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Defensive Financing

Posted on 10/31/2006

Back when I learned to drive we were introduced to a concept called "defensive driving". The idea was to expect the unexpected. For instance, if you anticipated the driver in front could suddenly stop, you'd be prepared to handle it if it occurred.

I still use the strategy today and I'm sure that it's helped me avoid accidents. It occurs to me that "defensive financing" could help protect our money. Anticipating how things could go badly is a good way to avoid financial accidents. Let's take a look at some ways that we can use defensive financing.

For our first defensive financing technique let's look at auto financing. The length of auto loans continues to increase. The reason is simple - lower monthly payments. But, there's a catch. Longer loans mean that you owe more than the car is worth for a longer period of time. Back in the day of the three year auto loan your payments generally outpaced the car's declining value.

With the advent of five and even six year auto loans that's no longer true. Today roughly one third of the people looking to trade their vehicle are 'upside down' and owe more than their ride is worth. And, on average they're upside down by more than $4,000!

You might be thinking that's no big deal. You'll keep your car six years or more. OK. But what happens if you have an accident in the first few years and total the car? The insurance company will cut you a check for the value of the car which won't be big enough to pay off the loan.

What's the auto defensive financing strategy? Keep your auto loans to three or four years. That way you'll be upside down for a shorter period of time and for less money.

Now for our next tool, credit card defensive financing. We've all seen the guy who looks like he's about to swerve into your lane. He's in his lane now, but you sense that he might suddenly invade your space. Credit card debt can work the same way. You can handle your monthly payment. And, you're not too close to the credit limit. But what would happen if the interest rate on your balance suddenly swerved to 30%? You'd probably have a financial accident on your hands.

It could happen. Just one late payment could trigger all of your credit cards to raise their rates dramatically. Most banks have amended their credit card agreements to allow them to raise your rates if you make a late payment on any credit card account. According the a Government Accounting Office study that rate averages 30% today. So if you're one day late with your MasterCard bill, your rate with Visa, Discover, Target, etc. could shoot to 30%.

If you're like the many families that carry a balance in the range of $10,000 that would be a problem. You'd be paying an extra $100+ each month in interest alone.

What's the credit card defensive financing strategy? Either make absolutely sure that your payment is on time or do what it takes to pay down your credit card balance.

Next, let's try some homeowner's defensive financing. Seems like lately everyone wants to own the largest home possible. The McMansion is in. During the last 30 years the average home has gained 50% in size.

No problem, right? Maybe not if everything goes according to plan. But what happens if energy costs increase by 50%? The bigger the house the more energy it takes to heat or cool it. Could you keep your budget from crashing if the summer electric bill went from $200 to $300 a month?

Or the county commission could raise property taxes. Bigger, more valuable homes will see the biggest increase. Same thing if insurance rates get a boost. In this case bigger is not better.

The housing defensive financing strategy is to only buy as much house as you need. If you find that you need more space later you'll have options available to you. And, the money to do something about it.

Finally, have you noticed how dangerous people are when they drive and talk on the cell phone? Seems like they forgot that the purpose of driving was to get somewhere safely. Not to visit with someone via cell phone.

Our mortgage defensive financing skill relates to a similar issue. There was a time when people expected to pay off their mortgages. The purpose of a mortgage was to allow them to pay for a home over a period of time, usually 30 years.

Ah, but that was before a whole slew of new mortgages were invented. Their purpose? To allow for the biggest loan possible for the smallest monthly payment. They do it with variable rates, negative amortization, balloons and 50 year maturities.

What's the problem? Nothing if you're able to keep up with your payments and the housing market goes up. But, if interest rates increase by 1/2% per year for three years on a $200,000 mortgage, your payment will increase by $250 per month.

Or if housing prices drop and you need to sell before they bounce back, you could be 'upside down' in your home. Sell your home? It's not easy for the seller to bring a big check to the closing table.

How can you protect yourself? Same as when you see someone talking and driving. Avoid them as much as you can!

Defensive financing, just like defensive driving, isn't complicated. Just a matter of preparing for the unexpected so that you can avoid accidents. Hopefully all your financing miles will be happy ones!

Gary Foreman is a former financial planner who currently edits The Dollar Stretcher.com website and newsletters. If you'd like to stretch your day or your dollar visit today. You'll find hundreds of helpful articles!

The author, Gary Foreman, is a former Certified Financial Planner who currently edits The Dollar Stretcher web site and newsletter.
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