You might remember the very first credit card you received in your own name. The feelings you had back then were probably happiness, pride, and accomplishment. Receiving that first offer of credit may have made you feel like a “big shot”, even if you were only making a small salary at a part-time job or just getting started in your adult life.
If you can relate to those feelings and are reading this right now, then you are probably cursing that same day when thatcredit card came in the mail. You may even look back and wish that your arm had been in a sling so that you couldn’thave filled out that first credit application. Maybe you received a small gift for opening your first credit account…a potterymug with the store’s name on it, a tee shirt, a small screwdriver set, or a little battery powered fan that you wished you’d never thought was so darn attractive at the time.
Knowing how you are probably feeling now, there are two thoughts we need to get out of the way before we go anyfurther: the first is, what’s done is done—you can’t go back in time (so you might as well stop kicking yourself!). The second is that credit, by itself, is not necessarily a bad thing. It’s just that it is very easily subject to overuse. To draw upon a famous movie phrase from just a few years ago, “credit is like a box of candy… once its open, it’s hard to just keep passing by without dipping in for just a little bit more” (especially when the makers of that candy keep calling out to us and offering us more and more and more!).
So, you can stop punishing yourself for getting started in this whole crazy credit and debt cycle. What you need to do now, instead, is to gain a better understanding of how the whole system of credit and debt really works.
Good Debt vs. Bad Debt
To begin with, it’s important to understand that not all debt is necessarily bad. There are good uses of credit and occasions when getting into debt may serve an important and useful function in our lives.
For example, few people can purchase a home without taking out a mortgage. A home mortgage may be considered “good debt” because the purchase you are making is really an investment. Your home and the property it sits on is likely to increase in value as the years go on and, of course, while you are living there and making your payments, your purchase provides you with a secure roof over your head.
College tuition costs are another expense that may make sense to finance. Student loans are another example of “good debt” not only because they are typically offered at attractive terms, but because they make possible a brighter and more prosperous future for those seeking additional education or career training.
In contrast, items purchased on credit that are consumed immediately or that bring about only short-lived benefits may be considered examples of “bad debt”. For instance, purchasing clothing on credit may not be a good idea as you may very well be paying for these clothes long after they have been outgrown or after styles have changed. The same may be said for expensive computer and electronic equipment that depreciate in value quickly and may need to be updated before you are even done paying for them. Travel expenses are another example of “bad debt” as the payments you are still making for last year’s vacation may prevent you from taking any trips this year or in the next several years to come.
Even seemingly essential items like gasoline and groceries should not be placed on credit cards if at all possible. While no one would argue the value of these everyday essentials, they are still consumed quickly and have to be replenished regularly through additional purchases.
To summarize, you might think of “good debt” as debt incurred for the purchase of items that open up new opportunities for you and your family members to improve your standard of living (e.g., educational costs). “Good debt” is also for items that either increase in value or at least maintain their value over time (e.g., your home). On the other hand, “bad debt” is incurred when you wind up paying for items over time that are quickly used up or discarded. “Bad debt” is paying for meals at restaurants with a credit card. While few can deny the pleasure of a delicious meal and fine service, when you put that meal on your credit card you will be paying for it–with interest and fees–long after the evening’s enjoyment has worn off.
What About Automobile Financing?
Of course, some examples of debt are difficult to categorize as strictly good or bad. An example of this is automobile financing. With the average price of a new car exceeding $20,000 these days, most people need to finance brand new vehicles. Certainly, cars provide us with transportation to and from work and school so that we can better ourselves and make a living. So, in that respect, auto loans may be considered acceptable debt. But, of course, new cars depreciate in value from the date of purchase no matter how beautiful and shiny they start out and you will be making payments on your vehicle long after the new car glow has worn off.
A compromise may be to finance the less expensive purchase of a carefully selected pre-owned vehicle. You’ll have your transportation, but the payments may be a little easier to handle. Of course, automobile leasing almost never makes sense from our point of view because your monthly car payments will leave you with nothing at the end of your lease term except a need to purchase or lease another vehicle.
Evaluate Credit Offer CAREFULLY
The key to using credit wisely is to know when to finance, how much to finance and for how long, and most importantly, when to stay out of the game altogether.
Remember there are well-paid professionals in the marketing business whose very job it is to make you think you not only want their products, but actually need them, have to have them, and can’t live without them. And, good salespeople and marketing professionals will do whatever they can to make you think you can afford their products.
The above statements certainly apply to how individual products are pushed in our consumer-oriented society. But, the same may also be said about how credit is “sold” in today’s age of relatively low interest rates and stiff competition amongst banks, credit card companies, and professional lending agencies. With more people than ever seeking credit, lenders today are lining up to get your business.
But, lenders are not doing this simply as a favor to consumers or because they like to see people happy with new furniture and appliances in their homes. It’s because the lending business is so profitable …it is really you who is financing them.
Think of all the promotions you’ve seen or read about: 0% financing for 6 months, no finance charges for one year, buy your car with no money down, refinance the equity in your home with no closing costs. In spite of how attractive these offers are, no creditor is out to lose money on a deal. What they want is your business and they spend a lot of money to know the spending and paying habits of the general public.
For instance, 0% deals along with the other examples listed above are known as “loss leaders” or more crudely as “the hook”. Once a credit card company has made you one of their customers, they know they will make a lot of money from your future business. You may be tempted to obtain a new credit card by attractive balance transfer offers that benefit the creditor because you will now be paying interest on your loan to them instead of your previous credit card company.
Most of the time when people take advantage of a temporary offer that promises no interest charges or extremely low interest for a period of time, that time runs out before they can complete all their payments and their interest rate skyrockets at the end of the introductory term. And, when you sign on for a period of zero interest or no payments for one year offer , make sure you read the fine print. No finance charge agreements require that you still make minimum payents and almost always any missed or late payments forfeit your deal and immediately send your interest rates skyrocketing. Some companies even expect you to pay a year’s worth of interest all at once if you have not paid off your loan completely within the no finance charge period.
So don’t assume that since a credit card company mailed you this great offer for their card, that it means you can really afford it or that it is in your best interest to take advantage of their offer. The truth is, your name may be on hundreds of mailing lists, which these companies will buy and use to solicit you. It is up to you, to determine what you can and can’t afford. You must police yourself. You need to determine the amount of credit you may use after a careful examination of your current income, debt load, and cushion of savings in case of emergency or job loss.
Avoid Co-Signing Arrangements
Co-signing a loan is something you may be asked to do or you may even consider asking someone else to co-sign a loan on your behalf. There is sometimes a misconception about what a co-signers responsibilities are and how the extension of credit affects them. First, lenders usually only want co-signers when the applicant has little or no credit history for them to base their decision upon. The co-signer has the qualifications the lender is looking for and by signing the loan papers, they are taking responsibility for making the payments if the applicant defaults for any reason. This is reported to the various credit reporting agencies and will have an impact on their credit rating. Other potential lenders will consider this debt just as much as if the co-signer took out the loan him or herself. Co-signing a loan for someone else could have serious ramifications and must not be entered into lightly. Your credit rating and your own ability to borrow could be hampered substantially. So think long and hard before you put your John or Jane Hancock on loan papers for someone else. If they don’t pay, the lender will come after you and even if the individual you co-sign for is late with payments, it will negatively effect your credit report as well as theirs. Our advice is don’t sign loan papers as a co-signer unless you are completely willing to accept responsibility to make the payments yourself.
Understand Your Own Credit History
It seems a shame that no company keeps an official record of all the many good deeds you’ve accomplished throughoutyour life. But, there is an official record of your money habits. It’s called your credit report.
Your credit report describes just about all the major decisions you have made with your money during the past several years. Usually seven to ten years worth of information may be found on your report.
Your credit report contains information about where you work and live and how you pay your bills. It includes your current and previous addresses, social security number, date of birth, and your employment history. It may also show whether you’ve been sued or have filed for bankruptcy.
Your credit report contains information about how much debt you have, how much total credit you have available to you, and the regularity with which you have made payments to your creditors in the past. Your credit report also includes information about how often you have applied for credit and even how often you have requested to check the details of your own credit report.
Your creditors routinely provide information about you to privately held companies that compile this type of information called credit bureaus. The credit bureaus then sell your credit report to businesses that use this information to evaluate your future applications for credit. Some people wonder who gave your creditors permission to record information about you and to share it with the credit bureaus…well, you did! Each time you signed an application for credit—whether it was a credit card, a loan, your mortgage, or even the overdraft protection at your bank, you gave your permission for your creditors and the credit bureaus to collect and make available to others information about the loan and about your patterns of repayment. It’s all in the fine print.
Many people think that making the minimum payments on their debts is all they need to do in order to have A-1 credit. However, it’s not at all that simple.
Debt to Income Ratio
The total amount of credit that has already been made available to you by lenders in relation to your household income is known as your debt to income ratio. The higher your presumed debt is in relation to your income, the less likely you will be offered additional credit. It is important to note that, when it comes to evaluating your credit worthiness, it doesn’t really matter whether you are using all or just part of the credit that has already been extended to you. For instance, even if you have only charged $1000 on a credit card that has granted you a credit line of $20,000, you may still be considered “over-extended” by another lender examining your credit worthiness. Potential new creditors protect their risk by assuming that should you suddenly decide to use all the credit currently available to you, (in this example, the remaining $19,000) you might not be able to make payments to them on a new loan amount. That’s why it is important to send letters to your creditors officially closing all lines of credit you do not use. In addition to lowering your debt to income ratio, keeping these credit lines open can only bring you temptation and trouble in the future.
So, stop thinking of these old cards like dear old friends that you cannot part with.
A Final Note…
Remember, obtaining credit for any purpose is a risky proposition. Lenders like to promote the old notion that being “granted” credit can create a heightened sense of personal self-worth and feeling of accomplishment. In truth, being granted credit creates profit for them and debt for you.
Your creditors like to caution that if you misuse your credit, you will lose it! The fact is, once you understand the credit business a little better, you may not wish to use the credit they offer you in the first place!
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