Credit – The Great (misunderstood and misused) Financial Shock Absorber
The first thing to say is: Credit is not bad. Credit is a marvel of civilization. Credit Cards are good, useful tools. But just as with most tools, it can be misused. Credit, and credit cards in particular, are primarily misused because they are misunderstood.
There once was a time when the order of things was “Every man for himself!” You raised your own food, made your own clothes and tools, and otherwise lived on your own resources. When everything was going right, you were very comfortable. When the crops did well, you prospered. When conditions declined, you suffered. When the crops failed, you starved. If the failure was bad enough, you and your family died. In many areas of the world, this way of life still exists. But in the United States today, we don’t have famines. Not even in the worst drought.
So what changed? We started cooperating. Instead of everyone having to raise their own food, we split the duties as a civilization and some concentrated on raising food for everyone and the others began concentrating on something else that would benefit someone else. A single man might be able to dig enough ore and smelt it to make an iron plow, but it would be impossible for a single man to take the raw materials needed and make an automobile. It takes even more cooperation to make something as complicated as a computer chip, let alone a complete computer.
But cooperating brings its own challenges. It’s easy enough to say “I’ll trade you this shirt I have for 2 bushels of grain”. But if I have a car you want, how many bushels of grain is it worth? And what would I do with all that grain? Money solved that problem.
And money gave us another opportunity to cooperate. When I have a little more money than I need at the moment, I can say “I’ll share this extra money I have with you so that you can do something that you couldn’t otherwise accomplish if you will share some of the extra you end up with.” Banks and Credit Unions are the institution where that process has become formalized. The person “borrowing” the money is said to have “Credit”. The “interest” you pay is what is shared with the person who deposited the money as a reward for sharing.
The money you put in a bank doesn’t simply lay there until you need it. Most Americans are familiar with the movie “It’s a Wonderful Life” starring James Stewart. A critical scene in the movie involves what is called a “run on the bank”. Everyone in town is trying to crowd into the bank to get their money out because of a rumor circulating that the bank is failing and their money might not be secure. James Stewart’s character ends the bank run by explaining how a bank works and appealing to their spirit of cooperation: “The money you deposited isn’t here- it’s in his home, and her home, and your home!”
Now, let’s get back to that idea of sometimes things are good, sometimes things are even better and, unfortunately, sometimes things are worse. Banks and Credit Unions are your primary partners in evening things out. They allow you to share your extra resources in the form of savings and give you a share of the increase in the form of interest. They allow you to share in someone else’s extra resources in the form of credit and you then return the favor with the other side of interest. Savings and credit then become the primary springs and shock absorbers for evening out the bumps from the ups and downs of life.
Most people are familiar with the springs and shock absorbers on a car at least to the extent that they make the ride in the car more comfortable. But how do they work? Without getting into a whole lot of physics, it can be boiled down to this: Both springs and shock absorbers take the energy from a sharp jolt to the tires and release it over a period of time so that the energy is not consciously recognized by the passengers. The springs are the first line of defense and the shocks are the second line of defense. If you have ever ridden in a car with bad shocks on a rough road, you can appreciate the work good shock absorbers are doing for you. Savings are the first line of financial defense, and Credit is the second line of defense. Keeping both healthy and active will make the ride on the road of life a lot more enjoyable.
Say that one day you got a rip in the clothes that you wear to work. If you are watching your money, you plan on buying some new clothes from time to time, but this is an unusual, unplanned expense. You simply use a little savings to buy some new clothes: a small financial bump easily handled by your savings.
But suppose you don’t have time to run to the bank to withdraw the money for the clothes and you don’t normally keep a lot of cash on hand. (Keeping a lot of cash on hand is definitely NOT recommended!) You might use a credit card to buy the clothes you need and then you can more conveniently use your savings to pay the credit card bill when it comes. This is an acceptable and even a responsible way to utilize your credit.
Now, let’s consider something a little more significant: having a roof over your head is one of the most basic necessities. But few of us have the savings to buy even a modest home with cash. Now, that is a BIG jolt to our financial ride. Credit (in the form of a mortgage) is the solution, as mentioned above in “It’s a Wonderful Life”. And the monthly payments over a 30 or so year period is the slow release of financial pressure. This is not only the most prominent feature of most peoples.
Ok, everyone has heard “Save, Save, Save” until it has gotten easy to tune out on the tired old refrain. We all intend to save more, but it only gets lost when “I want” turns into “I need”. So, when the good times end, and the bad times begin there are no savings to fall back on. And then people will turn to the remaining safety buffer: credit. Unfortunately, when savings are neglected, credit is usually also abused.
When a car hits a bump so hard that both the springs and shock absorbers are overwhelmed, we say that the car has “bottomed out”. People who have been in that kind of situation use expressions like “It just about shook my teeth out!” The proper care and maintenance of savings and credit can keep your financial world from “bottoming out”.
Proper care and maintenance of your financial shock absorbers
Rule: Make a game plan for financial emergencies. How are you going to handle your payments on existing debt? How are you going to handle the new debt? How are you going to handle large emergencies, like accidents? (Insurance will only handle so much.) How are you going to handle the loss of income? Could you survive financially if you were to be unemployed for a year or two? Not only can the economy at large get in trouble so that the unemployment rate rises, severe medical problems and accidents can also cause the loss of income (and then add insult by adding medical and legal costs). Think about very short term situations (before the next paycheck). Short term situations (in the next year). Near term situations (the next 1 to 5 years). Long term situations (10 years up). Extreme long term situations (retirement). Are you ready?
Rule: Always save a specific amount of money from every paycheck. How much? That depends on you. It is complex enough to be the subject for another article. However, if you want a quick, simplistic answer, most experts agree that you should save no less than 10% to 15% out of every paycheck. At the very least, every expert agrees that you should save something, no matter how little unless you are in emergency mode.
Rule: Never use debit cards that are attached to your checking account. At the time of this writing, there are no legal protections for debit cards. There are many state and federal protections on credit cards. The banks will protest loudly that they will support you if there is a problem, but the fact is, the information you need to gather,, the things you need to do and the rest of the hoops you have to jump through make it unlikely in the extreme that you will be able to get to the point that the banks can actually be of any help at all. The only real defense you have with debit cards is to use a prepaid debit card that is not attached to anything else. I hear horror stories about debit cards all the time – satisfactory solutions seem to be in the single digit percentages.
Rule: Always check every transaction on every statement you receive as soon as you receive it. Identity theft is one of the fastest growing, and certainly one of the most devastating crimes of our times. Follow the common sense rules you hear all the time to protect your identity and there is still a chance it will hit you. The most important thing you can do is catch it as quickly as you can. Don’t put off checking your statements until a more convenient time; make it a high priority in your life. The quicker you bring the problems to you institution, the better your chances are that they will be able to set things right – let things stack up and you may get stuck. A Money Manager can make reconciling not only your checkbook, but your credit card accounts so easy that you will actually do it!
Rule: Always know how and when you are going to pay off any debt you incur. Consumer protection laws require that this be spelled out in detail for standard mortgages, auto loans, signature loans, etc., but revolving credit lines (credit cards), by their very nature, are open ended (in other words, the balance changes constantly). If you use a credit card, don’t hand it over until you know exactly when you are going to pay that specific transaction. If you have an outstanding debt, set a time period (the shorter the better) to pay it off just as if it were a conventional loan.
Rule: Anything purchased with credit is going to cost you more. Interest adds up a lot quicker than most people realize. Things bought with a credit card because “it’s on sale!” or “it’s a really good buy” or “I really, really want it” and paid over time can cost you a lot more than it would have if you hadn’t bought it on sale and paid cash. Exception to the rule: Some credit cards have a “grace period” where no interest is charged. If you can pay the item off in the grace period, you really did get a good deal.
Rule: Keep your interest as low as possible. Pay off any debts you have as quickly as possible. Everything you pay out in interest means that you get to buy just that much less of what you want. That is so important that it bears repeating: Everything you pay out in interest means that you get to buy just that much less of what you want. Consumer protection laws require that the end of the year, lending institutions tell you exactly how much you paid in interest that year. When you get those statements, look at each one and ask yourself “what could I have bought with what I paid in interest?” Then add them all up and ask yourself the same question again. If things were really bad, get those numbers out and look at them every time you pay your bills. Hopefully, it will help you start putting the brakes on some of the less necessary charges.
Rule: Never pay the minimum requirement on credit cards. This is where interest will hurt you the most. Some situations exist where paying the minimum balance will mean that the total you paid for an item will be up to 10 times the original price because of the extra interest. Remember, the credit card companies are out to make a profit.
Rule: Always pay a little extra on loan payments. Something as simple as rounding off a mortgage payment can have dramatic results. I used to teach professional computer seminars for adults. The last exercise of any spreadsheet class I taught was always a loan amortization table. It was fun to watch people’s expressions as we explored the possibilities of different situations. For example, a $100,000 mortgage (small, I know, but a nice round number) for 30 years at 8.5% interest will require a payment in the range of $769 a month. If you were to make a single payment of $100 on the sixth month of the loan, you will save over $1,100 in total interest! If you were to simply round the payment off to $775, the small extra payment of $6 each month on that same loan will save nearly $7,900 and pay the mortgage off over a full year early! Would you even notice a difference of $6 a month? You would certainly notice $7,900!
Rule: Pay the lowest interest rate possible. Credit cards are notorious for having the highest legal interest rate available. If you have large credit card balances, contact several of the financial institutions you deal with and compare their debt consolidation loans. Not only will this reduce your interest rate, it will require you to commit to a specific completion date.
Rule: Get a credit card that matches your buying habits. As a generalization, cards that don’t have an annual fee have a very high interest rate, and cards that have an annual fee have a lower interest rate. Some cards require an immediate payment when you receive the bill, most will allow you to make just a minimum payment each month. Some start charging interest as soon as they receive the transaction from the vendor, some have a “grace” period during which you are not charged any interest if they receive your payment by the payment due date. In actual practice, various cards will fit somewhere in between the extremes. Look for cards that give you that interest free “grace” period. Balance your needs for a yearly payment amount with the annual fee. If you always pay your credit card balances in full, get a card with no annual fee; if you carry a balance forward every month, get a card that has a very low interest rate. In other words, identify your credit card habits (another good reason to use The Money Manager Software) and look around until you find a card that fits you.
Rule: If you get a “debt consolidation” loan, don’t spend more just because your monthly payments have gone down. Remember, your goal should be to protect your credit shock absorber by reducing your debt load, not increase your spending. If you do have a little extra each month, put part of it in savings and use the rest to pay off one of your debts quicker.
Rule: Too many credit cards are bad for your credit rating. The credit ratings given by the major reporting agencies determine how easy it is to get a loan and how much interest you will be charged when you are granted a loan. All of them will penalize you if you have too many credit cards – even if you have a zero balance for all of them!
Rule: Track your credit card purchases as you track your checkbook. Always knowing just how much you have already spent this month and how far “in the hole” you are will be a big help in reducing the “I want it” crave. The Money Manager can really help you here!
Rule: Watch your total debt each and every month. It isn’t hard to keep an eye on an individual bill, but it is usually the combination of all your debts that will get you in the most trouble. This is where A Money Manager really shines. Its whole purpose is to bring together all the different aspects of your finances in one easy to use place.
Rule: Determine how much financial risk your current debt puts you in. How much debt is too much debt? This question is too personal to have a concrete answer. Ask 100 different financial councilors and expect to get 103 different answers! “The less debt the better” is a little too trite to be truly useful and is unrealistic for those of us with a mortgage and families. Consider how difficult it would be to make your loan payments if you were to get in trouble. Contact several of the financial institutions that you deal with and ask what levels of debt load they use when considering loan applications. (But remember, it is their best interests to grant loans – you may want to be a little more conservative.) You may be surprised at how much trouble you are already in without realizing it.
Rule: Above all, and most importantly: When dealing with credit, use restraint, self-control, and common sense!