A Candid Convo on Debt
A Valuable Four-Letter Word
Let me start by making it clear that using debt to build financial wellness and wealth is as old as dirt. As long as humans have been busy making stuff and exploring new lands, they have been borrowing and paying back neighbors, friends and storekeepers to do it. Using debt to build credit is part of a healthy financial strategy.
It’s way past time to normalize debt and quit with all the drama as if it was the plague itself. Loans allowed early-settlers to start a new life in America. It allowed consumers to purchase their first sewing machine or bedroom furniture in the mid 1800’s and make payments over time while enjoying the use of the product. Farmers still survive by making loans against their crops before the seeds are even planted.
Know Your Numbers
Before you decide to borrow money, you need to understand the numbers. You are taking a risk by agreeing to make a set number of payments for a specific period, even though you could lose your job, get sick or experience some other crises. If you are unable to honor the agreement, your credit profile can be negatively impacted for up to 7 years and any asset tied to the loan can be repossessed. The lender is taking a risk that you won’t honor the agreement.
The first number to calculate is the total amount of debt your livelihood can handle. Depending on your skills and experience, it may increase over time, but so does inflation. It’s best not to assume your income will increase every year when calculating how much debt you can handle. A good rule of thumb is no more than 35% of gross monthly income. If you earn $20 per hour, full-time, then the sum of your minimum monthly debt should not exceed $1,096.
The three largest debts tend to be housing, vehicles and student loans. Even if you currently have none of these, it’s important to know your maximum monthly debt amount. This will help you make smarter decisions down the road and not get over your head.
If you find yourself in a position where you had to declare bankruptcy or foreclosure, use that experience as an opportunity to build healthy financial habits and to rebuild your credit. The financial experts at Bankrate created a guide to help those that have gone through a foreclosure get in a position to successfully obtain another mortgage. Check it out here.
Another important number is your Credit Utilization. This is the total amount of actual credit you have taken versus the total amount of credit you have available. If you have two credit cards with a limit of $5,000 each, you have a total of $10,000 available. If you carry a balance of $4,000, either all on one card or combined, then your Credit Utilization is 40%. For optimum credit strength, keep it under 30%.
Keep It Active
Did you know that you need at least two years of tax returns and credit history to apply for a mortgage? Lenders prefer to see at least two different types of credit experience – installment loan, revolving line or personal loan – at the minimum. If it takes two years to get your credit history established, then the earlier you start the better.
Building your credit history profile should be done with intention and purpose. Be strategic about what you do and how you do it. Many banks offer secured credit cards to help build credit, as well as secured loans. For example, if your car or motorcycle is paid off, you can use it as collateral for a loan. Don’t need the money right now? Consider investing it.
Once you’ve built your credit history profile, keep it active. If there is no credit activity for ten years then your credit file is deleted. Yep. You have to start from scratch. Even if you keep it active by using a credit card a few times a year, lenders may wonder about how you will handle new debt – such as a mortgage or car loan.
Three Important Take-aways
- Make credit strength part of your overall financial wellness strategy
- Know your limits and plan accordingly
- Use debt wisely to move you forward, not to drown you in stress and fear
*Image by Jae Rue from pixaby