Avoid Debt Holes

By Bob Peters || December 14, 2021

Past blog posts have referred to the benefit of Investing Wisely in order for you to achieve Financial Security.  While true, there is another side to achieving Financial Security; Avoid debt holes.

It’s probably a good time to clarify that Financial Security is not exclusively about where you end up in 30-40 years.  Financial Security is also about this week, next month and the year after.

Investing Wisely will give you a path to Financial Security in the medium and longer term and is achievable, particularly if you start when you are a young adult.  Financial Security is also impacted by your ability to meet your Basic Needs and build an emergency cash reserve account.

Your assessment of the stability and predictability of your future income is essential to achieve Financial Security.  It is also necessary to control your behavior and appropriately manage your brains’ desire for immediate gratification. If you overestimate your future income you could find yourself in financial stress, draining your emergency cash reserves and falling into the debt hole.  The view is better outside of a debt hole.

Debt comes in different shapes and sizes

What comes to mind when people think of debt?  Most often it is when you enter into a contract to borrow money for things like a credit card, car loan or mortgage (a mortgage is a contract to borrow money secured by real estate like a home.)  Sometimes it can be less obvious like your rent, utilities, cell phone or internet access.

Let’s first see how a secured car loan works and then cover what lenders consider when making you a loan.

If you go to a car dealer to purchase a car, the dealer will likely offer you a car loan provided through a financial institution like a bank, credit union or a finance company.  The dealer only facilitates the completion of the application and, if approved, the loan proceeds are paid to the dealer and you happily drive off the lot with a car.  The dealer is happy because the loan allowed them to sell the car and they likely got paid some amount of money by the lender for arranging the loan.  The lender is happy because they made a loan (secured by the vehicle) that they believe will give them an attractive return and protect them if the borrower defaults.

The lender (the bank, credit union or finance company) will consider making the loan to you based on a few things:  1) your credit score, 2) your debt-to-income ratio, 3) your down payment.

Credit Scores matter and you need to care about your credit score

When you apply to borrow money the lender that extends you credit wants to make sure that they are adequately compensated for the risk of making the loan.

The lenders’ long-term success will be, in large part, on their ability to assess whether you can repay the loan as agreed.  If they are too conservative they will not make loans.  On the other hand, if the lender is too liberal and incurs higher than expected loan losses they may get into trouble and may not survive.

Deep-Prime to Super Prime

A Credit Score is a tool to help a lender assess the “risk” of an individual (aka borrower or consumer).  Credit Scores range from 0-850.  There are businesses, like Fair Issac, which monitor certain debt related metrics and produce a numerical credit score and sell these credit scores to lenders.  The lender uses the credit report as one factor in determining whether to extend an offer to make a loan and the terms of said loan.

The Consumer Financial Protection Bureau reports five “levels” of credit scores; Deep Subprime (credit scores below 580), Subprime (credit scores of 580-619), Near-prime (credit scores between 620-659), Prime (credit scores between 660 and 719) and Super-prime (credit scores above 720).  These scores are used by lenders to help determine the riskiness of a particular loan and influence the cost of the loan (interest rate and fees) paid by the borrower.  You want to strive to have a Super-prime credit score to obtain the best access and terms of lending options.

What impacts your credit score?

What impacts your credit score?  Here are a few things:

-how long you have had credit (longer the better),

-whether you have ever been late on making a payment.  There may be a few “grace period” days from the payment due date but I advise you to get in the habit of paying on time,

-the percent of credit utilized.  Anything more than 30% of your available credit will ding your credit score.  Generally the highest credit scores will result if you limit your credit usage to less than  10% of your available credit, assuming no other adverse credit metrics,

-apply for only credit that you need.  Too many credit applications are a red flag for lenders as this could mean your personal financial circumstances have deteriorated,

-fraud activity caused by identity theft.  I strongly recommend that you review your credit report when you have a material drop in your credit score that seems inconsistent with what you know about your recent activity.  It’s also a good idea to check for errors.

Monitoring your credit score

Monitoring your credit score is important and fortunately it has become easier.  Many banks and credit unions offer their customers free access to their credit scores via their online apps and have alerts that notify you if you have suspicious activity.  The frequency of the updates depends on the financial institution but I would highly recommend this feature as a “must have” when you decide where you establish a depository relationship.

Establishing credit history.  The CFPB has your backside

Everyone starts in the same place with no credit history.  Establishing credit history takes time, timely payments and awareness of factors that influence your credit score mentioned above.  For those younger folks who have not previously obtained a credit card, you can look at a secured credit card option that gives you a chance to establish a pattern of making timely payments.

On time payments for credit cards issued by gasoline retailers (ie. Chevron, Arco, Shell, etc.), contractual rent and utility bills will also help establish a payment history that will build a credit score.

Key takeaway:  Pay your bills by the due date!  The Consumer Financial Protection Bureau offers advice and is a place where you can seek advocacy if you feel discriminated or where you believe a law has been violated.  The CFPB has your backside.

A bit more about Credit Cards

Having a credit card is, in my opinion, an important tool for your financial wellness.  Federal laws provide consumer protections when you use your credit card, including returns.  These laws also provide fraud protection.

Debit cards deduct the balance from your checking account immediately and offer fewer legal protections.  Credit cards have better legal protections and an interest free period where no interest accrues prior to the initial Payment Due Date. But there is a Big CATCH.

The BIG CATCH

Here’s the BIG CATCH.  While many credit cards can offer you a low “introductory” rate of interest when you begin to use the card always remember that there is never a free lunch.

Credit card issuers make a lot of money on the interest earned by consumers not paying off the credit card balance IN FULL.  We are not talking about just the “Minimum Payment Due Date”.  Yep, the entire outstanding balance.

The interest rate charged by the credit card issuer is influenced by your credit score, utilization of credit, credit history and state usuary laws.  While different states have different laws suffice it to say that having outstanding balances on your credit card could likely cause you to pay a very high annual interest rate.  I did a quick look today on credit card rates and most generally ranged between 18-26%.  You may recall that the long-term rate of return from investing in diversified businesses is 8-10% so paying 20%+ means your cost of living has just gone up and and you may very well be living beyond your means.

A small miss can grow into a big problem and require a tall ladder to get you out of financial trouble

Let’s give a simple example where I have a credit card with a credit limit of $3,000.  I currently have zero balance but the credit card issuer would charge me 20% interest if I did have a balance.

Now, you and I go into an electronics store and each buy the same TV that costs $1,000.  You and I both use our credit cards to make the purchase.  The difference is that you had saved $1,000 in your bank account and were prepared to pay off the credit card balance in full the minute you made the purchase.  I, on the other hand, did not have the cash and instead kept the balance on the credit card which started to accrue interest at 20% per annum.

Maybe I convinced myself that I intended to pay-off the balance of the credit card with my next paycheck.  Best intentions aside, before receiving my next paycheck I went to the dentist and found out I needed dental work that was not covered by insurance.  I now need to pay $1,500 out of pocket.  I did not have enough income to pay for my dental work so I charged the $1,500 on my credit card.  Voila, I now have $2,500 on my credit card.  Maybe next month I had a car repair that cost me $1,000.  Instead of repaying part of my $2,500 balance I now have $3,500 accruing at a rate of 20%.  You see where this is going.

There are countless examples of well-intended people who get into financial trouble with credit cards.  Purchasing Wants using a credit card before you have saved the money to pay off the balance in full.  Having a large medical/dental bill where you did not have the emergency savings and/or income to pay the amount due causing you to put the expense on a credit card.  An outstanding credit card balance is like a hole in the ground.  The more you have outstanding the deeper the hole.  A small miss can grow into a big problem and require a tall ladder to get you out of financial trouble.

“Avoid falling into the Hole”.  Be intellectually honest

You can avoid falling into a hole by doing three things:

1) Don’t purchase Wants that you can’t pay for with cash (or using your credit card and immediately paying off the balance),

2) Build up that 3-6 month emergency cash reserve account.  You might consider a bit more to cover expenses that are unpredictable but occur in life (appliance/car repair, vet bill, medical/dental expenses, etc.), and

3) consider trying to pursue a job where you can earn a greater salary so unexpected expenses can be covered by your monthly cash flow and/or take a critical eye to your expenses.

It is stressful being in a hole that seems to get bigger.  If you find yourself struggling to get (or stay) out of the hole be honest with yourself…what needs to change.  Can you increase your income and/or decrease your expenses to get yourself out of the hole and build that emergency cash reserve fund?  Do you need to move back home for a while to reduce living expenses while you repay debt or seek more education to get a higher paying job?  Be intellectually honest.

A final thought on Debt-to-Income, Secured vs. Unsecured and Borrowing More than you should

As mentioned early in this post, lenders try to establish the pricing and terms of the loan to match their perception of the repayment risk.  The amount of your regularly scheduled loan payments vs. your gross monthly income influences whether you can borrow and the Annual Percentage Rate of the loan.

Statisticlly, the higher this Debt-to-Income Ratio the greater the chance that a borrower has trouble staying current on their loan payments.  If you lose your employment, have a reduction in your pay or incur large unexpected expenses you may have a higher risk of missing your loan payments, particularly if you have a high Debt-to-Income ratio.

A loan that has pledged collateral (i.e. a car, house, stocks, etc.) is a secured loan.  A loan without any pledged collateral is an unsecured loan.  A typical credit card is an unsecured loan.  Suffice it to say, loans secured by pledged collateral are, in the eyes of the lender, lower risk loans and you would generally expect to borrow at better terms.  Most Banks and Credit Unions will, depending on the collateral and risk profile of the borrower, lend you between 50-85% of the value of the pledged collateral.  

Just because you can qualify for the loan does not mean you should take the loan

While there is a lot more worthy of touching on I’ll leave you with this:  Your personal situation matters and it’s not just about the debt-to-income ratio and your credit score.  The dependability of your earned income is very important.  Some jobs are seasonal and do not offer the equivalent of full time hours (40 hours).  Lower skilled jobs may have modest pay raises lagging inflation while higher skilled jobs often have greater medium and longer term income potential.  Just because you can borrow, does not mean you should.  Good to get some sound advice as you begin to navigate this part of adulthood.