Good Debt / Bad Debt: The Top Inappropriate Use of Credit

August 25th, 2010

Much has been said about the good debt versus bad debt, and the latest report from the Federal Reserve speaks volumes into how often people are misusing credit. According to the report, Americans owed a whopping $2,418 billion in debt in June.

With this much debt riding on their shoulders, how can Americans earn a great credit score? Worse yet, how can we be expected to invest in our futures if we have a huge amount of debt to carry?

By learning to distinguish good debt from bad debt, Americans can turn their bad credit into good credit, and make wise investments in their future.

Over the next seven weeks, I will take a look at three of the top inappropriate uses of credit, as well as the four questions a person must ask to determine whether something is good debt or bad debt.

Good Debt / Bad Debt, Inappropriate Use of Credit #1: Using Debt to Finance Debt

The first rule of carrying good debt instead of bad debt is this: Unless you have a budget that proves a loan or credit card will indeed help solve your financial despairs, never take out a loan to dig yourself out of debt.

Using a loan to solve a financial problem can be a smart move, if you have the budget to prove it. But if you are just reacting to your financial stress by applying for more loans and credit cards, you are carrying bad debt. In fact, if you cannot prove that the loan will improve your financial situation, getting a loan to pay debt is the single worst use of debt out there.

How will the loan help you dig yourself out of debt? When will you break even? What do the numbers prove? How will this loan reduce your overall debt? Unless you can answer these questions, never apply for a loan as a method of solving financial problems.

Using a business loan to increase cash flow is wise. Another example of good debt would be applying for a lower-interest loan to consolidate your credit card debt.

But you must run the numbers, or you risk complicating your financial situation. Without proof that the loan or credit card solves your financial problems, you are simply postponing a financial breakdown, which will be far worse if you add more debt. Always base your financial decisions on substance rather than on emotions. If you are scared for your future and take out a loan as a reaction to this fear, but you have no idea how this loan will provide a permanent solution, you are taking on bad debt. Why bother? The loan is nothing but a band-aid that will eventually fall off to expose wound that has been made deeper.

There’s no two ways around it: If you are in debt, you need to either make more money or spend less money. Building more debt to dig yourself out of debt? In the good debt / bad debt debate, this one is a no-brainer!

Be sure to join us next week for the second part of the good debt / bad debt series. And while you are at it, learn how to improve your credit score by attending our free teleseminar.

Tags: credit score, debt

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Part II: What does a credit score mean?

August 18th, 2010

In “Part I: What does a credit score mean?” we took a look at the meaning of credit scores in being approved for a loan and in obtaining the best interest rates.

“Part II: What does a credit score mean?” looks at:

What a credit score means in your job hunt.
What a credit score means for your insurance premiums.
What a credit score means in your search for a rental unit.

What does a credit score mean when searching for a job?

More than half of employers run credit checks on potential job candidates at least some of the time. This means that you must learn how to improve your credit score if you are one of the millions of unemployed Americans, particularly if you are applying for jobs that require you to handle money.

A potential employer considers a person’s credit score an indication of how reliable they are. And if the job requires you to handle money, a low credit score could also mean that you are financially strapped and might be tempted to skim a little money from the register. Whether you are a financial advisor or local hardware store cashier, a low credit score means that you might be less employable.

If you have a mediocre or bad credit, be sure to read my post about credit scores and jobs so that you can learn strategies for combating this problem.

What does a credit score mean for your automobile insurance premiums?

In some states, a low credit score will increase your auto insurance premiums! Auto insurers have found a correlation between a person’s credit score and the number of accidents in which they are involved, so the lower your score, the higher your premium.

What does a credit score mean for your rental application?

Landlords almost always run a person’s credit score before approving a rental application. The last thing a landlord wants to do is evict a tenant, a time-consuming and costly process. If your score is too low, you might have a problem finding a lease to sign. Be sure to read my article about renting and credit checks.

What does a credit score mean? A high credit score means that you are more employable, pay lower insurance premiums, and have more housing opportunities. A low credit score means you should learn how to improve your credit score!

Tags: credit score

Part I: What does a credit score mean?

August 10th, 2010

I spend a lot of time talking about the importance of building a good credit score, but a lot of people want to know: What does a credit score mean?

In this blog post, I’m going to answer that question, taking a look at two factors:

What does a credit score mean to a lender?
What does a credit score mean in terms of monthly payments?

What does a credit score mean to a lender?

A credit score is designed to give creditors an answer to one question: “What is the likelihood that this borrower will be more than three months late on a payment within the next two years?”

A credit score generally ranges from 300 to 850. A borrower with an 850 credit score (a rarity) is considered the least likely to default on payments while a borrower with a 300 credit score is considered the most likely to default.

A credit score above 720 is considered wonderful. These borrowers will qualify for the best loans and interest rates. Anything below 660 is considered weak credit, and anything below 620 is considered bad credit. A borrower with a score below 620 is considered “subprime,” which tells the lender that the borrower is highly likely to default.

A person’s credit score is the single most important factor in determining whether lenders will approve your credit card application, mortgage loan, and car loan. Generally speaking, lenders look at four things when determining your creditworthiness:

Your credit score.
Your salary.
Your savings.
Your down payment (for a home or car loan).

A person with a high credit score and a modest salary would be much more likely to receive a loan than a person with a modest credit score and a high salary.

What does a credit score mean in terms of monthly payments?

We always say that on a $300,000 30-year, fixed-rate home loan, the difference between a 720 credit score and a 620 credit score is $589 a month, or $212,040 over the life of the 30-year loan. Though this statistic is certainly an accurate representation of the difference a great credit score makes, the truth is that interest rates change daily. During the peak of the credit crisis, a person with a 719 credit score (normally considered a great score!) didn’t even qualify for credit.

The interest rates on a loan are updated daily in tandem with the Federal Reserve’s adjustments. As well, different types of loans call for different interest rates.

According to MyFICO.com’s August 2 listing of interest rates, a person with the best credit score would pay $753 a month on a three-year $25,000 car loan; a person with a 620 credit score would pay $919, a difference of $166 a month or almost $6,000 over the life of the loan.

As you can see, if you want to qualify for a loan and receive the lowest payments, you should learn how to improve your credit score.

And next week, we will take a look at several other reasons to build credit in Part II: What does a credit score mean?

Tags: credit score

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Should I Add a Consumer Statement to My Credit Report?

August 2nd, 2010

The Fair Credit Reporting Act allows a person to add a 100-word consumer statement to their credit report. Often, people use the consumer statement as a chance to explain a derogatory mark or a bad credit score.

The consumer statement does not change a person’s credit score; it simply gives the consumer a voice. The statement, which can be 100 words or shorter, can be used to dispute a mistake:

The Visa credit card account ending in 1234 does not belong to me, and I am currently in the process of disputing this with the credit card company and credit bureaus.

The statement can be used after bankruptcy to explain that a person’s bad credit was caused by a medical condition:

You will a bankruptcy on my report from January 2007. I was the victim of a hit-and-run car accident and was unable to work for eighteen months. As a result, I fell behind on my payments and declared bankruptcy.

Some say the consumer statement will hurt a person. After all, it draws the lender’s attention to derogatory information. Others say the consumer statement is pointless as it most often unread.

Still, consumer statements do have their uses. If you are trying to rent a home, the landlord might read the explanation. If you know a potential employer is running your credit score, you can be upfront—let them know about any mishaps, and direct them to the consumer statement.

How to write a consumer statement:

A consumer statement should always be short and to the point. Never place blame on someone else (unless you are a victim of identity theft). If you decide to write a consumer statement:

Do not complain or present yourself as a victim (unless you truly are a victim of identity theft)
Take responsibility
Do not blame anyone or anything
Do not justify what happened
Keep in 100 words or less

Let’s take a look at two examples:

An effective consumer statement:

I experienced bankruptcy because I naively expected the value of my home to go up. Instead, the payments grew and became unmanageable, so I began charging them to credit cards. Have since gone back to the basics and am working on building my credit and my savings. Also taking classes in financial management.

An ineffective consumer statement:

The bankruptcy is NOT my fault. I was sold a home that I couldn’t afford, and while the agent earned his commission, I lost my home, racked up huge credit card debt, and was stuck with poor credit! As far as I’m concerned, the mortgage broker should go to jail!

Do you see the difference? The first consumer statement makes the borrower seem responsible and mature. The second might sound entitled, immature, and irresponsible!

Tags: credit report

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