Credit and Debt Management

Credit Management

Credit is the total amount of funds that is available for you to borrow. This includes ongoing lines of credit such as credit cards and home equity lines of credit (HELOCs) as well as credit agreements made to finance a single purchase such as mortgages, car loans, and large retail purchases.

Advantages of using credit include convenience, documentation of purchases, and availability for emergencies. Disadvantages include the potential for overspending, high fees and interest, and the ongoing burden of accumulated debt.

Availability of credit is largely determined by your credit history and current income. Credit history is condensed into a single credit score that is used as a measure of creditworthiness. The most widely used credit score is the FICO score:

• Poor: 300–579
• Fair: 580–669
• Good: 670–739
• Very Good: 740–799
• Exceptional: 800–850

The following factors make up the FICO score:

• payment history (35%)
• amounts owed (30%)
• length of credit history (15%)
• credit mix (10%)
• new credit (10%)

A free credit report can be requested annually from each of the three main credit bureaus: Equifax, Experian, and TransUnion. You can also set up online accounts with each of these credit bureaus to view your credit report online as well as to limit third-party access to your credit history through a credit freeze.

Debt Management

Debt is the total amount of funds that you have borrowed and currently owe. In the short term, it can be used for convenience. In the long term, it can be used to even out lifetime spending. (Academics call this "consumption smoothing".) Debt allows you to spread out the payment for an asset over the use of that asset, such as a home or car, rather than needing to save up the full purchase price ahead of time.

There is a lot of discussion about what is good debt and what is bad debt. In general, good debt is:

• Debt that finances an investment with overall positive expected returns. This include student loans and some mortgages.
• Debt that makes an asset available for use that would otherwise need to be rented. This looks very similar to a rent-to-own scheme with the exception that the borrower takes ownership immediately and can't choose to stop renting. Car loans and mortgages fall into this category.

The key characteristic of bad debt is the debt remains after a benefit is no longer being received. This includes debt used for everyday purchases and for long-past vacations. Also, any debt requiring the payment of an onerous interest rate is considered bad debt.

Eliminating Bad Debt

The first step to get rid of bad debt is to have a change in mindset. It is futile to start a debt reduction plan if you are just going to turn around and run up the bad debts again. There needs to be a decision to live a different financial life.

The second step is to analyze your cash flow and figure out a budget that makes money available for paying down debts. This is a significant and tough step since it means not only stopping the debt-fueled spending, but also reducing spending even more to free up the additional funds to pay down the debt. A values exercise can help in determining how to prioritize your spending decisions.

The third step is to decide on a method for paying down the debt. Popular methods include:

• Avalanche method: Pay off highest interest rate debt first. This is the method endorsed by academics and results in the greatest savings.
• Snowball method: Pay off the debt with the lowest balance first. This method has behavioral benefits since it provides a greater sense of progress.

The final step is to track your steady progress and celebrate your wins!