CREDIT AND DEBT MANAGEMENT
“Credit can be a stepping stone to achieving your goals or a stumbling block on your path to financial independence. Choose your steps wisely.”
Credit is like having a borrowing superpower that lets you get stuff now and pay for it later. It’s like a special agreement between you and a lender, like your bank, allowing you to use their money to buy things or take care of responsibilities like paying bills. The catch is you have to pay back what you borrow over time, and they also want a little extra money called interest. Here are a few benefits of having good credit:
- Increased Borrowing Capacity: Building a positive credit history and maintaining a good credit score opens doors to increased borrowing capacity. If people can trust that you’ll repay your debts on time, they’ll be inclined to lend you more money later.
- Improved Access to Financial Opportunities: Lenders, landlords, insurance companies, and potential employers often consider credit scores when measuring an individual’s financial responsibility. A strong credit score indicates a history of managing credit obligations well, making you a trustworthy borrower.
- Favorable Interest Rates: Credit scores play a crucial role in lenders’ evaluating the risk of extending credit to individuals. A higher credit score signifies a reduced likelihood of default, leading to lenders offering lower interest rates. This ultimately translates into long-term savings, as you repay loans with less interest accumulated over time.
Types of Credit
Using credit as a business owner can extend your runway to reinvest in your business, hire staff, or manage cash flow. As you consider what areas of your business could most benefit from an influx of capital, here is a breakdown of the basic types of credit:
- Revolving Credit: This type of credit offers a predetermined limit that borrowers can use repeatedly. Borrowers with revolving credit can manage their payments by repaying the total amount or making minimum payments while carrying a balance. For example, suppose you have a minimum payment of $200 for your credit card. In that case, you can pay a larger amount, such as $500, toward the balance instead.
Revolving credit provides a flexible line of credit that can be used for various purchases such as retail purchases, everyday expenses, travel expenses, and home improvement projects, like renovating a kitchen.
However, remember that spending on credit impacts your credit score, which lenders will review when considering your loan request. Therefore, how you handle your credit will determine whether the impact on your credit score is positive or negative. When utilizing revolving credit, the credit utilization ratio is a crucial factor you should take seriously. This ratio compares the amount of credit you use to your total available credit limit, determining your credit score. Maintaining a lower credit utilization ratio, ideally below 30%, indicates responsible credit management and can positively impact your credit score.
- Installment Credit: with installment credit, borrowers receive a small sum they repay in fixed installments over a specific period. Examples of installment credit include mortgages, auto loans, and student loans. These loans come with an interest rate, repayment term, and fees, determining the monthly amount the borrower must pay.
Some everyday purchases made with installment credit are vehicles, education and training, medical expenses, home appliances, and electronics.
Regarding installment credit, payment history plays a significant role in calculating your credit score. Your credit score will not be negatively impacted if you make your scheduled monthly payments for an installment loan on time. Payment history contributes 35% to your FICO score calculation, making it crucial to ensure you meet your due dates and avoid missing payments.
ARE LOANS REALLY BAD?
Going into debt is not inherently wrong since there are circumstances where acquiring debt can be necessary or advantageous. For instance, loans can be a means to obtain immediate funds during emergencies or assist in paying off debts with high-interest rates. Whatever the case, it is crucial to approach debt responsibly and clearly understand the potential outcomes. Therefore, before applying for a loan, you must consider the following factors to make informed decisions:
- Purpose of the Debt: The reason you are going into debt plays a significant role in determining whether or not it is a wise decision. Debt taken on for essential needs like education, a home, or starting a business may be considered a strategic investment in your future. On the other hand, going into debt for unnecessary or frivolous expenses may not be the best financial decision for your future.
- Financial Ability: Before taking on debt, you must assess your ability to repay it. Taking on debt beyond your means or without a clear repayment plan can lead to financial stress and difficulty meeting your financial obligations. Therefore, always consider your income, expenses, savings, and other financial obligations before applying for a loan.
- Interest Rates and Terms: Understand the interest rates, fees, and repayment terms associated with the debt. Higher interest rates or unfavorable terms can increase the cost of borrowing and make it harder to repay the debt. Therefore, you must compare different options and choose the most favorable terms that fit within your financial capabilities.
- Repayment Plan: Do you have a solid repayment plan? If not, consider setting a plan for making the required payments and ensuring they fit comfortably within your budget.
- Overall Financial Health: Consider your overall financial health and long-term goals. Going into debt should align with your financial plan and help you achieve your financial objectives. Also, assess whether the benefits of taking on debt outweigh its potential risks and costs.
- Emergency Fund and Savings: Having an emergency fund and savings in place is generally advisable before taking on debt. This provides a buffer and can help you manage unexpected expenses or financial challenges without relying solely on credit.
Good and Bad Debt
Debt can have both positive and negative implications. To simplify this, let’s break it down: If the debt you incur generates income and increases your overall net worth, it can be categorized as “good” debt. However, using a loan to purchase assets depreciating is considered bad debt.
That means loans for education, business investments, or mortgages can be considered good debt. After all, these expenses can build long-term wealth and provide lasting benefits. However, going into debt for items such as cars, clothing, consumables, or payday loans is considered bad debt. Unfortunately, these assets tend to lose value rapidly, making it financially unwise to incur debt to purchase them.
THE TRILLION DOLLAR PROBLEM
In the United States, the issue of credit card debt has grown into what is now referred to as “the trillion-dollar problem.” This problem stems from the collective outstanding balances and accumulated interest on credit cards across the nation, which have reached a staggering amount of $986 billion.
Today, over half of Americans carry balances, as credit card debt has become a significant financial burden for many individuals and households in the US. This level of debt poses many challenges and consequences for both individuals and the economy.
One of the primary concerns associated with credit card debt is the high-interest rates charged by credit card companies. These rates can often be enormous, making it difficult for individuals to pay off their balances on time. Consequently, individuals may become caught in a vicious cycle of making minimum payments and accumulating interest, prolonging the repayment period and escalating the overall financial burden.
Credit card debt can have a detrimental impact on individuals’ financial well-being and overall quality of life. It can lead to increased stress, limited financial flexibility, and reduced ability to save for the future. Additionally, excessive credit card debt can hurt one’s credit scores, making it more challenging to obtain favorable interest rates on loans and mortgages or secure other financial opportunities.
Addressing the trillion-dollar credit card debt problem requires a multifaceted approach. It involves raising awareness about responsible credit card usage, promoting financial literacy, and encouraging individuals to adopt healthy financial habits.
Additionally, the federal government can implement policies that regulate credit card companies and promote fair lending practices, which can help protect consumers from predatory practices and mitigate the risks associated with credit card debt.
Tips for Avoiding Credit Card Debt
Despite the staggering $986 billion credit card debt in the United States, some individuals have effectively used credit cards without succumbing to overwhelming debt. Have you ever wondered what their secret is? Well, let’s uncover it now.
One potential approach to enhance credit scores involves utilizing the 15/3 credit card payment schedule, which aids you in ensuring timely payments and maintaining your credit utilization rates below 30%. Your payment history and outstanding balance are crucial elements in influencing your credit scores. If you struggle to make on-time payments, you can try following the 15/3 hack—ideally for at least six months to see a credit score boost.
This strategy can be executed in three ways to optimize credit card payments and minimize interest expenses.
Option 1. Pay the minimum payment fifteen days before, then pay off the balance three days before the due date.
In this method, you start by making the minimum payment required by your credit card issuer fifteen days before the statement’s due date. This ensures that you meet the minimum payment obligation on time. Then, about three days before the due date, you make another payment to pay off the remaining balance completely. Doing so reduces the outstanding debt reported on your statement, resulting in lower interest charges.
Option 2. Pay the minimum fifteen days before, then pay an additional amount three days before.
This is similar to the first approach, but you make the minimum payment fifteen days before the statement’s due date. However, you make an extra payment instead of paying off the balance three days before the due date. This additional payment can be any amount you can afford, whether a fixed sum or a percentage of the remaining balance. Reducing the balance before the due date minimizes the interest charges applied to the remaining debt.
Option 3. Split the minimum payments into two, then pay them fifteen and three days before the due date.
With this method, you split the minimum payment into two separate payments. You make the first minimum payment approximately fifteen days before the due date, satisfying part of the required amount. Then, three days before the due date, you make the second minimum payment to cover the remaining portion. Making two payments within the billing cycle reduces the average daily balance on which interest is calculated, resulting in lower interest charges.
It is crucial to emphasize that, despite which method you decide to follow, you must ultimately pay your statement balance in full by the due date to prevent accruing any interest on the remaining amount owed.
Below is another strategy that can help you avoid excessive credit card debt if you follow its steps. Let’s explore these steps together:
1. Prepay Your Credit Card Balance. One effective way to avoid credit card debt is to pay off your balance in full each month. Doing so eliminates the risk of carrying over a balance and incurring interest charges. So, make it a priority to budget and allocate enough funds to cover your credit card expenses. Paying off the entire balance on time helps you build a positive credit history while avoiding unnecessary debt.
2. Stick to One Credit Card. Credit card inquiries can have a temporary negative impact on your credit score. When you apply for a new credit card, the card issuer will typically ask one or more credit agencies for a copy of your credit report. This request is a “hard inquiry” or “hard pull.” Hard inquiries may lower your credit score.
Using multiple credit cards can complicate your financial situation and increase the likelihood of overspending. So, stick to one credit card that best suits your needs and preferences for a while. This approach allows you to focus on managing a single credit card account effectively, making it easier to track expenses, monitor due dates, and control your overall credit utilization.
3. Follow the 30% Rule (that is, use less than 30% of your limit). Credit utilization refers to the proportion of your credit limit that you utilize, expressed as a percentage. Keeping your credit utilization below 30% of your available credit is strictly recommended. When your credit utilization is high, it can hurt your credit score and suggest you are a significant risk to lenders. On the other hand, maintaining a lower credit utilization ratio demonstrates responsible credit management. It reduces your likelihood of accumulating excessive debt.
4. Save Up Cash for Big Purchases. Consider saving cash in advance instead of relying solely on credit cards for significant purchases. When you save and plan for more considerable expenses, such as electronics, furniture, or vacations, you can avoid relying on credit and accruing interest for yourself.
HAVING FUN WITHOUT GOING INTO DEBT
For many young individuals, living a debt-free life may seem like an elusive dream. Whether due to necessary debts like mortgages or student loans with lower interest rates or the burden of high-interest consumer debt from credit cards, being in the red has become a common experience for many young people.
However, some find the idea of owing money unsettling and a burden too heavy to carry, urging them to prioritize debt repayment.
Tara Falcone, a chartered financial analyst, certified financial planner, and the founder of the app Reason emphasizes the transformative impact of paying off debts on one’s life by offering a newfound sense of freedom.
Falcone explains. “Being debt-free means not owing anything to anyone, which grants you more control and options in managing your finances. When you have no debt, you can decide how and when you want to spend your money.”
As a young person, you can lead a fulfilling and enjoyable life without accumulating excessive debt or sacrificing the vibrancy of your youth for debt repayment. By embracing smart financial habits and making mindful choices, you can balance enjoying life and maintaining a healthy financial balance. Here are some practical tips to help you achieve this goal:
- Focus Your Spending on Things You Genuinely Enjoy Doing: Identify your passions and interests and allocate your resources to those areas. By spending only on things that matter to you, you can avoid frivolous expenses that could lead to unnecessary debt.
- Focus on Your Long-Term Financial Goals: While enjoying the present is important, remember not to lose sight of your long-term goals. Set clear objectives for yourself, such as saving for education, buying a home, or starting a business. Ultimately, this can help you avoid impulsive spending that could hinder your financial stability.
- Find Ways to Align Rewards with Leisure Activities/Interests: Look for opportunities to enjoy or pursue your interests while minimizing costs. For example, take advantage of loyalty programs, rewards cards, and cash-back offers that can provide discounts or benefits for the things you enjoy.
- Find More Ways to Make Money Without Working Harder. Explore alternative sources of income that align with your skills and interests to ensure you keep afloat financially.
- Set Aside a Healthy Amount in Your Budget: More importantly, create a budget that allows you to allocate a reasonable portion of your income to leisure activities and entertainment. This way, a specific amount is set aside for fun, and you can enjoy yourself within a predefined limit. The goal is a clear path toward eliminating debt, allowing you to balance your obligations and goals. Now that you have gained a solid understanding of the fundamentals of debt management, the next chapter will explore setting financial goals and implementing strategies to maintain a debt-free lifestyle.