Monday, July 14, 2008

My Credit Card, My Self

The benefits of saving are enormous, as evidenced by, well, basically every post I write. But I don't think I've stressed enough that the path to a lavish retirement and beyond is not only by way of saving -- it's also by way of paying off existing debt as fast as you can. The longer you are in debt, the longer it will take to pay back all those nasty little bills with their petulant interest rates. There is no point in saving over time if you are in the red and falling deeper into the rose-colored abyss with credit card debt.

If you are indebted to the man, take solace in knowing that you aren't alone:
  • 36% of Americans who owe more than $10,000 on their credit cards have household incomes of under $50,000, according to banking industry group VIP Forum, and 13% of those make under $30,000.
  • Consumer debt has grown almost five times in size from $355 billion in 1980 to $1.7 trillion in 2001, according to the Federal Reserve. Last year consumer debt was a whopping $2.5 trillion. (Put...the credit card....down.....)
  • The average household in 2007 carried nearly $8,500 in debt, the Federal Reserve says.
  • The average adult in 2002 was able to obtain $7,500 in credit, or says a 2002 study by Georgetown University.
  • According to the U.S. Census, there were 164 million credit card-holding Americans in 2003; that number is estimated to be at 176 million this year. Those same card holders own about 1.5 billion credit cards, or an average nine cards per person.
I know, it's enough to make any budgeter's head reel. Hopefully you haven't yet become a statistic, and if you have, don't fret!

The best way to stop from falling deeper into debt is to pay with cash, which includes using a debit card. Personally, I rarely ever use my credit card unless I absolutely have to (like if I'm buying a present for Love and don't want it to show up on our joint bank account statement). The rest of the time I whip out my trusty Bank of America debit card (oh, how I love you so!) for almost every purchase I make. This includes the small purchases, such as $1.50 slurpees or the occasional lunch at Subway, to the larger purchases such as airplane tickets and cell phone bills. I love my debit card because it conciously reminds me, as I fish it out of my wallet, of my spending, whereas tangible cash always seems to go too fast and for me promotes spending a few more impulse dollars here and there.

A rule of thumb when using your debit card is to always remember how much you have in your account at all times. There's no need to obsessively check it on the hour, but take a peek at your balance about every week to get a general idea of how much you're spending and how much you'll need to subtract. I always like to leave a buffer of about $1,500 in my account; make sure to set up a mental buffer of your own and try not to spend under that (sorry, $0 doesn't count).

Why do I condone swiping debit over credit at literally all times? Because whatever you put on your credit card -- even the teensy little purchases like that new Fergie cd or that adorable pair of hoop earrings -- does add up over time, and as they add, so does the interest you have to pay for borrowing the money in the first place. So that "Eat, Pray, Love" book that was only $15 at Target? If you charge it to a credit card with a 19% interest rate, which sadly isn't unheard of, you're really paying another $2.85 on top of the price of the book, for a grand total of $17.85, which still doesn't include tax. That might not seem like a lot, but it all adds up. Take a larger purchase, say a $1,200 airplane ticket to Paris. If you charged this delightful trans-Atlantic flight to the good ole credit card (replete with its pesky 19% interest rate), you'd pay an additional $228, or 19% of what the ticket is worth, and that's if you paid on time. Pay the minimum balance and you'll end up owing more in the long run, all for spending money you didn't have in the first place.

Don't have outright cash for the trip? The 1st commandment in finance, according to moi, is if you can't afford it, maybe you shouldn't be partakething in it.

But what if you have a credit card with a low-interest rate, you ask? Say you and a friend have identical balances of $8,000 on your credit cards. If your friend has a 16% APR, she's paying $1,280 per year on top of her balance (!!!). You, on the other hand, only have a 4.9% APR, and therefore only pay $392 per year in interest, or a total difference of $888 per year!

First off, I applaud you for the taking the time to do your research and find the best card for you. But just because your card may have a 6% APR doesn't mean you're free and clear from being an aforementioned statistic. A low interest rate tends to equate to a lower threshold against impulse purchases -- after all, what's another 6%, right? This problem multiplies if you have more than one credit card with a low APR. If you get suckered into mass credit-card ecstasy with promises of free t-shirts and airline miles, do know that you only need one credit card to build an excellent credit rating, according to Sallie Mae, the largest student loan company in the United States.

Now that the visions of sugar plums and low-interest credit cards have worn off, your best bet would probably be to consolidate all your debt onto a single card. Use that card only for emergencies (remember, no matter how you try to justify it, a weekend cruise for two is not an emergency), and keep it in a place sequestered far, far away from impulse buys. Try storing it in a filing cabinet, deep in a desk drawer, or in a jar of flour...anywhere but in your wallet. Doing so will physically inhibit you from buying that flat-screen TV that you "really need" to watch "My Best Friend's Wedding" on. Only charge what you know you can afford every month on said card, and if it's ever possible, pay your balance as close to full as you can.

Having credit is a privilege, not a right. Credit cards should never be your main source of spending money, or so Sallie Mae opines. It's one thing to use credit as a Plan B, in case you're ever in a tight place and need emergency backup, but this brings me to my next point: only borrow what you can afford.

If you're clueless as to how much you can afford, there is the snazzy debt-to-income ratio to fall back on. All it does is compare what you owe versus what you earn every month. If you apply for more credit, many companies look at this number as a way to measure how good you are for the money you'd be borrowing. To check your number, just divide your total monthly debts (not including rent) with how much you make every month before taxes. Say you make $2,000 per month and have a reoccuring $100 cell phone bill and a $200 car payment, giving you a total $300 in debt. Divide $300 (your debt payments) by $2,000 (your income) and you get a ratio of 15%. But what does that 15% mean, anyway?

Though they say ratios vary between lenders, Sallie Mae has compiled "very general" guidelines as to what "non-housing" debt-to-income ratios mean:
  • 10% or less = Excellent
  • 11% to 20% = Acceptable
  • 21% to 35% = Overextended
  • 36% or higher = Danger!
On a sidenote, when you're ready to buy a house, the "28/36 rule" follows, which are two benchmarks that home lenders use to approve you for loans. The 28/36 rule basically says that 1.) Your housing payments shouldn't be more than 28% of your income, and 2.) Your total debt, including house payments, shouldn't exceed 36% of your total income.

But I digress. The whole point of a debt-to-income ratio is to gauge what you can afford. You may feel cool driving around in your new BMW, but paying rent instead of owning and eating ramen like it's your religion while struggling to pay off a giant car payment every month just isn't that, well, cool. Love and I know people like this and, sadly, everyone can see through the charade.

Bottom line, with or without credit cards, don't borrow money for a lifestyle you don't lead.


Cali Bar Girl said...

First off, a tip for those who cannot help but root for their hidden credit card in the desk drawer when they hear about a big sale at the mall. Fill a plastic tupperware container with water, put your credit card in it and stick the container in the freezer. I actually had a boss do this because her credit card spendign got out of control. It takes a lot more effort to wait for your frozen card to defrost than simply going to your nightstand to grab it before you leave the house. Supposedly you only end up using it when you KNOW you need it.

I was wondering if you have any advice on student loans? Like your husband, I went to law school and between undergrad and grad school amassed 120K in debt. I freak out every time I check my loan balances. Any advice on how to deal with student loans generally? Any advice on how to deal with student loans when you're looking to buy a house? How do lenders view student loans? Obviously, I have much more debt than I expect to earn each year...

Anonymous said...

There are various financial services in the market that offer credit card debt management for people who are not able to manage their multiple credit card debts. Hopefully people can find the help they need to eliminate debt. Thanks for the info!

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