Managing Credit and Debt

First, what is the difference between “good” debt and “bad” debt?  Debt that is productive or helps increase your value is “good” debt. Debt that is tied to consumption or decreases in value is “bad” debt. For instance, if you purchase a home with a fixed rate mortgage, your mortgage payment remains constant, the amount you owe decreases, and the home potentially increases in value over time. In addition, you have the enjoyment of home ownership. Whereas, many of the purchases made with a credit card are either consumed or gradually lose their value. If you go to a restaurant and use your credit card, it may be enjoyable but there is no remaining value except for maybe leftovers. Electronics, appliances, and clothing are additional examples of items that if purchased with a credit card can result in “bad” debt. Although they may be resold later, they will decrease in value with time and use.

Given the differences in types of debt, it is proposed that repayment of “good” debt be stretched out as long as possible and “bad” debt be paid off as quickly as possible. For instance, after finishing college, you may have a significant amount of student loans which hopefully were consolidated into a loan with a fixed interest rate. Since this loan contributed to your professional standing and livelihood, the result was very valuable and productive. However, when you are first starting out, you have a lot of expenses. If you can stretch out the repayment of a school loan as long as possible, you give yourself more flexibility or breathing room. As you build your career, you can always increase the payments.  On the other hand, it is recommended that you keep the balance on credit cards low enough that you can afford to pay the entire balance each month.

Next consider how much overall debt you can afford. Although your home is one of the biggest assets you will acquire, it may be the largest amount of money you owe. So, calculate what type of home you can afford. One rule of thumb is to multiply your yearly income by 2.5. This is the suggested price to pay for your home in order to not overextend your budget.

Another step is to understand how your credit rating can impact your expenses and how to improve it. Your credit rating is used by lenders, financial institutions, and other merchants to determine whether to loan you money, the amount of interest you pay, deductibles on insurance policies, rent, etc.  Some ways to improve your credit status are:

• Establish a credit rating by opening a credit card account but don’t misuse it. Limit yourself to one or two cards
• Pay your bills, credit card payments, and loans on time. Don’t skip payments.
• Keep the credit utilization below 50%.  When a card is issued, you are given a credit limit or the maximum balance you are allowed.  Your credit utilization is equal to your current balance divided by the maximum balance allowed
• Always pay more than the minimum payment each month. Better yet, pay the full amount due each month.
• When closing an account put it in writing that you requested the account be closed. Your credit rating is impacted if the credit card company closes the account.
• Limit the opening and closing of accounts, application for loans, etc. Once you have established your credit history, don’t open new accounts unless you can obtain a lower interest rate to decrease your interest payments.  Continually opening new accounts is considered to be risky behavior

Once you have established a credit history, you are given a credit score that is calculated based on that history. These scores are the credit rating used by the three credit reporting agencies. They provide information to lenders, merchants, etc.

• Go to www.myfico.com to obtain your score and understand it.  There is a fee for obtaining the score. It is provided by a company named Fair Isaac Corporation

• To obtain information that is contained in the credit report, go to www.annualcreditreport.com.  It is provided free of charge once a year. To correct any information in the report, send a letter to the credit bureau
• Minimize credit card fees and the amount you pay for interest  
• Pay off cards with highest interest rates first. If possible move those accounts to a lower or no interest rate card or loan.
• Avoid cards that charge an annual fee.
• Understand how interest is calculated. The better and most common method is “Average Daily Balance Method.”
• Avoid late fees by paying on time
• Stop using cards with high interest rates
• Avoid cash advances and convenience checks. These are expensive due to the higher interest rate that is charged.
• Use cards that offer rewards.

 Maximize your net worth by minimizing your “bad” debt and the amount you pay for interest

• Compare the interest rates on other loans to the rates on your credit cards. If your loans have a lower rate than your credit cards, check to see if you can lower or extend the payments and use the difference to pay off your credit cards faster
• Credit card issuers detail their basic rates and fees in a table called a “Schumer Box.” Use that table to compare and select the right card for you. Make sure you understand the credit card agreement and any other type of loan
• New cars lose value faster than used cars. If you can get a good deal on a used car, this will help reduce future debt. If your car is needed to provide transportation to work and it is not extravagant, it is considered “good” debt. If you buy a car that is more than you can afford, then it becomes “bad” debt.

In summary, build your assets by leveraging credit while minimizing credit card interest.