Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, oneill@aesop.rutgers.edu
Credit is the use of borrowed money for a price, called interest. Other expenses, such as fees for late payments, may also be charged. The use of credit creates debt, which is the outstanding balance owed to lenders. Debt repayment is a major expense for many families. Some people spend a day’s pay (or more) per week repaying car loans, credit cards, and other debts. Not only is this expensive, but the money spent on debt payments is unavailable to save or invest. Below are 20 tips for smart borrowing:
Planning Strategies
¨ Borrow as little as possible by making the largest downpayment you can afford (e.g., to buy a car). When car payments end, continue making the previous monthly payment to yourself to build up a downpayment for your next car. A large downpayment can also keep you from being “upside down” on a car loan (i.e., where you owe more than the car is worth).
¨ Shop for credit, just like other purchases. Compare at least three credit issuers (e.g., banks) for the lowest annual percentage rate (APR) and fees.
¨ Separate borrowing decisions from purchasing decisions. In other words, don’t just accept the financing arrangement offered by a merchant (e.g., car dealer or furniture store). Shop around for the best terms (e.g., through a bank or an employment-based credit union).
¨ Apply for a secured credit card if you are having difficulty establishing credit. A secured card is backed by money deposited with the lender, often $500 to $1,000. The account serves as security for the card. If you don’t repay what you owe, the money in your account can be taken. A list of secured card issuers can be found on the Web site www.cardweb.com.
¨ Avoid borrowing money from finance companies. Apply at a bank or credit union first. Finance companies generally charge high interest rates and can be considered a negative reference in credit reports, thus lowering your credit score. This is because potential lenders often view borrowing from a finance company as an indication that you couldn’t get a loan elsewhere due to prior problems.
¨ Negotiate an interest rate discount from lenders. Many credit card issuers will reduce annual fees and/or interest rates upon request. Before calling, role-play your request with a friend to sharpen your negotiating skills. If you have other credit cards or pre-approved offers, hint that you will close your account or switch to another card issuer unless your request is honored.
¨ Read credit card disclosure charts and footnotes carefully. By law, all credit cards must include a so-called “Schumer Box” (named for the sponsor of the legislation) that includes the annual percentage rate (APR), various fees, the balance calculation method, and the minimum finance charge.
Credit Use
¨ Say no to credit life or disability insurance if you already have adequate individual or group policies. If you don’t currently have life or disability insurance, and need it, shop around for more affordable coverage that is not linked to debt repayment.
¨ Limit credit card cash advances. The interest rate is high because most creditors charge interest from the date money is borrowed (i.e., there is no grace period), along with transaction fees (e.g., $2.50 per advance). In addition, many creditors charge a higher APR on cash advances than they do for regular purchases.
¨ Transfer balances on high-rate credit cards to those with low six-month “teaser rates.” Aim to pay off the balance before the low rate expires or seek another low-rate card.
¨ Carry a list of credit card billing cycle dates with you when you shop. This will help you select the card that provides the longest “float” time between the date of purchase and the date that the credit card payment is due.
¨ Select a credit card that best matches your debt repayment style. If you generally make minimum or partial payments, look for a credit card with a low interest rate. If you pay your bill in full, seek a grace period and no (or a low) annual fee. Information about credit card fees and interest rates is available from the Federal Reserve Web site http://www.federalreserve.gov/creditcard/.
¨ Complain if you get hit with an unjustified penalty (e.g., late fee). Many creditors will reverse these charges upon request, at least for the first time, if you are a customer in good standing.
Debt Repayment
¨ Always pay more than the minimum monthly payment. Otherwise, it could take years, even decades to repay a loan. Even small amounts added to minimum payments produce awesome savings. For example, send 6% of a $5,000 outstanding balance on an 18% APR credit card, instead of 3%, and you’ll save 9 years of payments and $2,975 in interest.
¨ Pay credit card bills promptly to reduce the average daily balance on which interest is charged. The sooner you make a payment, the lower the average daily balance will be.
¨ Design your own debt repayment schedule by paying more than the minimum amount required. For example, repay a home equity loan over 3 to 5 years, not a bank’s 15 to 20 year schedule. Another example is a “do-it-yourself” bi-weekly mortgage. Simply divide your mortgage payment (principal and interest) by 12 and add that amount to each monthly payment. This has the same effect as a bi-weekly mortgage (i.e., 13 payments per year).
¨ To accelerate the repayment of existing debt balances, visit www.powerpay.org and enter the names of creditors and the APR, outstanding balance, and monthly payment on each debt. PowerPay will print out a debt repayment calculator that adds the monthly payments from paid off debts to the balance due on remaining debts. Following a PowerPay calendar can result in hundreds, even thousands, of dollars of savings on interest.
Assessing Your Credit Status
¨ Request a copy of your credit file. Under federal law, consumers are entitled to receive one free copy of their credit file once a year from each of the major credit bureaus: Experian, Equifax, and Trans Union. See www.annualcreditreport.com for details.
¨ Obtain your credit score. Credit scores are three digit numbers that range from 300 (worst) through 850 (best). They are used by lenders to assess a person’s creditworthiness and to determine the interest rates charged for a loan or credit card. Credit scores are available online for a fee from www.equifax.com and www.myfico.com but may be free as part of a credit check for a loan application.
¨ Calculate your debt-to-income ratio by dividing the total monthly payment for household debts into net (after-tax) household income. For example, a family with a $250 car payment and $100 of monthly credit card payments and a $2,500 net income would have a debt-to-income ratio of .14 ($350 divided by $2,500) or 14 %. Financial experts generally recommend a debt-to-income ratio of no more than 15% to 20%. Above that, it is easy to become overextended and experience difficulty making payments. It is also recommended that consumer debt, plus housing costs (e.g., rent or mortgage payment), not exceed 40% to 50% of take-home pay.
