Ask The Money Coach

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If it was just a matter of evaluating the wisdom of using your life insurance to pay off your charge card debt, I would be inclined to tell you that it would probably be a smart move. However, there is a big wrinkle in the whole equation: namely, you stated that your job is ending soon. Normally, I would have counseled you to seriously consider paying off the debt quickly while you can – especially since taking a loan from your whole life insurance policy should have no tax consequences to you. However, the bigger issue is your looming unemployment status.

Use Insurance as a Cash Cushion in the Future

If you don’t find another job or a replacement contract, you will have to consider how you will pay all your normal monthly obligations – housing, food, utilities, transportation, and so forth. I assume you have little to no savings (or some of that likely would have paid the debt already). Unfortunately, it is taking people longer than ever to find jobs. And with 10% unemployment, 1 out of 3 job-hunters has joined the ranks of the “long-term unemployed.” This means they have been out of work for at least six months. So given the current economic environment, and the fact that your credit card debt is carrying an extremely low interest rate right now, I would suggest continuing to pay on that debt as aggressively as you can, but don’t yet tap the cash value of your whole life insurance policy. Keep it untouched for now, as a standby cash cushion that you can access in the future if things get especially tight and you can’t easily replace your income.

Although homeownership offers many benefits – not the least of which are tax perks – buying a home should never be done just because you can get a tax break from the government. Making the leap from renter to home owner is best done when you’re financially ready, credit-worthy and personally prepared for the rights and responsibilities of homeownership. Having said this, let me first briefly explain the $8,000 tax credit and then tell you why I think you should definitely wait to buy a home later.

Some Basics About The $8,000 Housing Tax Credit

The First-Time Home Buyer Tax Credit offers up to $8,000 to individuals who sign a written, binding contract by April 30, 2010 to buy a new home. Then you must close on the home by July 1, 2010 in order to be eligible for that tax credit. The government’s definition of being a “first-time” home buyer is someone who hasn’t owned a home in the past three years.

The tax credit can be used as a down-payment or closing costs on a FHA-insured mortgage. In 2009, figures from HUD show, the typical FHA borrower had a credit score of 670. That’s because FHA loans are primarily based on your debt-to-income ratio, not your credit scores. In fact, there are no credit score minimums required to get an FHA loan – at least none imposed by the government. Most lenders do, however, want to see credit scores of 700 and higher amid the current credit crunch, in order to give you a mortgage with a decent interest rate.

Better to Wait and Prepare for Homeownership

In your case, unfortunately, several factors lead me to believe that you and your husband are simply not ready at this time for homeownership – and thus should wait to buy a house.

First, your message indicated that you have three credit cards that you’d like to pay off. You didn’t say exactly how much debt is on those cards, but you did state that the $8,000 tax credit can be used to pay off those cards. (That’s not actually true.) In any event, I’m assuming you have thousands in credit card debt.

I also assume you don’t have very much saved, because if you did, you likely would have used that savings to pay down debt. The ability to save money consistently over time is good preparation for becoming a homeowner because you will no doubt have to dig into savings to pay for the ongoing costs, maintenance and upkeep that all homeowners face.

Lastly, the poor credit scores that both you and your husband have tell me definitively that you’ve not yet learned to responsibly manage credit – or are in the early phase of re-building credit after past problems. Why take on the biggest form of credit there is – a mortgage of perhaps a few hundred thousand dollars – if it’s only going to potentially get you in more trouble or further damage your credit rating? Don’t run into buying a home under these circumstances. Worst-case scenario – for a couple that’s deep in debt, with no cash reserves and poor credit already – is that the two of you could wind up in foreclosure. We had 2.8 million foreclosures filings in America in 2009, according to RealtyTrac. Experts predict there will be between 3 million and 3.5 million foreclosure filings in 2010. I don’t want you to become one of those statistics.

I also don’t want to completely dash your dreams of becoming a homeowner, because I truly do believe that it’s a great thing – once you’re ready for it. But instead of rushing to try to buy a home in less than six months, take the necessary time to do what’s required to become a successful homeowner. This means get your credit together, work on becoming a disciplined saver, and knock out a good chunk of that credit card debt. If you can do those things, you’ll be setting yourself up to enjoy the joys of homeownership – as opposed to setting yourself up for failure.

Debt is such a huge problem in America. We’re up to our eyeballs in debt of all types: Mortgage loans. Credit cards. Student loans. Automobile loans. You name it – we’ve got it. The average size mortgage in the U.S. is about $200,000 – and this number is smaller than it was due to the housing crisis. The typical U.S. family carrying a balance on their credit cards owes about $10,000 on those cards. The average college graduate leaves school owing more than $20,000 in student loans. And the average car loan now exceeds $27,000.

Is it any wonder that, according to the Federal Reserve Bank, Americans collectively owe $2.5 trillion in consumer debt – excluding their mortgages? Throw in another $14 trillion in home loans, and it’s clear we have a major issue with debt that won’t go away any time soon.

As of June 2009, the FDIC had about $42 billion in total resources; this includes money in its Deposit Insurance Fund, plus amounts set aside in the agency’s “contingent loss reserves,” funds earmarked for current and future losses. While the FDIC takes pains to tell the public that the agency is in no imminent financial danger and that it will not need to be bailed out by U.S. taxpayers, the agency in November 2009 adopted a new plan requiring all insured banks pre-pay (on Dec. 30, 2009) their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012.

FDIC Says Costs of Covering Failed Banks Is Taking a Toll

These quarterly premiums are the fees that banks pay in order to receive FDIC deposit insurance.  The FDIC asked for these $45 billion worth of early payments from its member institutions because the FDIC said it had under-estimated the cost of taking over failed banks, and needs to immediately replenish its available funds. In 2009, 140 banks collapsed in the U.S. However, some observers saw the FDIC request as a “gimmick” move to help the banking industry because the $45 billion would be treated as an asset on banks’ balance sheets (a prepaid expense, to be exact), and would not diminish banks’ capital or hamper their ability to lend money.

There are currently about 8,100 FDIC-insured financial institutions in America. In order for a bank to declare that it is FDIC insured, it must meet certain financial requirements imposed by the FDIC. Specifically, banks must maintain healthy, federally-mandated “capital ratios.” This refers to the amount of capital (or dollars) a bank must have set aside in reserves in order to guard against future, potential losses.

Banks Lend (or Not) Based in Part on Their Ability To Meet FDIC Rules

One key capital ratio for banks is called a “risk-based capital ratio.” It measures the capital a bank has (such as its common stock, preferred stock, and undistributed net income/profits) versus the amount of “risk-weighted” assets that bank has. These risk-weighted assets can be anything from corporate bonds and consumer loans (including mortgages, auto loans and leases, student loans, credit cards and personal lines of credit) to government notes and cash. The former – corporate bonds and consumer loans – all carry a risk rating of 100%, meaning they are highly risky since there’s no guarantee at all that they will be repaid. Meanwhile, government notes and cash are deemed risk-free.

If the notion of a loan being both an “asset” and something that is “risky” seems a little tricky, let me explain it briefly. A loan/credit line is called a “risk-weighted” asset because on the one hand, it is an asset, inasmuch as it represents a promise by a borrower to repay that loan/credit line (most often with interest). At the same, a loan is also considered a “risk-weighted” asset (emphasis on the word “risk”) because there’s always a chance, no matter how small or large, that the borrower will not repay a bank as agreed.

Banks Follow a 10-to-1 Rule

OK, now stay with me here. To get the highest stamp of approval from the FDIC, a bank’s capital must total 10% or more of its risk-weighted assets. Put another way, for every $10 that it loans, a bank must maintain $1 in capital reserves. For example, if a Bank A has $1 billion in capital, and that bank has made $10 billion in loans (or extended $10 billion in credit to its customers), then Bank A’s capital ratio is 1 to 10, or 10%. But if Bank B also has $1 billion in capital, and has made $20 billion in loans (or extended $20 billion in credit to its clients), then Bank B’s capital ratio is 1 to 20, or 5%. These are critical measures because the FDIC insists that member banks have a more than ample amount of capital on hand to deal with any financial scenario. Thus, the FDIC categorizes banks into five groups:

FDIC Classification of a Bank Capital Ratio

Well Capitalized                                        10% or higher

Adequately Capitalized                         8% or higher

Undercapitalized                                      Less than 8%

Significantly Undercapitalized           Less than 6%

Critically Undercapitalized                  Less than 2%

As you can see, the more credit a bank extends, the more capital it must be able to show the FDIC as proof of its financial strength – especially in the event of potential losses or other unforeseen circumstances. Without a healthy amount of capital, a bank runs into trouble with federal regulators. Once the FDIC labels a bank as “Undercapitalized,” it issues a warning to that institution, telling it to shore up its reserves. If the bank fails to perform, and its capital ratio falls below 6%, into “Significantly Undercapitalized” territory, the FDIC has the right to step in, change the company’s management, and insist that the bank take appropriate steps to remedy its capital shortfall. If a bank’s finances become so dire that its capital ratio drops to less than 2%, and it is deemed “Critically Undercapitalized,” that’s the point at which the FDIC declares the bank insolvent and can take over management of the institution. These illiquid banks are either run by the FDIC, as is currently the case with IndyMac, which failed in 2008, or the insolvent institutions get sold off by the FDIC to another bank.

The Long-Term Implications of the Financial Meltdown

So what does all this mean for you? If you went through the ringer during the downturn, say you lost a good-paying job or maybe you even lost your home to foreclosure, you may have thought that those setbacks represented the single-biggest impact on you resulting from the financial crisis. If you believe that, however, you are sadly mistaken. Don’t get me wrong: Unemployment and foreclosure are major challenges, and they can have a host of far-reaching implications. But in the scheme of things, those are one-time obstacles. In truth, the single-biggest impact on you stemming from the financial crisis is that the credit environment has dramatically changed – mainly because the entire banking landscape has been forever altered. This new economic, banking and credit environment have the power to impact you, your family and your financial dealings for decades to come, likely for the rest of your life. You might miss that old job, or your previous home, but their loss will not impact your credit, or your ability to get a much-needed loan in a decade from now, let alone two or three decades into the future. The new credit environment, however, will continue to have reverberations for decades.

Banks Cutting Back on Lending Are Fighting for Survival

Considering the enormous upheaval the financial community has undergone, can you see why banks, credit card companies and others have become a lot pickier about to whom they lend money? They had to. It’s a matter of survival. Otherwise, making too many bad loans can mean the death of a financial institution – even a century old bank that was once seemingly rock solid. Look no further than the spectacular collapse of Washington Mutual in September 2008 and its takeover by Chase. WaMu was founded in 1889. For many decades, it was considered a great and mighty financial powerhouse. But with $307 billion in assets, and $188.3 billion in deposits at some 2,239 branches, WaMu went under in what is to date the single largest bank failure in U.S. history. In fact, as of October 2009, if you examined the biggest American bank failures ever, where insolvent banks had $1 billion or more in assets, you’ll find that 72% of those bank collapses (more than 7 out of 10!) occurred in 2008 or 2009. These bank failures have cost the FDIC billions of dollars and, some say, threatened the stability of the FDIC, the very institution that is supposed to back up banks.