1. Managing Debt and Credit

Credit was once defined as “Man’s Confidence in Man.” But in fact, the definition of credit today is more like “Man’s Confidence in Himself.” Using credit today means you have confidence in your future ability to pay that debt. Forty years ago, your parents may have paid cash for their homes and their cars, a largely unheard-of event today. If they borrowed money at all, chances are it was from a relative or friend, and not a financial institution.

Today debt and instant credit are part of our everyday lives. The convenience of instant credit, however, has taken its toll. Many individuals use credit cards to spend more than they earn, and a few of these people actually build themselves a debt prison from which some never emerge. On the other hand, those who never use credit can be denied a loan or credit when they have a justifiable need or use for it. Using credit establishes a history of financial responsibility: Until you establish a credit history, your chances of qualifying for an important loan, such as a mortgage, are greatly reduced.

What is the balance between using credit wisely and staying out of overwhelming debt? Let’s look at the facts and some pros and cons.

2. Installment Debt

Debt comes in many forms, and most types help us in our daily lives — when used responsibly. Most people cannot buy a home without some financial help, and many cannot buy a car (especially a new one) without some sort of financing. The money borrowed to purchase large-ticket items is called installment debt: The debtor pays a portion of the total at regular intervals over a specified period of time. At the end of that time period, the loan with interest is paid off.

Installment debt allows you to purchase items at a competitive interest rate: for example, 5% to 7% for a 30-year home mortgage and 8% or 9% for a car loan. The loan is paid back on an amortizing schedule, monthly payments of a fixed amount that remain constant over the life of the loan. At first, most of the monthly payment consists of interest. In later years, principal begins to be paid down.

3. Revolving Credit

A revolving line of credit, also called “open-ended credit,” is made available to you for use at any time. Examples of revolving credit are credit cards such as Visa, Mastercard, and department store cards. When you apply for one of these cards, you receive a credit limit based on your credit payment history and income. When you use the credit line, you must make monthly minimum payments based on the total balance outstanding that month. Some lines of credit will also have an annual account fee.

While revolving credit is a convenient way to borrow, it can also become an endless pit of minimum payments that barely cover the interest due. Many cards charge annual rates of interest of 18% or higher. As you pay off your debt, the minimum payment is also reduced, thus extending your payoff period and, consequently, the interest you pay. Paying just the minimum due on a $2,000 credit card loan could mean making monthly interest payments for 10 or more years!

Revolving credit, in addition to being convenient, eliminates the need to carry a lot of cash and can help establish you as a creditworthy risk for future loans. The itemized monthly statements also can help you track your expenses. But some people can easily yield to the temptation that the convenience of credit cards offers. Impulse buying, failing to compare costs, and purchasing large items you can’t afford are all downfalls brought on by always available purchasing power. Spending more than you earn in any given period is a dangerous practice at best, but doing it over an extended period of time can be financial suicide.

Installment debt is easily budgeted and the debt is eliminated on a predetermined date. Even for those who may actually have the cash to purchase the desired item, installment debt can make financial sense if you can earn a higher return (after taxes) on your investment of cash than you must pay on your installment debt.

4. Using Credit Wisely

To use credit intelligently, start by examining the terms of the card(s) you are currently using. Keeping track of your cards, their rates, and your current balances will help you to be aware of how you use credit cards. Increased competition in recent years has led some credit card companies to offer enticing features to attract new cardholders, including no annual fees and low interest rates for an introductory period. (And credit card companies sometimes will give their introductory rates to existing cardholders so that they won’t transfer their balances to another credit card company.)

5. Eliminating Credit Card Debt

If you think you may have too much credit card debt, begin to address it by honestly evaluating your spending habits. Examine your existing expenses to analyze how your money is spent. You will most likely be able to identify the problem areas where you are more likely to spend too much or too readily with credit cards. Then, based on your current spending practices, create a realistic budget to pay off your credit card debt in the shortest time possible while not adding any more debt to it. For assistance, you may want to turn to your financial advisor, who can help you to allocate your resources wisely to address your credit card debt.

6. The Role of Debt

Today, carrying installment debt is almost a fact of life. Mortgages, car loans, or small-business loans (to name a few) are part of almost everyone’s life. On the other hand, carrying credit card debt is usually not a good idea. At interest rates of 16% and up, it’s hard to justify keeping savings that could pay off that 18% department-store credit card in the bank at 2%.

Debt and credit play increasingly important roles in our lives. As the aging Baby Boomers get closer to their peak earning years, many are realizing the need to reduce debt and increase savings. Even though analyzing your spending habits and creating a budget to address your debt may seem a little overwhelming, the simplicity of the philosophy of the Depression era still stands: Never spend more than you earn. Once you have come to grips with this basic fact, managing your debt will become far easier and more rewarding.

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1. How to Dig Yourself Out of Debt and Save

You’re living paycheck to paycheck and it’s causing a lot of stress. Bills and credit card payments are eating up most of your income. You know you need to rid yourself of debt and save some cash — a cushion of three to six months’ living expenses to use in case of emergency. And you’d like to begin investing on a regular basis to build some financial security.

But how can you get ahead with the bills you already have, not to mention the unexpected ones that seem to crop up automatically whenever you have a little extra cash? Chances are, you find it difficult to do anything because you don’t know where to start.

Relax. A lot of people are in your situation. What you need to do is face up to the matters at hand and set up a plan of action. The time to do that is right now. With a little self-discipline and some faith in yourself, your financial picture can potentially change for the better in about six months.

2. Paying Debt and Saving

What should you do first? Reduce your debt or start saving? The following three-part strategy may help you control your cash flow, pay off your debt, and encourage saving so you can handle the unexpected expenses that may have gotten you into debt in the first place. In time, you’ll be ready to invest. But first you have to know what you owe and what you’re spending.

3. Tracking Spending

The steps outlined in the box below will help you determine how much cash you have to pay off your debt.

Next, you’ll want to keep track of your typical expenses for one month or so, to find out where your money is going. Also figure your unexpected expenses for a year’s time — auto and home repairs, gifts, vacations, etc. — and divide that number by 12. You may want to use one of the personal finance software programs available to track your spending. Once you have a record of your spending, compare your monthly outlay to your monthly income. If you have a surplus, this is the amount you can apply each month to paying down debt and building savings. If you have a shortfall, you’ll need to cut expenses.

4. How to Build Savings

A key to establishing good saving habits is to make saving even easier than spending. Here are some tips.

• Ask your bank about linking your savings and checking accounts via an ATM card. Set up three savings accounts with goals attached to them. One may be labeled “cushion” for emergency cash, a second for “expenses” for unexpected bills, and a third for “investments.” Carry your card only when you really need it to make transactions, and withdraw only what you need for one week. Then you won’t be tempted to take out cash for impulse purchases.
• Whenever you’re paid, put only what you need to live on for one month (or two weeks, if you get paid every two weeks) into your checking account. (If you put more into checking, you’ll probably spend it.)
• If you can, put money equalling one month’s expenses into your expenses account for unexpected bills. The idea is to build at least a small stash so you’re less likely to use your credit card if your car needs a new tire.
• Begin building your emergency cushion by depositing a portion of each paycheck into your “cushion” savings account. If your goal is to have three months’ living expenses, you could reach your goal in 30 months by saving 10% of each month’s pay or in 15 months by saving 20%.
• Put whatever is left into your “investments” account, including found money such as birthday and holiday checks, bonuses, or money made from a garage sale. If you get a raise, put the difference into this account on a regular basis.
• If your bank can’t link your checking and savings accounts, or if you find it hard to control your spending when access to your savings is easy, ask your employer about direct deposit. You can have money taken from your paycheck and placed in a savings account automatically.

5. How to Reduce Debt

Paying off debt is easier once you stop using your cards.

• Pay off your highest interest credit card debt first, making sure you avoid the “minimum balance trap.” Because credit card companies make their money from interest payments, they purposely set those payments low so it will take you years to pay off the balance. Paying just a little more than the minimum can make a big difference.
• For example, assume you have a balance of $5,000 at an interest rate of 15% and you make the minimum monthly payments of 2.5% of the balance or $25, whichever is greater. It would take you 183 months to pay off the debt and cost you $4,395 in interest. However, if you were to pay an extra $150 each month, you would pay only $845 in interest over 27 months. This is a hypothetical example for illustrative purposes only.
• Consolidate your debt by transferring outstanding balances to lower-rate cards. These days, the competition between credit card issuers is so intense that you can often negotiate your interest rate. If you don’t want to transfer your balances, chances are that your current credit card company will match the interest rate of a competitor. Just be aware that some of the low rates available these days are “teaser rates,” which only apply during the first 6 to 12 months you have the card.
• Cancel your old cards so you won’t be tempted to use them again. The most you need is two. And leave them at home unless you really need them.
• Set up a realistic payment timetable and stick with it. If you need to readjust your timetable, do so. If you have trouble, talk to a professional. The counselors at the nonprofit National Foundation for Credit Counseling can develop a more structured plan for you, if needed. To find their nearest location, call 1-800-388-2227, or log on to www.nfcc.org.

6. Put Time on Your Side

You may not be able to solve your debt problem overnight, but you can solve it over time. Not only will a combined debt reduction and saving strategy begin to lighten the load now, it will help you feel better about your future.

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