potential employees, and even by landlords to choose reliable renters.

Credit scores are fluid numbers that change as the elements in your credit report change. For example, payment updates or a new account could cause scores to fluctuate. Many different credit scores are used in the financial service industry. Scores may differ by lenders, depending on the scoring model used. The Fair Isaacs Company (FICO) scoring system is based on the following weighted categories2:

Payment history, 35%
Amounts owed, 30%
Length of history, 15%
New credit, 10%
Types of credit, 10%

The approximate distribution of FICO credit scores in the US population is3:
780 to 850—20%
740 to 780—20%
690 to 740—20%
620 to 690—20%
        <620—20%

Under the FACT (Fair and Accurate Credit Transactions) Act, consumers can request and obtain a free credit report once every 12 months from each of the 3 nationwide consumer credit reporting companies (Equifax, TransUnion, and Experian), accessible at www.AnnualCreditReport.com. You can request your report from all 3 companies at once to compare their information (and wait 12 months before you become eligible for another free request) or one at a time throughout the 12 months to check for unauthorized activity. You will be able to view your credit file immediately online, and review it later. Although no credit score is reported with this free service (reports with scores are available for a fee), you have the opportunity to review the information to ensure that it is accurate.

Tips to improve your score
Payment history. Paying your bills on time is the single most important contributor to a good credit score. Even if the debt you owe is a small amount, it is crucial that you make payments on time.

Amounts owed. Another important contributor to your credit score is the credit utilization in revolving accounts (this excludes mortgages and student loans). High utilization rates lower your score.

• Reduce the balance in revolving accounts to less than 20% indebtedness

• The notion that you should cancel any unused credit cards is a myth. It is generally true, however, if you have weak impulse control and would end up using those cards. But unused cards can help your credit score by decreasing your credit-utilization rate. If you have 4 cards with a $1000 limit each and you owe $500 on 2 different cards ($1000 total debt), your utilization rate is 25% ($1000 owed/ $4000 total limit). If you cancel the 2 unused cards, however, your utilization rate jumps to 50% ($1000 owed/$2000 total limit).

• Assuming you can control yourself and will not max out your credit cards, you can ask for a higher credit limit. Some companies will allow you to increase the credit limit every quarter or so. In so doing you reduce your credit-utilization rate by increasing your total credit limit.

Length of history. Assuming you have an excellent payment history, the longer you have had established credit, the better your score. This includes student loans you received 10 years ago or your first credit card 8 years ago. You should not cancel that first credit card, even if it has a zero balance and you never plan to use it again (assuming no annual fee)—cancelling the card would lower your score. Canceling newer cards will have less effect on your score.

New credit. Avoid signing up for new credit cards. It may help by giving you a higher total credit limit, but each credit inquiry on your account above 4 to 6 per year will hurt your score for 1 to 2 years (until the inquiries slowly expire).

The FICO score is used by lending institutions to estimate your risk of missing payments or defaulting on debts. Higher scores indicate lower risk and are rewarded with lower interest rates. Other factors, such as assets and employment, are factored into the lender’s risk assessment, and each lender determines its own “cutoff” score.

Hodgepodge
Cash-back credit cards with no annual fee
Almost all cards with cash back offer approximately 1% cash back, but avoid programs with less than 1% cash redemption value (eg, MBNA World Points). We recommend getting one or two of the following cards and using them for specific purchases (www.fatwallet.com/t/52/564358):

1) HSBC direct rewards card: 5% cash back on gas, groceries, and drugstores, and 1% on everything else. The $500 cash back annual limit equals $10,000 on purchases, at a rate of 5% cash back (www.directrewardscard.com)

2) Costco American Express card: 3% cash back on restaurants, 2% on travel expenses, and 1% on everything else, including Costco purchases. Cash back is in the form of Costco certificates (www.costco.com/Browse/Product.aspx?Prodid=10028121)

3) MBNA 529 plan card: 2% cash back on all purchases, with the money deposited into a Fidelity 529 plan (www.fidelity.com/college)

UPromise
Register credit cards and grocery cards of your family and friends. UPromise will track your grocery card purchases and give you cash back for certain brands. UPromise will also track your credit cards for certain stores and give you a percentage of those purchases. See the UPromise website at www.upromise.com for brands and stores. If you have a cash-back credit card, you can still register that card and double/triple dip. The money is intended for funding your 529 plan. UPromise has a relationship with a few 529 plans for direct deposit. To deposit the money into other 529 plans, you must write a letter requesting the transfer. Alternatively, you can request that a check in your name be mailed directly to you.

Smart banking
Brick and mortar (B&M) banks with physical locations are losing their appeal. You should have at least one account at a local bank, but do not keep large amounts of money in that account, because interest rates are particularly horrible at B&M banks (often 0%-0.5%), and they have fees for everything. The following are some Internet banks that have great rates and features/offers (check each website for the latest rates):

• The American Medical Association (AMA) banking center is available to all AMA members. It offers a high-yield money market account with a $0 minimum, free online bill pay with your AMA checking account, and no fee for most services (www.amabankingcenter.com/ama/rates.asp)

• ING Direct. A savings account with a $0 minimum and a $25 new-account bonus. You can set up links to 3 accounts held at different banks and initiate transfers to and from those linked accounts. This is an easy way to transfer money between banks without writing a check or paying a transfer fee (www.home.ingdirect.com/products/products.html)

• Pentagon Federal Credit Union. It offers awesome personal loans and mortgage loans, with low points and rates. Savings rates are not as good as with the ING and AMA accounts. This credit union has very easy eligibility requirements (www.penfed.org/index.asp).

Money management
One of the best things you can do to get a hold on your finances is to use a software program such as Microsoft Money or Intuit Quicken. You can track all your bank accounts, investment accounts, credit cards, even frequent flyer miles/credits. All programs are approximately equal in functionality, so choose one that intuitively allows you to:

• Consolidate all your financial information
• Perform daily investment portfolio updates
• Track transactions and see where your money comes from and goes to every month
• Set up automatic statement downloads from selected financial institutions, manually import online for other institutions
• Set up bill payment reminders
• Receive minimum balance/bounced check alerts.

An interesting feature enables you to look back and see how much you paid for things years ago (assuming you entered these items in the memo line). Do not forget to password-protect your file. The program becomes much more useful if you update your transactions regularly and keep your transactions detailed. You should set aside a few minutes every 2 to 4 weeks to update your accounts, depending on how much activity you have (eg, rent, bills, purchases, income). You can purchase Microsoft Money or Intuit Quicken at a very low cost from eBay. You do not need the latest versions, nor do you need to update them every year (every 2-3 years is sufficient).

Conclusion
Residents are in a unique financial position: we make very little money now but are on the cusp of a huge raise within a few years. Unfortunately, medical education rarely teaches us the financial skills to take advantage of our severely anemic wallets (eg, by opening a Roth IRA, adjusting W-4 withholdings, consolidating loans, using cash-back credit cards) and maximize our income once we become attendings (eg, by opening tax-deferred accounts, saving for college education, or general investing).

We have covered many topics over the 4 parts of this series, and although the breadth of options may be a bit intimidating, the first 3 steps you should take are creating a Roth IRA, consolidating your loans, and rereading this series. Where you go from there depends on your specific situation. Please contact a financial advisor if you have specific questions.

References
1. Student loan consolidation: getting around the single lender rule and other info. Discussion thread. FatWallet forums website. Available at www.fatwallet.com/t/52/472911. Accessed January 13, 2006.

2. What’s in your score page. MyFICO website. Available at www.myfico.com/CreditEducation/WhatsInYourScore.aspx. Accessed January 13, 2006.

3. Credit scoring basics page. About.com website. Available at www.credit.about.com/od/creditscoring/a/073105.htm. Accessed January 13, 2006.

ACTION CHECKLIST
For a reminder of the financial tasks you need to accomplish, refer to the Action Checklist that appears in Part 1 of this series. You can now access this online in the Archives section (June 2006) of www.residentandstaff.com.


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