Being in debt is often an unavoidable situation. There are a lot of things you cannot accomplish in life without getting into debt like getting an education, buying a house, going into business, or if you are in dire financial straits, surviving for the next day. Before you get into debt, here are some things you need to know:
- There are good debts and bad debts. Some good debts can turn out to be bad.
You take good debt when the debt adds value to your life, and when the benefit for the use of the debt is long-term or permanent. Examples of the use of good debt are for college education, a home that builds equity and enhances your family’s life, or a car that you need to reach your place of work effectively and on time. You also use good debt to seize an opportunity that would otherwise pass you by.
You take bad debt to buy stuff that make your life enjoyable, but add nothing in the long term. These stuff are typically those that you consume, lose value, and go out of style. Although there is nothing wrong with buying things that you enjoy in the short term, you should not finance them with debt.
Good debt can also turn out bad when the stuff you incurred the debt for turns out to have far less value. Money you spent on college education is wasted if the course you took has no job demand. A home debt can also turn out bad if the home you bought is overvalued.
Action: Before taking that debt, evaluate if it is good or bad. For your financial health, only take the good debt.
- The interest rate of your loan is affected by your credit score.
- Generally speaking, in budgeting your income, aim to eradicate your debt.
- In some situations, you are better off maintaining your debt.
- Being in debt affects your credit score.
- Take only loans for which you can afford monthly payments.
Good debt can sink you as easily as bad debt – if you cannot afford it!
This is where budgeting your income will prove useful as your budget will show you what you can and can’t afford. Budgeting shows you what you have to forego in order to make that monthly payment affordable.
Action: Before you take that loan, do your budget and see if you can afford it.
- Always shop for the best deals for the credit you need.
- When you have multiple debts, pay off the one with the highest interest first.
- Paying off your debt is not always a good idea.
- Not being able to pay your debt has terrible consequences.
- Your last resort for saving yourself from not being able to pay debt is bankruptcy.
- If you are drowning in debt, get help as soon as you need it.
Your credit score is what your prospective lender uses to learn about your history of borrowing and paying back credit. Three credit bureaus: Equifax, Experian and TransUnion compile these information into a credit report. Fair Isaacs Corporation or FICO take the information from your three credit scores, apply a FICO formula, and distill the 3 credit scores into one – with scores ranging from 300 to 850.
A high credit score, between 760 to 850, means you have a very good history of borrowing and paying back your debt. You can expect mortgage, auto and other lenders to offer you lower interest rates and more loan choices.
A median credit score of 620 to 550 makes you a “subprime” borrower, and you can expect a higher interest and less loan choices from lenders.
You can hardly get a mortgage if your FICO score is low, at 500 – 520.
A 100 difference in FICO score can spell a big difference on the amount of loan interest you pay throughout its life. On a $300,000 home loan, it could mean a $40,000 extra payment over 30 years.
Action: Make sure you have a high credit score by borrowing and paying promptly what you owe before you apply for that big mortgage.
Debt costs money in the form of interest. This is money that you can use for your other present needs or for investing.
Debt can make your life insecure, making you fearful about losing your job. If you become unemployed and are unable to pay your debt, you risk losing your house and other properties.
Debt can make your debt-to-income ratio too high to qualify for a much needed loan.
Debt can also give rise to many emotional problems like having relationship problems with your spouse, and being afraid of opening mail and answering phone calls from creditors. It can also give rise to health problems caused by stress.
To save money and for peace of mind, it is generally best to eradicate your debt.
Action: In budgeting your income, consider eradicating your debt as a goal. Adopt a frugal lifestyle. See these money saving tips that can help you live frugally.
The best situation is, of course, to be debt-free, but when the use of your debt is returning more than the interest you pay for the debt, then it is best to just maintain the debt. When you are looking at an investment opportunity, look at its rate of return and compare it with the interest rate of your debt. For example, if you have a choice between paying off a car loan that has a 6% interest or putting your money in an investment that pays 8%, it is better to have the debt.
You have to consider though the tax implications of your investment. Also, home mortgage payments are usually tax deductible, so our effective interest rate is actually lower.
Action: Before paying off your debt, find out if there are better uses for your money.
Your outstanding debt accounts for 30% of your credit score. Credit account payment history is the most important factor, at 35%. The length of time of your having a credit is 15% (the longer the better), the number of new accounts opened is 10%. A mix of other factors account for the other 10%: mortgages, credit cards, auto loans, etc.
Action: Do not get into so much debt such that if affects your credit score.
A credit, like any product, is being offered by many companies competing with each other, and you can take advantage of this fact to get the best deal. Do not get trapped into signing up with the first mortgage company you find. Sometimes, the same lender offers different prices to different customers with the same loan qualifications because they are giving their officers and brokers extra compensation for getting your business. You can negotiate this extra cost.
Shop around before you commit. Shopping, comparing and negotiating can save you thousands of dollars. Along with the interest, look at all cost information and fees.
Do the same thing with credit cards. Use the internet to compare annual fees, interest rates, and rewards. Consider the hidden costs and other “fine print”. For example, some credit cards may only remain to be “no fee” if you spend a certain minimum amount on it.
Action: Always research and compare before signing up for a credit or mortgage.
Credit cards have by far the highest interest among debts, and you should look at paying them first. Mortgages are usually cheap, which becomes cheaper because of the tax deduction, so make this less of a priority. You may pay the no-interest debts from your friends or relatives last – if that will not affect your relationship with them.
Action: Pay your debt according to the size of the interest they incur, except in rare situations.
If you have debt that is cheap and flexible, it makes more sense to pay the minimum due to this debt and put the money to better use. For example, you can build up your emergency savings which enables you to meet emergencies without taking more expensive loans.
Action: See if you have a cheap and flexible debt, and decide if it is better to pay it off or use the money in smarter ways.
If you have several thousand dollars of debt, your lender will sell your account to a collection agency who will start hounding you at home and work.
Your lender will give you a negative report with the credit reporting agencies, resulting in denied credit by other lenders.
You probably will lose your home or other properties if you have substantial debt that you cannot pay. You may get a letter from an attorney informing you that you are being sued. When they get a judgment, any real property you own can have a lien put on it. They will sell your property, and the amount of lien has to be paid off before you get any money from the sale.
Action: Manage your debt before it gets out of control.
You need to hire a bankruptcy lawyer who knows bankruptcy laws to do this successfully.
When you file for bankruptcy, the courts halt all collections activities against you until your case is resolved. However, bankruptcy will not eliminate some debts like tax debts, student loans, child support or alimony and criminal fines.
Although bankruptcy can give you a fresh start, it comes with a big price. It stays in your credit report for 10 years, and during those years, hardly anybody will be willing to give you a loan – this means no credit cards, no apartment rentals, no cellphone nor anything that requires a credit check. Some employers even make a credit check to gauge your sense of responsibility before they decide to employ you.
Action: Avoid bankruptcy.
Seek help through reputable debt counseling services that may be able to consolidate your debt. On the internet, you can go to The Association for Financial Counseling and Planning Education or The National Foundation for Credit Conseling
Avoid scammy “credit repair” services that may even make your credit problems worse.
Action: None if you are financially responsible and budget your income to manage your debt.
