Many financial planners approach debt like it is Lord Voldemort, the evil dark lord who must not be mentioned. However, debt can be a powerful financial tool if it is used to build credit instead of used to bind you under financial burdens. If you are disciplined and understand how your credit score works, you can leverage your purchasing power to fund your financial goals. In this post, we will discuss some important steps to approach debt in your financial plan.
Don’t be afraid of credit
I often recommend establishing a good credit history as soon as you start earning income. I learned the importance of credit history after I got married and my wife and I tried to purchase our first car together. We went through the process of picking out the perfect car and then when we were introduced to the finance manager, he showed us a monthly payment that was much more than we were expecting. We were told that we didn’t have enough credit history for a good interest rate. We both argued that we paid our bills on time, however when they explained our credit report to us, it was mostly made up of retail store cards with small purchases and a few student loans that were still in deferment. We didn’t have any significant credit to establish a payment history.
We are often taught as students to avoid debt. The result is that we can enter the real world with inexperience and a fear of how the system works. Starting early with using credit and paying off your debt balances monthly will help you build discipline and start a long track record of good credit history.
Start with knowing your Credit Score
At the start of any financial plan, there are two important metrics that we have to understand to measure your financial health. The first is your net worth, and the second is your credit score. Your credit score is a rating that helps lenders determine how much risk they are taking on when giving you a loan. It is typically the bottom line of how they judge you and will determine whether you are going to get good loan terms or poor loan terms. It is extremely important to 1) know your credit score and 2) maintain a high credit score.
Many financial institutions now offer a free monthly credit score. I recommend checking with your bank or credit card to see if they will provide you with your free score. Once you know your score, you can go to work on maintaining it.
Your score is calculated by information collected by the 3 major rating agencies, Experian, TransUnion and Equifax. The information is compiled, and a formula is applied to determine a score. Here are the important factors that affect your score:
Payment history (35%)
Amount owed vs. your credit limit (30%): Higher available credit/low balances are good
New credit recently applied for (10%): Lots of credit applications are negative
Length of credit history (15%)
Credit Mix (10%)
Now that you know what makes up your score. Here is how your score is ranked by lenders:
300 – 669: Poor to not good. If you score is in this range, then you need to go to work on making improvements.
670 – 739: Ok credit. This isn’t going to get you the best rates, but you are doing well.
740 – 799: These are great scores. Nice work!
800+: You are the best around!
Know your limit
Typically, the best way to maintain good credit is to know your limit. Debt becomes a burden when you have taken on more than you can handle. Since credit is often easily accessible for a lot of people, it is difficult to stay disciplined and practice delayed gratification. You can prepare yourself to say no by planning ahead and knowing how much debt you can afford. This begins with knowing your debt to income ratio.
Your debt to income ratio is simply the total amount of monthly debt payments divided by your monthly gross income. An industry rule of thumb is that you should keep your DTI ratio below 43%. This is the ratio that mortgage lenders use to determine how much mortgage you can qualify for. However, I recommend keeping your debt to income ratio lower than this. You should strive to not exceed 35% of your gross income with debt payments if possible. This way at least 65% of your income can be applied to your current spending needs.
Know interest rates
If you are planning on taking out a loan, it is extremely important to know what a good deal is. Make sure to do your homework to research where interest rates are for the types of loans that you are seeking. You should feel confident to ask questions about what interest rates a lender can offer and how discounts can be obtained. If you know your credit score going in, you should be able to negotiate a good rate with confidence. Don’t be afraid to shop around until you find the rate that you want.
Walk away from high interest rates. No matter how bad you want the loan, you shouldn’t sign up for a bad deal. If you know current rates and you are not within that range, you need to wait until you can qualify for a good rate.
Plan the end from the beginning
Debt only becomes a burden if you don’t have a plan. You should know exactly why you are taking on a loan and how long it will take you to pay it off. You should know exactly how much room you have in your monthly cash flow for the payment and think of any circumstances that may prevent you from making a payment during the loan period. If you feel doubt, then don’t go through with it. You should feel like you are in control when you take on debt and make the educated decision to leverage your cash flow to buy the items that you need.
Bonus:
If you are working to establish your credit history, I recommend using one credit card that has a good reward system. Often cards offered by credit unions provide a low rate compared to most retail cards. Use the card to buy your lifestyle expenses and pay the balance off each month.