When it comes to our financial well being, one thing above all else has ruined more people, requires lots of treatments, and is the #1 problem to great financial health… DEBT. This may be the dirtiest 4-letter word in the financial world, and it’s a silent killer! Each year, the money and emotional toll debt causes is devastating. As we have been discussing, regardless of our income, practicing good financial habits and avoiding mistakes can help our money go further. Debt isn’t a good solution, and we only need to think back to the financial meltdown of 2008 to see why. Most think that the government caused the problem, Wall Street, corrupt banks, Federal regulations, but at it’s very core, it was that so many of us got overextended on the amount of our credit and debts. We were taking out loans for 100% percent of the homes value, overstating incomes, and thinking that things would just keep going up and up. Taking on a bunch of debt was a good thing, and it didn’t matter how much we took, because we would just sell our rapidly appreciating house to cover it all. It wasn’t sustainable, and at the first sign of weakness, all of it came crashing down! It was the worst economic disaster since the Great Depression of 1929. Consider the consequences from all that debt in 2008:
- Real Estate lost over $ 7 trillion dollars in value, with over 4,000,000 Americans losing their homes.
- The stock market lost over $ 11 trillion, and the average American lost 1/3 of their net worth
- By 2010, 46.2 million Americans were living in Poverty, the highest number ever recorded in 52 years of publishing that report
- 8 million jobs were lost, resulting in over $ 19.2 trillion in lost incomes
- Fannie Mae, Freddie Mac, Shearson Lehman Brothers, Countrywide Financial, Bear Stearns, American Home Mortgage, New Century, Washington Mutual, and bailouts saved companies like GM, Merrill Lynch, Chrysler
According to several reports, roughly 80% of Americans are in debt from mortgages, student loans, car loans, and lots of credit card debt. As a matter of fact, credit card debt is second only to mortgage. As many as 40% of us have credit card debt, and 65% carry a balance every month (revolving debt). The average credit card’s interest rate is 15% according to CreditCards.com. What’s even more alarming is to consider a few examples of not paying your bills in full every month:
If we had a credit card with an APR (Annual Percentage Rate) of 18%, and a $ 5,000 balance. The minimum payment requirement is around 2.5%, or $ 125. You think that this means $ 125 x 40 payments = $ 5,000, this means in about 4 years the debt will be paid off.
This is the shocker, keeping on the minimum payment schedule, that $ 5,000 actually would take 273 payments… over 22 years!
The credit card companies keep the minimum payment schedules low, so that they can collect on that debt for as long as possible. As the balance is coming down, the minimum payment becomes even less. It’s one of the major ways they make money. Also, by hoping that many of us will only make the minimum payment, it helps people rationalize the debt, “This $ 5,000 charge is only going to cost me $ 125 per month, so we can afford that!” Ironically, the $125 went to reducing our balance by $ 50, and the other $75 went towards interest. This mean that over the long term, 60 cents of every dollar would go towards interest!! We would pay more in interest than what we had originally charged.
That same $ 5,000 credit card balance, making only the minimum monthly payment of 1.5% of the outstanding balance every month, at a 14% interest rate, takes almost 61 years to pay it off, adding almost $ 16,000 of additional interest charges over that time.
We often hear this question, “what’s the best investment?” Besides investing in ourselves, it would be PAYING OFF YOUR CREDIT CARDS! In the 18% credit card example above, we would save 18% by paying off that debt. Americans should be sprinting to the finish line to get out of debt, but it seems like it’s closer to molasses going up a hill. We’re trying, we’re pushing, we’re paying, but it seems like we are going nowhere. What’s even more frustrating is that we are doing the right thing by paying the debt, and staying on track, but it’s just not providing any meaningful results. The potential problems only intensify, because many of the credit cards companies notice that when we have charged up to our limit, they offer a credit increase. They “rewarded” us for being such a great customer that now we have a $ 6,000 credit limit, or maybe $ 6,500, or $7,000 in hopes that we will get excited that we have more money to spend! It’s a psychological boast, “they feel so good about me, that they gave me more credit.” Unfortunately, the studies have shown that most of us will take advantage of this increased credit limit immediately, and it increases current long term credit card debt by 10% on average, according to Time.com We have heard those exciting stories about getting a new credit card in the mail, or an increase in our credit line. However, we also have the power to rip-up those credit card offers, or contact the lender and ask that they don’t increase our limit. Tip: banks make money by lending money, the more they lend, the more the profits! Credit card providers will often set lower limits on newer accounts to protect themselves, but as they learn more about how we handle money, they gain valuable insights on our ability to handle debt. If we are responsible with our payments, they raise the limits in hopes that they will prevent us from borrowing from other companies. Also, they get to track our account behavior, targeting the kind of purchases we make, the interest revenues that we generate, possible late fees, and interchange fees (the fees merchants pay card companies for accepting their card, roughly an average of 82 cents for $ 50 of credit card purchases). Have you ever heard the phrase, “We don’t take American Express”, it’s because the merchant doesn’t want to pay their higher interchange fees, which run as much as 3.5% per transaction. Also, they get can pull a consumer report detailing how we are handling any of our other debts to target their approach towards our account. For example, if they see that we make payments, but are usually late, they can offer a card with a much lower introductory rate that automatically goes up if we are late with a payment. The other tricks is to hit us with a late charge fee for being late. Finally, credit cards generate billions of dollars in fees and interest, it’s BIG business. The amount of credit card offers are staggering, with the average person having at least 2 credit cards. The offers are enticing, especially if we have good credit, then they lure us with “lower interest rates,” offers, and low credit scores, get “pre-approved” offers, or “we won’t turn you down.” It’s like fishing, hopefully we catch one, and then we try for more, because banks and credit card companies are fishing with the bait to hopefully catch us! Often, these cards are enticing us to make purchases, that we really can’t afford. Once they have us in their nets, we are caught, and hopefully all the profits that hopefully come with that. Credit cards can be a great convenience, offer rewards, and have their benefits, but we need to be aware of all the responsibilities that comes with them. They are not a license to spend, and can cause major financial damage.
Credit scores and credit history are also very important when it comes to debt, and debt management. Our ability to buy a house, get a car loan, qualify for student loans, personal loans, and credit cards are just a few of the many things impacted by credit scores. The interest rates charged on many things depends on our credit score, the lower the score, usually the higher the interest rates. How we handle our debt has a huge influence on our credit score, so it’s important that we try to follow a few tips:
- Carrying a lot of debt, especially high credit card debt, hurts our score. Our level of debt is 30% of our score, so paying the balances quickly, or reducing them can help.
- Late payments, or missed payments hurt your credit scores. Payment history is 35% of your credit score.
- The lower our amount of debt, the better. Try to keep the revolving debt (credit card, retails cards, gas cards, etc) below 10% of our total available credit.
- Taking out loans, or keeping credit balances helps build they credit score, this is FALS
- Understand any “enticement” offers, such as charge $ 5k in first 60 days, and we will give you 25,000 reward points, or incentives to transfer your balances at 0 interest for 6 months, etc. These cards could be loaded with lots of other costs, such as much higher interest rates, fees for late payments, or rate hikes for over charging. Also, too many cards exceeding your credit limit.
- Having too many cards creates more temptations to charge more debt, or can become very unmanageable.
There are (3) big credit reporting bureaus, Experian, Equifax, and TransUnion, and they track our borrowing behavior, and borrowing history. Just like our GPA at school, we get a credit score, which helps determine how we rank as a borrower. Our credit scores help to evaluate what type of a credit risk we are, our outstanding loan balances, the number of accounts that we have, our payment history, etc. The credit scores (FICO) range from 300 to 850, which helps to rate us as a borrower, the higher our score, the better the risk, and the lower, the more risk. Credit scores are very important, and it changes each time it is requested. Unfortunately, while it’s based a number of criteria, it doesn’t usually change that much on the positive side, but negative actions can substantial impact our score, like a bankruptcy or missed payments. Also, someone with a limited credit history can be more affected by opening a new credit account.
It’s important that we check our credit report every year from the 3 credit rating agencies. It’s possible to have some potential differences on the reports, possible fraudulent activities, or mistakes. Unfortunately, it often up to us to fix those mistakes, but there is information on the agency’s website how to fix any mistakes, and how to order the free credit report. Tip: Fair Credit Reporting Act allows us to pull a FREE credit report once a year from each agency, it shouldn’t cost money, or require you to sign up on some website for the report. Just like the importance of keeping a budget, monitoring your credit keeps track of your financial activities. It’s also important to make sure that we understand the terms and conditions of our credit card contracts. “Terms and conditions,” lay out all the fees, interest rates, payment rules, and penalties. Make sure that the credit cards matching your needs, such as if you don’t pay off your bill every month, you should consider a card with the lowest rates, not worry about all the rewards points, which can have a much higher interest rate. Another example is the cards that offer a 0% for balance transfers, because if you make an occasional late payment, the interest rates will automatically skyrocket, losing the 0% teaser rate. Also, these 0% rates are good for only a set period of time, so try and pay off as much of your debt as possible, since you are getting 0%. Lastly, annual fees can be a killer, especially if you aren’t using any of the points, free miles, gifts, etc. AMEX Platinum card fee can be $ 450, and the 40,000 rewards points assume that you make $ 3000 of purchases in the first 3 months. AMEX is a good company, but we need to be aware of any fees or charging requirements. Many credit card companies offer bonuses like the lots of miles, rewards points, or cash back, but also have charging rules, such as so much in a short period of time, or cash back on certain things, encouraging you to charge a lot to get your cash back, because it sounds good. As we mentioned, make sure to study all the rules. Finally, think twice before cancelling cards as credit scores do reflect the amount of credit that we have available. Cancelling cards can send up a red flag that we may be having financial problems, so if we want to cancel credit cards only do 1, and then maybe another one a few months down the road. Having multiple cards with low balances, gives us a good credit utilization ratio, which is a component of our credit score. Remember to use your cards every so often to keep them from also being closed or cancelled by the card company. If the temptation to charge is just to great, just cancel the cards and don’t worry about the credit score, because going into continued debt isn’t worth it. It’s important to properly manage your credit cards, mortgage, and loan account which is the best advice of all!
Other keys to Debt Management:
- Know all your debts, the amounts, payment due dates, and how much you are budgeting towards your debt every month.
- Pay off the highest interest rate debt first, which saves the most interest, and is psychological win- it feels good to have paid it off!
- Pay more than the minimum balance every month, remember the minimum payment is what is good for the company’s pocket book to earn interest, it’s not good for us. Try to make bi-weekly payments, or double up the payments to help pay things off faster, and save money in interest.
- Take advantage of the 0% balance transfer offers, and use to pay things off, saving lots of additional interest, just remember that those offers expire and rates will jump up on any remaining balances.
- Spend cash or a debit, not credit cards, leave them at home, and cut up credit cards if needed to avoid going into debt
- Any raises, bonuses, tax refunds, extra money should be used to pay off debt aggressively, or we can consider selling anything that we don’t need, or use for money
- Don’t fill out personal information when checking out at the stores to avoid getting on possible credit card lists
- Cut back on our spending, and use the extra money to pay off debt. Think before we charge it, “Do we really need it?” “What’s it really cost, when all the interest is added on?”
- Reward ourselves for positive milestones, feeling good make us want to do more. Contact your creditors if you get behind, work out a plan that fits your budget, and makes things more manageable. Don’t wait for things to go to a debt collector. We can also seek out credit counseling, or debt relief services, but make sure to do our homework before hiring anyone to help. There are lots of scams and potential fees, so make sure that we understand everything. We can also ask your CPA, lawyer, or trusted advisor for a referral, or advice.
Maybe the biggest step of all, once we are out of debt, stay out of debt!