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The credit marketing blitz has made debt a buyer's market. But the credit boon has also brought new perils. To steer clear of the traps that creditors have laid, you have to understand the new borrowing realities and how to put them to work for your advantage. The following plans will help you know when it make sense to borrow, how to use credit wisely, and how to pare down what you already owe. Debt products are also sorted out explaining which may be most appropriate for your needs and which to avoid.
Temptations to borrow are everywhere — at the gas station or grocery store, a credit card gives you an instant loan. If you run out of vacation funds, an ATM will spit out a cash advance. You can borrow against the equity in your house, your stocks, your insurance policy, and your retirement plans. No wonder the nation's personal savings rate now hovers at zero.
Charging isn't the Best Way to Pay
Step back and decide for yourself where debt will be most useful instead of letting the lending industry decide for your. It takes discipline to develop a comprehensive plan that will let you tap your borrowing power when you need it while keeping your total debt loan under control. You have to learn to practice basic budgeting in the short run. Strategize to get what you need in the next few months or years, and put in place mechanisms that will slowly but steadily assemble money you'll need for far-off future plans for kids' tuition and your own retirement.
When should you use debt to underwrite your goals?
Not for regular day-to-day obligations in your monthly operating budget. These should be paid entirely out of current income with cash, checks or a debit card - or a credit card you pay off fully each month. At the same time, get into the habit of setting aside a portion of your paycheck into savings or having cash swept electronically from you checking account into a savings account. That money will help you build up a cushion of cash to buffer you against unforeseen financial blows - a spell of unemployment, an uninsured medical emergency, or a divorce - events that commonly tip people into debt they cannot manage. Financial planners say that families with one breadwinner should save six months of expenses, two-income families need enough to cover three months.
Don't Stop Saving
You'll need money for your current goals — a down payment on a house, a new car, appliances, furniture, college tuition, and maybe a business venture. Money you will absolutely have to have for your retirement will grow fastest in a 401(k), a Koegh, an individual retirement account, or other options that allow you to defer taxes on contributions and realize capital gains.
Make a strong start by trying to invest as much as 10% of your income when you're in your 20s. Earnings on funds saved early will have more time to compound. You should stick to the 10% level throughout your career; saving more money if you can as your income grows. A lifetime of saving will not eliminate your need to borrow, but it will reduce your debt burden and save you tens of thousands of dollars in interest.
Some forms of debt can nourish your life goals; while other forms can compromise your financial health.
A Good Debt
This kind of borrowing fulfills two requirements. First, the purchase you're financing should outlast the length of the loan taken to pay for it. A mortgage to buy a house is the most obvious good debt. Even after 30 years when it's been paid off, the house will still be standing. And after a 48 month loans, your car should still get you to work. Second, the asset you finance by borrowing should provide a return that will offset the cost of interest. A house usually appreciates in value, though at times modestly. Education loans are investments, too, when they help increase earnings.
When Good Debt Goes Bad
Not all debt backed by the collateral in your home qualifies as good debt. One of the lending industry's hottest products today, for example, the high loan-to-value mortgages (HLTV) This type of loan allows you to borrow up to usually 125% of the value of your home at higher interest rates usually just below credit-card issuers. HLTV lenders claim such loans help borrowers buy home furnishing and consolidate credit-card debt. But after paying interest on one of these costly loans for 10 years, a borrower still won't have made a dent in the principal.
"Bad" debt includes almost everything that builds an unpaid balance on your credit cards. Many of the items purchased with a credit card will last longer than the repayment but depreciate the minute you bring them home. You should pay for them from current income or from short-term savings set aside for purchases of durable goods.
Borrowing for operating expenses - groceries, toiletries, gas - is not just bad, but ugly. You should pay for such items with cash, a check, or a debit card to save on interest expenses. If you use a credit card, pay off your balance in full each month.
WHICH LOAN FOR WHICH PURPOSE
There are plenty of ways to borrow money, but each has its own advantages and snags. This table can guide you to the right type of loan to meet your needs. The interest rate given for each loan type is the annual percentage rate (APR) prevailing as of mid-May, 1999.
|Type of loan||Solicitation||Drawback||Best used for|
|Home-equity credit line||Borrow cash from you house to pay off high- interest rate credit cards; benefit from tax deduction interest||Reduces your investment in your house. May raise cost of debt consolidation if principal isn't repaid promptly. Your home is collateral if the debt is not repaid, you could lose it.||Financing home improvements, college costs not covered by lower-priced government -guaranteed loans; or as a reserve to tap in the event of long-term unemployment or other major setbacks.|
|Mortgage refinancing||Lower your monthly payment; free up cash to pay other bills; tax-deductible interest.||Boosts the total cost of your house by extending the time you'll be paying for it; requires payment of closing costs.||Reducing housing costs if you plan to stay in your house long enough for savings to pay off closing costs. Often works best if you switch from a 30-year mortgage to one lasting 15 or 20 years.|
|High loan-to-value mortgage||A mortgage on your house plus 25 to 50% of its value in cash.||Gains you no equity in your home even after years of payments; if home prices drop, you're sunk. Interest payments on amount that exceeds homes appraised market value are not deductible for taxes.||Nothing: it's not a good deal.|
|Credit Card introductory rate||Low introductory rate or fixed rate on either transferred balances or new purchases or both.||Over-the-limit fees, late-payment fees, interest rates can go higher.||Buying big-ticket items you can pay off in a few months; moving balances you plan to pay down in three to five years.|
|Credit Card with Rewards||Free air miles, discounts, and/or cash rebates.||Usually a higher interest rate; an annual fee; restriction including when, or what, and how points can be redeemed.||Getting extra benefits that you really plan to use.|
|Car Loan||Ownership, unlimited mileage; no require- ments to fix dents and dings.||Higher monthly payment than for a lease.||A purchase made on the most favorable terms you can negotiate for a vehicle that will last longer than the loan.|
|401(k) Loan||Borrow your own funds at a low rate; no credit record necessary.||Immediate payback required if you leave the job before loan is due; liable for payment of taxes and penalties if loan remains outstanding.||As a secondary source to meet education expenses if low-interest education loans aren't available; large home improvements if you cannot rely on a competitively priced home-equity loan.|
*When does borrowing on a credit card come in? If you're lucky, rarely. Unexpected expenses that can't be funded from savings do pop up however; a fridge that refuses to chill or a furnace that has blast its last. In such cases, a credit card can be ideal if you can pay off the balance within a few months.
For more information see, Using a Credit Card.
Looser lending standards are found everywhere. Car dealers, who once gave you 24 to 36 months to pay off a loan, now may stretch payments out for 60 or 72 months with cash down payments disappearing. Home buyers now need less than 5% down and the percent of monthly income that goes toward your house payment (including escrow) can be as high as 31% of your gross income.
Know Your Limits
Determine your own borrowing capacity by sticking with proven debt-to-income ratio yardsticks appropriate for the type of purchase you want to finance. Coming up with a substantial down payment before buying a home, for example, is not the insurmountable barrier it may appear to a young couple at first glance. On average, a couple can take less than 2 1/2 years to assemble the money. And you should keep your debt ration to income under the traditional 25% of your net income (after taxes). Adhering to those limits will leave some room for other expenses.
For more information see, Measuring and Using Your Credit Capacity.
How Much Car Can You Afford
Spend no more than 10% of your income multiplied by the number of years you're financing and try to keep that number within 48 months. (Cars can start to fall apart by years five and six.) For example, if you earn $40,000 a year and you have a 4-year term, your spending for the new car along with any other vehicles you own should not exceed $16,000. Any amount over that is bad debt.
For more information, see, How to Finance a Used Car.
Bad debt is a bearable nuisance but before you know it can multiply. To avoid the nasty buildup, you have to understand the math that creates it.
The $40 Dinner
Take that $19 dinner you charged the other night. If you carry no balance on your credit card and pay your bill within the 20-25 day grace period, the dinner won't cost anything extra. But consider instead the cost of that dinner if you are already carrying an unpaid balance of $5,000 on your credit card. If you simply add the cost of the dinner to your other revolving debt, that "inexpensive" dinner out would have cost a total of $40.04. Did you really want to pay so much for that dinner? Probably not, next time pay cash.
The Minimum Payment Trap
Lenders would prefer you didn't worry how much a debt will cost or how long it will take you to repay. All they want you to think about is the minimum monthly payment that will keep your account current. Paying off balances with the minimum now takes longer than ever because, over the years, credit-card companies have downsized monthly minimum payments from between 3% and 5% of the balance to between 1.5% and 2% now. Thus, a credit-card balance of $3,000 with a 15% annual rate (which is low compared to some credit cards) would take over 12 years to repay for a consumer making only a $45 minimum payment and it would cost a whopping $3,491 in total interest payments.
Traps in Mortgage Refinancing
Even the mortgage refinancing can add up to trouble for many of the hundreds of thousands of borrowers who rolled over a higher-interest-rate mortgage for one charging today's lower rate. What looks like a big win for the borrower can end up costing plenty.
When you refinance, take the new loan out for a shorter term than 30 years. A refinanced mortgage can save you money if you can take the difference between the old payment and the new payment and invest it. But if you just spend it, like most of us, the new loan for 30 years can cost you more money. Another way to save on your interest is to keep on making the higher first loan payment amount. The extra you pay each month on the new mortgage will shorten your loan and save you thousands of dollars.
Refinancing can be an even worse deal for people who take out extra equity from their homes to pay off credit-card debt. This is an especially attractive lure since mortgage interest, unlike credit-card interest, is usually tax deductible. For example, if you transfer $15,000 of credit balances to a new $93,202 mortgage, you must finance $108,020 mortgage plus about $2,160 in closing costs. Your new monthly payment still drops from $752 to $719 and you no longer have to make those credit-card payments for which you were paying over $250 a month at 15%. If you had gone on to pay off the credit card debt in as long as nine years, your interest payment would total $12,900. Now, you will be paying off this debt over 30 years and the total cost of your card debt would be $20,090. Even if you are in the 28% tax bracket, you would still pay more than $15,000 in interest for the 30 years on your credit card debt.
Car loans and leases should also be analyzed for their full costs. Leasing may give you a grand vehicle for a low payment, but you would be paying for half of a 60-month car loan without owning the car.
For more information, see How to Cut the Costs of Credit.
You may have several credit cards already crammed into your wallet and offers for new ones show up daily. But your need for this expensive plastic money is shrinking. Debit cards, which directly tap funds in your checking account, now offer most of the convenience, safety, and ease of use that credit cards provide. For most of the daily expenditures you make - groceries, apparel, personal-care items, meals, and entertainment - using a debit card is preferable to relying on revolving credit. However, you do have to keep close track of your spending or risk being hit with penalties if you overdraw your checking account.
Playing the Card Game
Still, credit cards have their place. They are handy for purchasing goods by mail order, over the telephone, or online-when you need assurance that you can have the charge reversed if the merchant doesn't deliver. They can be indispensable for making hotel, airline, and rental-car reservations, even though some providers of these services are now willing to accept debit cards.
For more information, see Debit vs. Credit Cards.
How many cards should you have? If you are married, both you and your spouse should have separate cards so each of you has an individual credit record. Likewise, either or both of you may want an additional card for keeping track of business expenses. If you're really insecure about having extra money in an emergency, get another card, but keep it in a drawer.
Charge cards issued by department stores and other retailers are good only at that business and the rate of interest is usually 21% or more. Since most department and retailers accept credit cards, it's not necessary to have their own cards.
Pick a Card, But Not Any Card.
Don't wait for a card offer to find you; you should seek out the best offer yourself. You can comparison shop by visiting www.bankrate.com or http://www.cardtrak.com two services that rank cards and other lending deals.
Don't simply opt for the lowest interest rate, a rebate for purchases you charge, or the most frequent-flier miles. Get out your magnifying glass and scrutinize the terms and conditions in the fine print on the back of the offer. Does the low introductory rate apply to new charges, cash advances, or just balance transfers - and how long does that rate last? How long does the card issuer give you to pay off your monthly charges without incurring new interest payments? What penalties does the issuer impose if payments are recorded late or if you unwittingly exceed your credit limit?
Since card issuers contract for rate changes, you need to know when and how changes occur. Even one late payment can be an excuse to boost your rate. You don't have to be very late, one bank now slaps a late fee if a payment arrives after 10 a.m. on the day it's due.
If you are hit with a rate hike or a new fee, call the credit-card company immediately to complain. If you have a good credit rating and spend at least $250 a month (the breakeven point at which fees that card issuers collect from merchants begin to yield a profit), the customer-service rep probably has the authority to reduce the interest or waive the fee. After all, a bank would have to shell out between $50 and $125 in direct mail solicitations, teaser rates, and other perks to replace you.
If you think you don't have to worry because you pay your balance in full each month, watch out. Because 42% of all credit-card customers have become so-called convenience users who incur no interest, more and more banks are looking for opportunities to extract revenue from these credit-card "freeloaders" by reinstating the annual fee.
Despite lenders' willingness to hand out money, a good credit record is as important as ever. Nearly all lenders have come to rely heavily on computerized profiling to determine what credit they are willing to extend to a potential borrower. High scorers get the best deals - low interest rates and high lines of credit. Those with low and even failing scores-people who have declared bankruptcy or gone through foreclosure - will get only a little bit and pay high rates. Rates on mortgages for them could be as much as 6 percentage points above the prevailing rate that creditworthy consumer can get. That's little better than charging your house on a credit card.
A high credit score will not only give you better terms, but it may be more important in the future should interest rates rise and credit standards tighten during an economic downturn.
How to Score
The obvious way is to pay all your bills with precision timing. Collection accounts, serious delinquencies (payments 30 to 90 days late), liens, foreclosures, and bankruptcies also make you look like a less-than desirable risk.
All this seems simple enough, but there are more complicated issues involved. First, every bank from which you seek a loan consults one of the three credit bureaus - Equifax, Experian, and TransUnion - each emphasizes distinct combinations and permutations of your credit data. Even if you pay your bills religiously, the credit-scoring software could downgrade you if, among other things, you regularly brush up too close to the limits, have too many accounts with unpaid balances, open too many accounts within a short period, or even have too many inquiries in your credit report from potential lenders.
The first thing you can do to protect yourself is to make sure that your credit records are accurate. If you anticipate applying for a major new loan or refinancing an old one - or if you've recently been in a dispute with a creditor over a claimed unpaid balance - request a copy of your personal report from all three major credit-rating agencies and go over them carefully ( Equifax, Experian, and Trans Union ).
Often there are mistakes-a delinquency report on a department store account that you never had-for example. If you spot an error, have the credit bureau investigate. If it won't remove the problematic entry or amend it to your satisfaction, write a letter to be inserted in your file giving your side of the story.
When you are in too deep what are your options? Say your "bad" debt-credit card balances plus any excessive house and car debt-is relatively modest, between 5% and 15% of your income. In that case, some belt-tightening is in order. Start by exhuming your financial records for the past three months to trace where your money is going. Then list your fixed expenses (mortgage, car payment, utility bills, etc.) and variable expenses (food, clothing, entertainment, etc.) Once you identify items on which you splurge, either purge them from the budget or set strict limits on how much you'll spend.
"Bad" Debt Between 15% and 25% of Yearly Income
"Bad" debt between 15% and 25% of your yearly income calls for a more systematic debt-repayment plan. Like millions of Americans have done in the past decade of declining mortgage interest rates, you may be tempted to fold those debts into a home-equity loan or a new mortgage to reduce your monthly payments. Such a move can save you money, but for many borrowers it generally ends up costing more in the long run. Worse, the debt elimination may be only temporary. 70% of households who consolidate their credit card bills have run up new credit card balances within in a year. Those that run up credit card debt again will have little or no home equity to draw on for a long time and their total debt will be increased.
People who have fallen into debt should make a commitment to pay it off in three to five years. One step is to move credit card balances to a new card that has a low interest rate. Preferably paying off the balance while the low introductory rate applies. You could also try calling a present card issuer and ask them if they would lower your rate if you transfer some balances to that card. (You have to have some line of credit available, of course.)
You should start thinking of paying off your debts as an investment. If the credit card rate is 17%, every time you pay $100 you'll earn $17 compounded annually over the life of the loan. Pretax, that's the equivalent of a 25% return. Few investments are that safe and that profitable.
For more information see, How to Cut the Costs of Credit.
"Bad" Debt Between 25% and 50% of Yearly Income
If your "bad" debt is between 25% and 5o% of your yearly income, you should consider enlisting professional help to pull out. You can turn to a financial planner or one of the nonprofit debt-counseling services. Help with your debts these days is no further than a mouse click or a flick through the yellow pages, but choose carefully. A reputable debt counselor will help design a budget, negotiate with creditors for easier payment terms, and teach you to live within your means. Most will ask for a donation when you can make one or impose modest monthly charges of $2 to $3 per creditor. There are no shortcuts for getting out of debt. The process may take three to five years, so avoid companies offering overnight credit repair, a switch to another credit identity, or other quick fixes.
For more information see, Credit Problem Help.
"Bad" Debt Over 50% of Yearly Income
If your "bad" debt makes up more than 50% of your income, the best course may be to seek bankruptcy protection. Borrowers plunged in debt have had two options to extricate themselves: Seek the protection of Chapter 7 bankruptcy, which erases most of their bills (though not taxes or child support), or enter credit counseling as discussed above to develop a repayment plan.
Finally, as you pay off your old debt, try to save something, however, modest - even if it prolongs your indebtedness. That way, when you're done, you'll have something to show for your sacrifices and a healthy new money discipline that will keep you out of the debt trap for years to come.