This article will increase your financial literacy by explaining how to use credit and when to avoid getting yourself deeper into debt.
You’ll also get tips to help you build a high credit score, get out of debt more quickly, and execute a mortgage refinancing strategy that saves the average homeowner $100,000.
Understanding how credit and debt work means that you never have to end up buried in debt or stressed about upcoming payments.
We walk you through a healthy approach to credit and debt in the article below.
Here’s what you’ll learn:
- Borrowing Money: Is It Good Or Bad?
- What Is Credit?
- What Is Debt?
- What Is Good Debt Versus Bad Debt?
- How To Use Credit To Your Advantage
- Why Credit And Credit Scores Matter
- What Is A Credit Score?
- Why You Should Build A High Credit Score
- How To Build A Good Credit Score
- How To Improve A Bad Credit ScoreHow To Use Credit Cards Responsibly
- How To Use Credit Cards Responsibly
- How To Get Out Of Debt More Quickly
What Is Credit?
Credit means that someone extends goods, services, or cash, based on an agreement that the buyer will pay for it in the future.
Credit comes in several forms, including credit cards and loans.
In most cases, it costs money to get something using credit (although some credit cards allow you to avoid fees when you pay your balance within 30 days).
For example, if you take out a five-year bank loan for $20,000 at a fixed 5% interest rate, it will cost you $2,645.48 in interest.
How we pay for the interest and fees often misleads us into thinking that credit isn’t expensive.
On the loan mentioned above, you get $20,000 cash when you take out the loan, then repay it by making sixty payments of $377.42 each.
The $2,645.48 in interest is worked into your monthly payments, making it easy to forget that you’re paying any interest at all.
Even when you make payments on time, loans are expensive.
However, the problems with credit aren’t just the high expense of your interest payments.
When people make late payments on loans or credit cards, they incur additional fees that grow quickly over time.
Yet, 39% of Americans don’t even have $1,000 in emergency savings, so their credit card and loan payments get derailed at the slightest financial emergency.
Many times, when people encounter a financial crisis (such as car repairs or medical expenses), they use credit cards to pay for things they can’t afford. They often look at a purchase price and think “It will only cost $20 a month — we easily can afford that!”
But purchases add up over time, and making minimum payments on credit cards becomes outlandishly expensive due to growing interest.
Like loans, there are also significant fees added to your bill if you are late on any credit card payments.
Ironically, the people who can’t afford to purchase something without a credit card are at the highest risk of missing payments — and owing more than what they intended to.
Credit, when used improperly, makes broke people even more broke.
However, when used by financially literate, disciplined people, credit can be a tool that enhances your financial health and lifestyle.
What Is Debt?
Debt is something (usually money) that you owe to a person or business. It’s typically incurred by using credit cards or taking out loans.
When you use credit the wrong way, you can build up debt that eats into your income for years, even for a lifetime.
If you ignore your debts and allow them to build up over time, you can easily find yourself living paycheck to paycheck, working long hours only to hand your paycheck over to debt collectors.
Allowing debt to build up can eventually compromise your quality of life in ways you may not even imagine.
Your credit score reflects your history of debt repayment, and if you don’t pay your bills on time, you’ll get penalized with a lower credit score.
Carrying a low credit score means you may have difficulty (or find it impossible) to buy a home or even rent a simple apartment. Your insurance rates can rise, utility companies may require advance deposits, and buying a new car may become impossible.
Not all debt is bad.
When it comes to debt, people often go to one extreme or the other. Some people bury themselves in it, while others avoid it altogether.
Taking on too much debt or bad debt can lead to losing your wealth or going bankrupt.
However, avoiding debt altogether isn’t the best choice, either, since it can prevent you from reaching your full financial potential.
There is such a thing as “good debt” and “bad debt,” and the key to responsibly managing personal finances is understanding where that balance lies.
Credit and debt get a bad rap because they’re commonly misused in the U.S., where more than half of all credit card users only make the minimum required payments each month. This costs them a significant amount of fees and ensures that they’ll remain dragged down by debt for years.
There are better, more productive ways to use credit. Debt doesn’t have to weigh you down if you know how to manage it.
Credit can be used to your advantage if you understand how they work.
How can you tell the difference between good debt and bad debt?
Good debt increases your wealth or enhances your quality of life in a way that’s significant but not extravagant.
What Is Good Debt?
Good debt helps you earn more money or significantly enhance your quality of life.
For example, student loans, mortgage loans, business loans, real estate loans, and even credit cards can be considered good debt under the right circumstances.
- Student loans can dramatically increase your earning potential if you pursue an education that leads to a profitable career.However, student loans can also end up being the worst kind of debt imaginable. For example, if you miss payments or need to adjust your monthly payments to fit a lower salary, then the fees, fines, and interest can end up costing more than the loan itself.If you use student loans to pay for an education that lands you in a high-paying job, that’s good debt. In this case, you can pay off your student loans on time, or early, and enjoy life without constantly allocating your income toward loan payments.
If you use student loans to pay for an over-generalized education that doesn’t land you in a high-paying job, or if you don’t complete your education, student loans can turn into bad debt of the worst kind.
Student loans are notoriously difficult, if not impossible, to pay off if you make any type of payment arrangements, such as payments determined by your level of income, payments delayed or paused for any reason, or late payments.To ensure that your student loan is “good” debt, ask yourself whether you’ll make enough money, right out of college, to make double payments.Paying off your student loans quickly (and earlier than required) is the key to making sure that your education is good debt, and that the payments don’t drag out until your own kids are in college.
- Mortgage loans can significantly increase the quality of your life, while often holding equity. Mortgage loans are good debt when you are financially prepared to buy a home, can make a downpayment of at least 20%, and end up with monthly payments no greater than 25% of your income.
- Credit cards that offer cash back rewards, discounts, and perks can be good debt if you use them responsibly. For example:
- Personal or business cashback credit cards pay you money every time you use them.If you’re spending $3,000 a month on expenses, and you use your credit card to pay for everything, earning 1.5% cashback means an extra $45 a month in your pocket. That’s $540 of passive income each year, just by using the card! When you own a business and pay your business expenses with a cashback credit card, the free money can really add up. For example, if you use a 1.5% cashback credit card to pay for $35,000 in business expenses each month, you get $525 monthly – $6,300 a year – dropped into your bank account for free.Cashback credit cards are an excellent way to generate income without having to put in any of your time. All you need to do to earn money with cashback credit cards is use them to pay for your expenses and purchases, then pay your balance in full at the end of every month.
- Travel credit cards can provide sweet perks such as special airport lounges, free food, free hotel upgrades, rental car upgrades, and even free vacation packages.
Rewards aren’t the only way credit cards can enhance your life. With most credit cards, you also enjoy a few additional perks such as:
- All your transactions recorded for you, often categorized for tax purposes
- Fraud protection
- Purchase protection
- Sometimes, product insurance (if you break it, they replace it) on your purchases
Credit cards, when used wisely and responsibly, can easily fall into the category of “good debt,” since your money becomes more valuable when you use them.
However, if you use credit cards to purchase things you can’t afford to buy, then they turn into bad debt machines.Using credit cards to pay for things you can already afford to pay for in cash (then paying your balance in full at the end of every month) helps to strengthen your credit rating and earn some extra cash and other rewards along the way.Always read the terms of your credit cards carefully, avoiding high-interest cards or ones that charge monthly fees when no balance is carried.
- Business loans that help your company grow and earn more money are “good debt,” since they can turn your money into more money.
- Real estate loans for investment properties may be good debt, although you should work hard to also put a large cash downpayment (or find investors) on your first property, instead of fully funding it through a loan.Owning real estate investment properties (rentals) can provide a passive income every month, helping your money to earn more money — with barely any labor on your part.To ensure that your real estate loan is “good debt,” make sure that you’re financially prepared and that you’re well-educated on how real estate investing works.
The quality of any type of credit lies in the amount of interest you pay.
Any high-interest debt is a bad choice when rates are not competitive or when the economy drives a surge in credit prices.
Always compare prices when it comes to loans and credit cards, and look for credit with low interest rates through lenders that do not charge early payment penalties.
What Is Bad Debt?
Bad debt drains your wallet, prevents you from building wealth, and can make your riches disappear shockingly fast.
High-interest credit cards, car loans, personal loans, payday loans, and any type of credit that’s used for living expenses luxuries is bad debt.
Student loans and home mortgage loans can quickly become bad debt if you borrow the money without a solid plan on how to repay them.
- Student loans can become the worst type of debt if you can’t afford payments or if you have to adjust your monthly payments to a lower salary.Americans owe more than $1.5 trillion in student loan debt, according to Nitrocolleg. Despite the fact that a federal student loan should take ten years to pay back, most four-year degree holders take nearly twenty years to pay off their student loans.With one-quarter of Americans owing an average of $393 per month in student loans, it’s no wonder 125 million U.S. adults, including 70% of millennials, live paycheck-to-paycheck.More than half of people who owe federal student loan debt are currently in default, and 8% of them haven’t made a payment in at least nine months.The problem with student loans, in addition to the risk of whether or not you’ll get decent-paying work after graduation, is that you can end up owing more than what you borrowed if you don’t make full payments on time every time.Using credit, such as student loans, to pay for a college degree that doesn’t get you a job in which your income outweighs your payments and living expenses– is bad debt.
- Car loans are almost always bad debt. The high-interest rates, high payments, and declining value make them a risky credit choice.
However, if the car loan will earn you more money (for example if you work at a high-profile job that demands a nice car), then it may fall into the “good debt” category, provided you get a low-interest loan with payments that you can easily afford.
In most cases, it’s smarter to purchase a used car with cash than to take out an auto loan that’s going to eat into your paycheck for years to come (as the car rapidly depreciates in value).
- High-interest credit cards can destroy your finances for years, especially if you use them to buy things you can’t afford, such as:
- Rent or utilities
- Eating out
- Financial emergencies that should be covered by your savings
Many people use credit cards to buy things they can’t afford or to act as their emergency fund in place of a real savings account. This is a high-risk and very expensive way to use credit cards.
Using your credit card to pay for consumer goods is bad debt because there is no monetary return on those purchases.
If you can’t afford to buy something with cash, then you probably can’t afford the credit card payments either.
Anything you buy and pay for with monthly credit card payments is more expensive since you have to add the cost of interest to its original price.
On top of the interest costs, buying things you can’t afford with credit cards quickly becomes a habit that can easily destroy your financial well-being.
Before long, you’re looking at hundreds, if not thousands, of dollars in credit card payments due at the end of every month.
Not only do the credit card payments devour your paycheck, but if you miss a single payment, then you’re facing fees and fines that make it much more difficult to pay off AND you’ve harmed your credit rating for years to come.
Payday Loans are always bad debtPayday loans typically charge between $10 – $30 for every $100 that you borrow, and are due within a week or two, depending on your terms. In addition:
- If you need to extend the loan by a week or two, you may pay an additional “rollover” fee.”
- If you don’t pay on time, you’ll be subject to a late fee.
- If you don’t pay on time, the lender will probably send the charge through to your bank anyway, and you’ll pay two NSF fees: one to your bank and one to the lender.
For example, if you take out a $300 payday loan and pay it back in two weeks, it might cost you about $370.However, the average amount of time it takes to pay back a payday loan is five months.If you pay the loan back in five months, like most people, you can end up dishing out $1,000 for that $300 loan.
Payday loans are illegal in many states, while other states regulate them or have pending legislation to curb the harm they cause to borrowers.
- Auto loans are almost always bad debt because cars immediately lose their value. Unless you absolutely must own a newer car for business reasons, the auto loan won’t earn you any money.
Bad debt is using credit to pay for things that don’t provide a solid return on your investment.
Bad debt serves no good purpose and doesn’t increase your wealth or significantly improve your quality of life.
Accumulating bad debt can put you in a vicious financial cycle that’s hard to break free from.
To build lasting wealth, you need to avoid bad debt, even if it means selling your car or valuables, picking up a part-time job, or downsizing your lifestyle to keep up financially.
In the long run, you can always replace your things or sacrifice luxuries much easier than you can undo the long-term effects of bad debt.
How Much Debt Should You Have?
To maintain a healthy financial scenario, we recommend keeping yourdebt-to-income ratio at 33% or lower.
Your debt-to-income ratio (DTI) is a figure that shows how much debt you carry compared to how much income you earn.
In many cases, your DTI is considered by credit rating companies and lenders to determine your creditworthiness, with lower DTI scores being ideal.
For example, to qualify for a mortgage loan, many lenders prefer a DTI score of less than 36%, although some grant mortgage loans to people with a DTI of 43% or lower.
Front-end DTIs reflect only how much you pay for housing costs; mortgage, taxes, and insurance.
Back-end DTIs are formulated using all of your debt payments, including housing plus:
- Credit cards
- Car loans
- Student loans
- All other types of debt
How To Calculate Your Debt-to-income Ratio
You can calculate your own debt-to-income ratio by dividing your total monthly debt by your total gross monthly income.
For example, if your total monthly debt, including credit card payments, mortgage or rent, homeowners insurance/taxes, and student loans equals $2,000, and you earn $4,000 per month:
Total monthly debt: $4,000
Total monthly income: $8,000
Calculate $4,000 ÷ $8,000 = .5
Turn your answer into a percentage (multiply by 100) = DTI 50%
With a 50% DTI, you can easily recognize that you owe too much money compared to what you earn.
To build and retain wealth, keep your debt-to-income ratio at 33% or lower, and avoiding using credit for things you can’t afford.
As with money in general, credit is a tool that enhances who you are.
If you’re responsible and ambitious, and lean toward long-term goals, credit can enhance your ability to achieve goals and build wealth.
To ensure that you avoid getting buried in debt and always use credit to your advantage, keep the following in mind:
- If you have to use a credit card to purchase something, you can’t afford it.
- If you have to take out a loan to buy something, you can’t afford it.
- If you need financing to make a purchase, you can’t afford it.
Home mortgages, business loans, and student loans may be an exception to these rules since they can be used to help you make more money. Keep in mind, though, that you want to go into these types of loans with caution, making sure that you can afford the payments while still keeping a healthy emergency savings account intact.
Remember that lines of credit from your bank and credit card limits are not part of your spending money, not even in emergencies.
Credit can give you serious long-term financial advantages if you pay your debts on time, every time, and pay your credit card bills in full at the end of every month.
Why Credit Matters
Credit is a healthy part of financial planning and security when used properly.
Managing credit properly by paying your debts off on time (or early), earns you more credit along the way. As you make on-time payments and prove that you’re trustworthy with money, credit agencies take note and raise your credit score.
Today’s economy requires a solid credit rating for much more than purchases and loans.
You’ll have a difficult time meeting basic needs if your credit score is poor since you typically need a good credit rating to enjoy basic things such as:
- Getting a job
- Renting an apartment
- Purchasing a cell phone plan
Additionally, when you’re ready to take out loans that can benefit your future, such as a mortgage or business loan, you’ll save a fortune on interest rates if you have a good credit rating.
For example, a high credit score might mean you get a 3.5% interest rate instead of 4.5% on a 30-year fixed mortgage loan.
If you buy a $300,000 home and qualify for the lower, 3.5% interest rate mentioned above (instead of 4.5%), you would save about $173 per month — or $62,252 over the lifetime of your mortgage!
Good credit paves the way for a lifetime of opportunities, so it’s essential to understand how to use it to your advantage.
What Is A Credit Score?
A credit score is a measurement of how trustworthy banks believe you are with money.
Credit scores are based on your history of borrowing and repaying things such as loans and credit cards.
FICO, which was created by the Fair Isaac Corporation, is the standard credit score system.
FICO gathers data from your credit reports to calculate a 3-digit number that rates your trustworthiness with money.
FICO scores are used by bankers to approve or deny credit, by landlords to determine whether to rent to you, by insurance agents to help determine your rates and even by employers who rely on them to shed insight on your character.
What Does Your Credit Score Mean?
FICO uses the following guidelines to assign you a credit score:
- 800 – 850 Exceptional
- 740 – 799 Very Good
- 670 – 739 Good
- 580 – 669 Fair
- 300 – 579 Very Poor
To give you perspective on how your FICO score affects your ability to gain access to credit, here’s what scores you need to obtain some of the most common types of credit:
- Mortgage loan with the best interest rate: at least 740
- Auto loan: 700
- Personal loan: 600
- Low-interest credit card with perks: 750
The higher your FICO score, the easier it becomes to get affordable credit for the important things in life such as a home or business loan.
That’s because lenders can use your credit score to determine how likely you are to pay back the money that you borrow, based on what you’ve done in the past.
If your credit score is exceptional, creditors may be willing to give you a lower interest rate & more money, because you are seen as less of a risk.
However, if your score is very poor, lenders may view you as too risky. And, if you are able to secure a loan, you’ll be stuck with higher interest rates, which means you’ll pay more money over time, for no reason other than your low score.
To check your credit score for free, you can visit your credit card issuer’s site and check out the credit score section. Or visit a site that allows you to view your credit scores for free, such as Experian.
How FICO Credit Scores Are Calculated
FICO determines your credit score using information from credit reports.
FICO looks at the following details to compile credit scores:
- 35% of your score: Your payment history
- 30% of your score: How much credit you’re currently using (total amount owed)
- 15% of your score: Length of your credit history:
- 10% of your score: New credit (whether you've opened several new accounts within a short period of time)
- 10% of your score: Your credit mix (whether you’re successfully managing different types of credit over a period of time.
According to FICO, there are several factors that do not have an effect on your credit score, including:
- Age, race, color, religion, national origin, sex, or marital status.
- Any public assistance you receive
- Employment history or details such as your salary or occupation
- Child support
- Requests you make to check on your own credit report
- Promotional inquiries made by lenders, such as pre-approved credit offers
- Inquiries from employers
Paying your bills on time is the #1 best way to earn a good credit score, since half of your FICO rating is based on the payments you make to creditors.
Why You Should Build A High Credit Score
Your credit score determines how much, if any, credit you’re allowed to use.
People with high credit scores are able to borrow larger amounts of money, which comes in helpful for bigger purchases such as a home or business loan.
When you have a good credit score, you’re more likely to get approved for larger amounts of money or higher-quality credit, such as:
- Better credit cards that offer bigger perks and higher cashback percentages
- Home loans that can help you purchase a house for your family to live and grow in
- Student loans that can help you get an education and increase your income for a lifetime
- Business loans can help you start a company that employs other people, and grant you the opportunity to build a physical and financial legacy that you pass on to your children
Your credit score also determines the interest rates on future loans, which translates to a significant amount of money when making larger purchases.
For example, if you take out a mortgage loan on a $300,000 home, a good credit score might help you secure an interest rate of 3.5% instead of 4.5%.
The one percent difference in interest rates would save you $62,252 over the lifetime of your mortgage — more than $170 per month.
Building and maintaining a high credit score is important to your financial future because it grants you the ability to borrow more money for larger purchases and reduces the amount of interest you pay in the future.
How To Build Credit From Scratch
If you’re new to using credit and don’t yet have a visible credit score, here are a few tips to help you get started.
- Secured credit cards can be an excellent way to build credit from scratch. Secured credit cards require you to put down a security deposit equal to the amount of your credit line. They give you the opportunity to build credit because your use of them is reported to major credit agencies.If you use your secured card regularly and pay off your entire balance at the end of every month, you can begin building a better credit rating rather quickly.Secured cards are an excellent way for you to build a credit history, provided you
- Don’t use your credit card to buy anything that you can’t afford to purchase with cash.
- Pay off your balance at the end of every month.
There’s a risk in using secured credit cards, though.
Interest rates on secured cards can be extremely high — up to 25% — unless you pay your balance in full at the end of every month.
If you pay the entire balance in full at the end of every month, instead of making monthly payments, you can usually avoid the high interest rates and fees. Be sure to check with the lender on their policies/interest/fees before applying for a card.
When you use credit cards to purchase things you can already afford to pay cash for and pay the balance in full at the end of each month, it helps you to build an excellent credit rating and avoid going into debt.
- Credit builder loans are a type of loan that considers your income instead of credit history, making them a good way to build a credit rating from scratch.With a credit builder loan, you pay off the loan before you receive the money, and your payments are reported to credit score agencies.Just keep in mind that you won’t get any of the loan money until the entire loan is paid in full.To find out more about or apply for a credit builder loan, visit your local community bank.
- Passbook loans (also called “secured personal loans”) use the money in your savings account as collateral on your loan. The lender freezes your funds until the loan is paid back, but your money does continue to earn interest while it’s frozen.Passbook loans usually charge low interest rates and are offered by smaller banks, such as a local or community bank.Not all lenders report passbook loan payments to credit bureaus. A passbook loan will only help your credit rating if your bank reports your payments to credit bureaus.Check with your local community bank if you’re interested in a passbook loan, and be sure to let them know that you’re trying to improve your credit score, so credit bureau reporting is critical to choosing a lender.
- Get credit for paying your bills on time. You can get credit for on-time bill payments through programs such asExperian Boost, Rental Karma, and eCredible. These credit-boosting programs can help you build good credit without having to borrow any money, since you get credit for paying your regular monthly bills, such as:
If you typically pay for rent, utilities, phone, and Netflix, getting credit for paying them might be an excellent way to build a good credit score. Keep in mind, though, that if your payments are late, it can backfire and harm your credit rating even more.
If you’re building credit from scratch or trying to repair a severely damaged credit score, consider a secured card, credit builder loan, passbook loan, or bill-pay reporting program.
Are You Ready To Begin Building Your Credit?
Before you get started building credit, we recommend that you have your personal finances in order.
All lenders report bad credit activity, including late or missed payments. If you take out secured credit cards or loans before you’re ready, you will do your credit rating more harm than good.
How do you know if you’re ready?
If all your debts are paid and your emergency savings account is in place, plus you can live on 75% of what you earn, and you’re prepared to make responsible, on-time payments, you may be financially ready to apply for credit.
Also, before you apply for credit, consider whether you are ready to use credit to your advantage rather than using it to pay for living expenses or luxuries.
How Long Does It Take To Build Credit From Scratch?
It usually takes about 3 – 6 months of regular credit activity before you get a credit score.
Keep in mind that with all of the suggestions above, if you fall behind on payments you could end up with negative reports that can hurt your credit score.
If you are willing to handle your money responsibly and use discipline with your spending, it may be time to begin building a credit score.
If you’re still learning to live within your means and pay your bills on time, though, don’t attempt to build credit until your financial habits are in order.
How To Improve A Bad Credit Score
It takes time to repair a poor credit score, but there are several things you can do to speed up the process.
1. Improve your payment history.
Bringing your past due accounts up to date and then paying every bill on time, every time will help improve your credit rating.
Payment history accounts for 35% of your credit score, which is why establishing a solid history of on-time payments is critical to your credit rating.
2. Pay off your outstanding debt.
Instead of making minimum monthly payments on your current debt, pick up some extra work or cut your living expenses (or both) so that you can pay it off quickly.
3. Lower your overall debt.
The amount of credit you use, compared to what your credit cards allow you to use, accounts for 30% of your FICO score.
Lowering the debt you carry on your credit cards can have a significant positive impact on your credit score.
To improve your credit score, cut back on your credit card debt so that it falls between 7 – 30% of the credit lines available to you.
4. Use credit consistently over the long term.
The length of your credit history accounts for 15% of your credit score.
The longer you’ve been using credit, and paying it off on time, the higher your credit score rises.
If your credit is poor, the first step to improving it is by changing the financial habits that got you here.
To improve your credit score, pay off your outstanding debt, make all your payments on time, reduce the amount of credit card debt you carry and use credit responsibly and consistently over time.
How To Get Credit
Find out what to expect when applying for a loan or credit card.
How To Get A Loan
When it's time to get a loan, whether for business or personal reasons, how do you know where to start?
In this section, we explain the standard types of loans available, share tips for choosing a lender, and list what you need to qualify for a loan.
Type Of Loans
You’ll find countless options for loans when you need one, but there are nine basic loan types that can improve your financial future and help you build wealth. Most loans are some variation of one of the following types of loans.
- Mortgage loans are loans you use to buy or refinance a home.
- Student loans are loans used to pay for higher education, typically at a college, university, trade or technical school.
- Business loans are loans used to start or upgrade a business.
- Real estate loans are used to purchase property, usually for real estate investing purposes.
- Refinancing and consolidation loans pay for outstanding debt such as mortgage, student loans, and credit card debt. These types of loans can help lower the interest on outstanding debt so that monthly payments are lower and debt gets paid off quicker.
- Personal loans (secured and unsecured) are used for miscellaneous reasons, usually when your needs don’t fall under any other type of loan. For example, people take out personal loans for things such as weddings, home renovations, medical bills, emergencies, debt consolidation, and moving costs. Personal loans are almost always bad debt, since they are a way to finance things you can’t afford. Unsecured personal loans are granted based on credit requirements and credit history. Secured personal loans require you to offer some types of collateral such as your car.
- Auto loans finance the purchase of a car. Auto loans are almost always bad debt since the car loses its value the minute it drives off of the lot. When lenders promote auto financing for anyone — even people with bad credit — they are typically financing extremely high-interest, expensive loans that you should avoid at all costs.
- Equity loans are given to homeowners willing to use their home as collateral in exchange for a cash loan. Equity loans are risky (and never good debt) because your home could be taken away if you don’t pay it back as promised.
- Title loans allow car owners to borrow a relatively small amount of money for a short period of time (usually 30 days). Title loans are risky, and always fall under the “bad debt” category because they are expensive (high interest rates) and require the borrower to hand over their car’s title until the money is paid back. If the money isn’t paid back on time, the car gets repossessed.
- Payday loans are expensive short-term loans that are typically due by the next payday. Payday loans are always bad debt, since the interest and fees are almost certain to bury the borrower in unmanageable debt.
- Credit card advances allow people to get quick, short-term cash using their credit card, but the interest and fees are high, and build up quickly. Credit card cash advance is bad debt if you use it to purchase something you can’t afford, since these types of loans only work for people who can afford to pay them back almost immediately.
Whatever you need, there’s almost always a lender willing to “help” you with a loan tailored to your situation. However, very few types of loans fall under “good debt.” Many loans, such as payday loans, add such high interest and fees that they’re nearly impossible to pay back if yo’re already broke.
If you’re living paycheck to paycheck, or often running short on cash, taking out a loan is always a bad idea because loans make broke people broker.
If your finances are healthy and you want to grow your income or expand your assets, a loan may be worth considering.
How To Choose The Best Loan
When shopping for loans, there are few things to look for that can help you avoid regrets down the road:
- Find the lowest possible interest rate.
- Find the lowest possible processing fees.
- Make sure there are no prepayment penalties, so you can pay it off earlier to lower the overall cost of your loan.
- Choose a reputable lender you can trust so that the paperwork goes smoothly and there aren’t any mistakes made when recording on-time payments.
- Make sure you can afford the loan payments so you don’t risk accumulating massive interest and fees that can bury you in debt.
Ideally, your loans should fall under the category of “good debt,” meaning the money will help you earn more money or significantly impact the quality of your life.
Additionally, try not to consider a loan unless you’re already living on less than 75% of what you earn.
3 Things You Need To Get A Loan
- Your numbers. Think carefully about how much money you need and how easily you can afford to make loan payments. If you know these numbers in advance, you’ll be less likely to borrow more than what you can afford or get persuaded by lenders encouraging you to borrow more. Remember, lenders make money when you borrow from them, so it’s in their best interest to encourage you to borrow more and more of it.
- Documentation, including the loan application, proof of ID, income verification, employer verification (if applicable), and proof of address.
- Qualifying credit score: More than 90% of lending decisions are based on your FICO credit score, and most lenders require a rating of 670 (“good”) or higher to qualify for a loan. Keep in mind that the higher credit scores mean lower interest rates on loans. In many cases, it’s worth taking time to improve your credit score before applying for a loan.
How To Choose A Credit Card
Credit cards are an excellent way to improve your credit and earn rewards, perks, and cash for buying things you normally buy anyway.
If you never used credit cards to purchase things you can’t afford, and always pay the balance in full at the end of each month, credit cards can be a significant asset to your financial health.
When it’s time to choose a credit card, select the one(s) that’s best for your situation and provides the highest rewards:
- Personal credit cards: If you normally spend $3,000 a month on household expenses, you can use a cashback credit card to pay for them and earn some extra money without having to work for it.For example, if you find a card that offers 1.5% cashback, you’ll earn $45 per month ($540 per year) just for using your credit card.When choosing a personal credit card, look for one that offers the highest cashback rates and no interest if you pay the balance in full each month. Be sure to read the fine print to learn whether the lender charges significant annual fees, and avoid cards whose fees cancel out your cashback earnings!
- Business credit cards help business people, especially freelancers and self-employed workers, keep track of their business expenses.When choosing a business credit card, look for one with the highest cash back perks, which can provide you with a nice stream of income if your business is spending tens of thousands of dollars each month.
- Travel credit cards can turn a simple vacation into a luxury experience, thanks to some of the perks they provide. By using a travel credit card, you can get exclusive access to airport lounges (with free food and comfy seating), free hotel upgrades, rental car upgrades, and even free vacation packages.When choosing a travel credit card, look for the ones with the best perks that you’re most likely to take advantage of.
When you’re responsible with credit cards, they can provide you many fantastic perks plus some extra cash in your bank account.
How To Get A Credit Card
Applying for a credit card is pretty simple and requires only two things:
- Your personal information on the application.
- A qualifying credit score.
In most cases, the credit card application will request that you fill in your:
- Date of birth
- Social security number
- Annual income
Credit card companies don’t typically ask to verify your employment or any other information on your application. Instead, they check your credit rating to determine whether you qualify.
In most cases, you’ll need at least a good credit rating to qualify for a credit card. However, certain programs and secured credits cards allow applicants to qualify, regardless of low credit scores.
If your credit score is too low to qualify for a standard credit card, we recommend paying off your debt and improving your credit score before applying for a credit card.
Better credit scores qualify you for lower-interest cards with better perks, so it’s worth taking five or six months to repair and improve your credit before applying.
When you choose the right credit cards and use them wisely, they can improve the quality of your life by providing you with passive income and fantastic travel perks.
Here’s how to use credit cards responsibly:
- Don’t use credit cards to purchase things you can’t pay for in cash. Credit cards shouldn’t be used to buy things you can’t afford.
- Pay off your entire credit card balance at the end of the month — every month. Not only is this the responsible way to manage credit card debt, but it also helps you avoid paying interest on your credit cards.
- Choose credit cards that offer the best cashback rewards or travel perks, depending on your priorities. To earn the most cash, use your cash back credit card to make all of your purchases, including rent or mortgage and utility payments, if possible.
- Keep an emergency savings account in place at all times so that you’re never tempted to use your credit cards to buy things you can’t afford.
You may have heard that credit cards destroy people’s lives, but that’s not the truth. Poor spending habits are what can destroy people’s lives.
However, if you manage credit cards responsibly, they become a financial tool that provides you with outstanding benefits and perks.
Debit Card Versus Credit Card: What’s The Difference?
Debit cards and credit cards are alike in several ways:
- Both can be used to make online and offline purchases.
- Both are issued by major credit card companies such as Visa or Mastercard, and have the credit card logo imprinted on the front.
- Both provide some form of fraud protection, both online and off (ask your bank for details since fraud protection may vary).
The difference between credit and debit is that debit cards directly withdraw the money from your bank but credit cards bill you for the amount due.
Debit cards do not provide the option of breaking your purchases into smaller monthly payments the way that credit cards do.
Most debit cards don’t offer the same perks and rewards as credit cards, although some, such as Paypal Business Debit Mastercard and Discover Cashback Debit, do provide cashback rewards.
Perhaps the biggest drawback of debit cards is that they don’t help improve your credit score. Debit card activity isn’t reported to credit agencies.
Missing out on the opportunity to build a better credit score is significant because when you make bigger purchases such as a house, people with high credit ratings can save tens of thousands of dollars in interest.
In some cases, however, debit cards are an excellent option over credit cards.
For example, if you’re deep in bad debt and need to build healthier money habits, debit cards can help you avoid overspending and racking up more debt. When you’ve developed more discipline, you can go back to using credit cards (but in a healthy way).
Finally, when you use a debit card in person, you’ll typically be asked whether you want it to be processed as a “debit” or “credit.” Please note that the word “credit” in this situation doesn’t refer to a credit card.
When using a debit card and asked to choose between “debit” and “credit”:
- Choosing “debit” requires you to enter a PIN number and there are often additional fees attached to your purchase. The benefit to using debit processing of your debit card is that the money is immediately taken from your bank account and included in your online banking transaction records.The downside to using debit processing is that there may be additional fees for each purchase and you have to enter your PIN number in a public place, which is almost always a security risk.
- Choosing “credit” means you need to sign for most purchases, but there usually aren’t any fees involved. It also means you don’t have to enter your PIN number in a public place since you sign for the purchase instead.The benefit to using credit processing of your debit card is that it’s often a quicker in-person transaction and there usually aren’t any additional fees. Plus, you don’t have to enter your PIN number in public.The downside to choosing credit processing of your debit card is that the transaction may take 3 -5 days to show up in your bank account. Then, the pending charge may disappear for a day or two before showing up as a permanent charge in your account. This makes keeping track of your actual account balance inaccurate unless you manually record every purchase.
Overall, credit cards are a better long-term solution for your financial health, as long as you pay off the balance in full at the end of every month. Debit cards are a convenient, safe way to make purchases if you prefer to avoid using credit.
If you’re deep in debt, you’re not alone.
According to a report by Credible, 44.7 million Americans currently owe more than $1.71 trillion in student loan debt, and nearly 3 million of them owe more than $100,000 each.
During the pandemic, 30-40 million American homeowners were at risk of losing their homes before the end of the year, and about 30 – 40% of renters were at risk of eviction.
Around the same time, the average credit card balance was $5,313.
And, a recent study found that 73% of Americans are likely to die with debt.
Americans have a debt problem, and if you’re one of them, you know it’s no joke. Living a life in which you work day in and day out, just to make minimum payments on your bills, is no way to live.
Debt is the #1 reason people are stressed out.
More than half of Americans who are in debt say that it’s negatively affected their lives:
- Nearly 60% of people who are in debt do not get routine medical checkups.
- 60% of people who are in debt do not exercise regularly.
- 38% of people who are in debt are likely to skip preventative health measures.
- The majority of workers who are financially stressed experience mental health symptoms such as anxiety and sleeplessness.
- People with financial stress are likely to get more migraine headaches, ulcers, and heart attacks.
The stress we feel from outstanding debt is literally killing us.
If you’re buried in debt, whether it’s from credit cards, student loans, a pricey mortgage loan, or any other type, there is a way out of debt, no matter how impossible it seems.
Tackling your debt head-on might be one of the biggest challenges of your lifetime, however, accepting the challenge will improve your physical and mental health, your relationships, and your future quality of life.
Debt doesn’t go away on its own, but you can take control of it and find ways to pay it off quicker than you might have thought possible.
If you’ve gotten yourself deep in debt and it’s hard to imagine climbing your way out of it, don’t turn to companies who want to charge you more money to fix your credit rating.
These companies are mostly scammers and may charge you hundreds or even thousands of dollars to do nothing more than what you can do yourself.
Instead, follow the legitimate tips in this section to work your way out of debt and improve your credit rating.
Below are some steps you can take to eliminate your debt and build a better financial future for yourself and your family.
1. Adjust Your Spending And Expenses.
Debt becomes more and more expensive over time, sometimes making it nearly impossible to pay off entirely. That’s why making big sacrifices to remove it from your life is worth it.
Begin by slashing your monthly spending budget to the lowest possible amount you can live on.
This includes living with your parents or roommates if you need to, shopping at dollar stores and discount grocery stores, cooking foods from scratch, and tossing a blanket around yourself in the winter to cut your heating costs a bit.
It might seem impossible to live on only a fraction of what you earn, but consider this:
- 2.5 billion people in the world live on $2 a day or less.
- Globally, 783 million people do not have access to clean water.
- An estimated 7500 children die every day from causes related to extreme poverty.
Simply by living in the U.S., you have access to entertainment, social circles, and community gatherings that don’t cost a dime.
For example, you could cut your streaming services and instead spend an hour each day volunteering at a community center or local charity — you’ll meet more people, make more memories, and sleep more soundly at the end of the day.
And, if the idea of cutting back on your streaming subscriptions causes a panic attack, then it’s probably time to take a break from TV anyway.
2. Sell Anything Of Value You Can Part With
If you own any valuable items, consider selling them to help pay off your debt as soon as possible. Jewelry, cars, and even clothing can earn you a nice chunk of change that you can put toward paying down your debt.
If you don’t have any high-value items, consider organizing a yard sale to sell some of the common household items you’re not using frequently.
Selling personal items that you don’t need accomplishes two things: 1) helps you quickly raise money to help pay off your debt 2) helps you clear some of the clutter out of your life, which also reduces stress.
3. Earn More Income
Pick up a part-time job or side hustle, or start your own business on the side to earn extra income to pay off your debt.
While it can be a challenge to take on the extra hours, keep in mind that it’s a temporary sacrifice that can improve your financial well-being for the rest of your life.
4. If You Have Student Loans, Consider Refinancing Them
If your student loan is more than a couple of years old, consider refinancing as soon as possible to take advantage of the lower interest rates.
Current interest rates are at an all-time low, so refinancing may provide you with a rare opportunity to reduce your debt so you can pay it off more quickly.
For example, if you have $50,000 in student loans at 6% interest and you can refinance at a 4.5% interest rate, your $650 monthly payments will drop to about $500 a month.
The trick to using financing for debt reduction is to continue making the same size payments as you did before you refinanced.
So, if your previous student loans required $650 in monthly payments but your new ones have a $500 minimum payment, you continue paying $650 per month– and your loans will be paid off three months earlier than originally scheduled.
5. If You Have A Mortgage Loan, Consider Refinancing
Thanks to interest rates that are at an all-time low, you can probably save a small fortune by refinancing soon, before the rates jump back up.
Additionally, if you follow the steps below, you can save even more money (an average of $100,000).
Here’s how to use a mortgage refinancing loan to dramatically cut your mortgage debt:
- Compare mortgage financing rates before you decide where to get the loan. A fraction of a percent can add up to a lot of money when it comes to mortgages.
- Choose loan options that set you up with a fixed 30-year mortgage and no prepayment penalties.
- Make full mortgage payments every other week, instead of once a month.
By following this refinancing format, you can massively decrease your mortgage debt.
For example, imagine you purchased your home for $250,000 but it’s now worth $350,000. Your mortgage balance is currently $200,000 with a 6% interest rate.
You refinance your mortgage and secure a 4% interest rate.
After refinancing, your minimum monthly mortgage payment drops by $500 a month, from $2,000 to $1,5000, but you continue making $2,000 payments.
Using this approach, your home is paid off within 15 years and you’ve saved $100,000.
If you haven’t refinanced lately, you may be losing tens of thousands of dollars to unreasonably high interest rates. Look into refinancing your mortgage to help you get out of debt years earlier than you thought possible.
Carrying a lot of debt can have a significantly negative impact on your finances, your health, and your quality of life.
By making a few changes and sacrifices, you can fully pay off your debts and enjoy better financial health and a greatly improved quality of life.
6. Debt Consolidation
Debt consolidation is a way of refinancing your current debt, which makes sense only if you can get a fixed, lower interest rate than your current debt.
Debt consolidation loans allow you to combine high-interest debt, such as credit cards and loans, into one loan with single monthly payments.
Debt consolidation loans are risky because you have to put down collateral (often your home or car) to qualify.
However, you can often save a great deal of money while also lowering your monthly payments through this type of loan.
Before you take out a debt consolidation loan, consider speaking with a debt manager at a non-profit debt management firm such as the National Foundation for Credit Counseling (NFCC). They can help you communicate with creditors and possibly lower your existing interest rates and new monthly payments.
Even with lower interest rates and monthly payments, debt is still not easy to pay off.
You’ll need to change the way you perceive and handle money to truly benefit from debt consolidation.
Making a fresh start involves more than consolidating your debt. Adopting a new mindset means making changes such as:
- Make sacrifices to build a healthy savings account (equal to 6 months of living expenses) and pay off your debts quicker than what you agreed to.
- Never use credit to purchase consumer goods or services that you can’t afford.
- Pay 100% of your credit card bills off at the end of every month.
- Live on less than 75% of your take-home pay.
- If you can’t afford to buy five of something (in cash), you can’t afford to buy it at all.
Getting buried in debt can feel like a nightmare that offers no way out. Keep in mind that you’re not alone, and there is plenty of hope. Earn extra cash, use refinancing and consolidation when it benefits you, and scale down your living expenses if you need to.
When your debt is paid off and you adopt a healthy financial mindset (paired with financial education), you’ll have a good start toward learning how to build wealth and live a financially secure life.
Using Credit And Debt To Your Advantage
Using credit and debt responsibly can provide you with a long list of financial, health-related, and quality-of-life benefits. Good debt helps your money or lifestyle increase in value, but bad debt can take you from broke to “more broke” in no time.
Use credit as a tool to enhance your financial well-being, and avoid using it to purchase things you can’t afford.
If you’re carrying bad debt, consider paying it off sooner by making a few extra sacrifices today.
Clearing your debt and managing credit responsibly not only provides you with more money to enjoy your life but also cuts down on the kind of stress that puts your health at risk.
Credit is often misused, but when you understand how finances work, you can use it as a tool to enhance your financial well-being and security.