Prepare for the unexpected now to avoid accidents later
Defensive Financing Tools to Protect Your Wealth
by Gary Foreman
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; people want 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 six and even year auto loans, that's no longer true. Today roughly one third of the people buying a new car are "upside down" and owe more than their ride is worth. And, on average, they're upside down by about $5,200!
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 card suddenly swerved to 30%? You'd probably have a financial accident on your hands.
It could happen. Just one late payment could trigger any new purchases to be charged at a 30% rate. And, to make matters worse, your payment would be going to repay the older, lower interest charges first.
If you're like the many families that carry a balance in the range of $10,000 that would be a problem. By the time you paid the old, lower interst charges, 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.
Use these guidelines to choose the best plan to pay off your credit card balances.
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.
Calculator: How Much House Can I Afford?
Finally, have you noticed how dangerous people are when they drive and talk on the phone? Seems like they forgot that the purpose of driving was to get somewhere safely. Not to visit with someone via 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!
Reviewed February 2018
Take the Next Step
- Take a few minutes and consider where the unexpected could hurt your finances.
- Find out how you can pay off your credit cards in less time for less money.
- Want to pay off your car faster? Consider refinancing into a lower auto rate.
- Compare your mortgage to today's mortgage rates.
- Get control of your financial life. Subscribe to Financial Independence, a free daily email that provides you with the tools to help you gain that control and achieve financial independence. Subscribers get a copy of Are You Heading for Debt Trouble? A Simple Checklist for FREE!
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. Gary is available for audio, video or print interviews. For more info see his media page.
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