Financial Learning Center

How do I improve my credit rating?
Credit scores. They may sound a little boring… But you should get to know what goes into a credit score because landlords, employers and banks look at them. So a bad score can keep you from not only getting a loan, but also keep you from getting a great job or a great home.

Getting to know how the system works will help you manage your score and prevent your life from getting derailed. Financial institutions share all of your credit information with the three main US credit bureaus: Experian, TransUnion and Equifax. Everything from balances, credit available to late payments is shared with the credit bureaus.

The first thing you need to do is to get your free credit report once a year from AnnualCreditReport.com. The credit bureaus are notorious for getting data wrong. Sometimes someone else’s transactions can appear on your report. Fix the mistakes right away!

Each credit bureau has a different way of calculating your credit score but the logic is the same for all of them: The higher the score, the better. The most commonly used score is the FICO score. It ranges from 300 to 850. Anything over 660 is considered good.

So here are some strategies for helping you keep your score as high as possible.
1. Never miss a credit card or loan payment. Period. Too many bad things can happen if you do. Try setting up an auto pay to cover at least the minimum payment so this never happens.
2. Don’t cancel your inactive credit cards. Credit bureaus love it when you have tons of credit available. If you cancel your card and reduce your available credit, credit bureaus won’t know why. They may assume that a bank cancelled your card. All they know is your available credit dropped, and your score will go down. So keep your card open and use it only once in a while.
3. Use less of your available credit (30% or lower is best). The crazy part of this means that if you buy an airline ticket one month and max your card, your credit score may suffer. So a tip: Pay down your big purchases before your statement is generated, so you can lower your balance before it’s reported to the credit bureaus. Or another strategy is to auto-pay your credit card once a week. If you make three payments before bill goes out, your month-end balance will be lower and you’ll look better to the credit agencies.
4. Get different kinds of credit. Even just getting a store card or gas card could improve your credit score because those cards are seen differently to credit cards. The more types of credit you have, the better.
5. But… only apply for credit that you need. Too many inquiries into your credit and any rejected credit applications will hurt your score. And if you’re shopping around for credit, do it quickly. Most credit bureaus know you’ll shop around for mortgages or student loans, and will leave your score alone for around 30 days while inquiries are made into your credit score. But if you delay, those multiple enquiries may hit your score, thus risking the credit you’re applying for.
6. Consolidate your credit card loans. Companies like Prosper will take your higher interest loans and pool them into a single, lower cost loan. To the credit agencies you look good because they look more favorably on these installment loans. And you’ll have freed up credit on your credit cards. And you’ll also saved interest charges with the lower rates. Win-win! Just make sure you don’t charge up those cards again!
7. Finally, if you have a terrible credit score, try to get a secured credit card. It means saving some money and giving it to your bank to be used as collateral against a credit card. Banks are much more willing to give secured credit cards than unsecured cards. Your credit report will show that a bank gave you credit even with a terrible score. That will quickly improve your credit score.
In the end, the best action you can take is to pay your bills on time each and every month. Time will heal all credit wounds. But also make sure you know the rules of the credit score game, because your score can affect everything from buying a house to getting a job. It's a big deal.
How do I lower my APR?
APR is one of those expressions that bubbles up from the acronym soup that the financial word is so good at brewing. But what does it mean, and why is it important?

First of all, APR refers to the Annual Percentage Rate of a loan. It includes not only the interest rate, but also any fees attached to the loan, so it gives you a good overall view of how much your loan costs. A high APR means that your lender is charging you a lot of money to borrow their money, and a low APR means that the lender is giving you cheap money.

APRs vary widely, and right now can range from 2% for a car loan to 29% on a credit card. The difference in dollar terms is huge. On a $10,000 car loan, the 2% will cost you about $200 in interest in the first year. If you instead bought that car using a credit card with a 29% interest rate (a terrible idea by the way!), you would pay $2,900 in interest. That’s a huge difference!

So here are some ways to reduce your APR.
1. If you have a credit card, the issuer has two rates, the regular rate and a penalty rate. The penalty rate is always much higher, and kicks in if you miss two payments. So NEVER miss a payment. Set up an auto pay to make sure something goes to pay your credit card bill every month. And secondly, if you do trigger the penalty rate, make sure you make the next 6 consecutive payments. Your credit card company must lower your after the 6^thpayment.
2. Consolidate your debt. If you have a bunch of debt that has an APR in the double digits, think about rolling that debt into a consolidated loan. These are installment loans, so they have fixed payments over a fixed term that are focused on paying the debt off. You cannot use this debt like a credit card and buy new shoes with it. But they are terrific ways of lowering your APR and paying off your debt.
3. Home equity loan or home equity line of credit. If you own a home, you can borrow against it at competitive rates, and you can usually use the money for whatever you want. Rates are usually in the mid single digits. So if you pay off your 16% debt using a 7% home equity loan, your overall APR will drop substantially.
4. Roll your credit card debt to one that has a 0% introductory interest rate. These are great ways of getting TEMPORARY relief from your high credit card interest rate. But be careful. There are fees associated with these products (usually 3% of your balance). If you use these products, make sure you use the time pay down your credit card balance; otherwise this break makes no economic sense.
5. Refinance. Interest rates are hovering at super low rates. See if you can refinance your existing mortgage or home equity loans at a lower rate.
6. Get help with you student loans. There are fantastic programs for federal loans that base your payments on your income or allow for loan forgiveness. Look to see if you qualify. If you have a private loan, ask your lender for a graduated or reduced repayment plan. Go to the Consumer Finance Protection Bureau for more information.
And as a final note, when you get some debt relief, make sure that you don’t rack up more debt with the money you’re saving. Once you’ve reduced your overall APR, work to ensure it doesn’t creep back up again.

And finally, stay VERY far away from Payday Lenders. They hide their APR by calling it “fees”. In reality their APRs can be as high as 300%! Stay away.

Lowering your APR may not be as fun as a new pair of shoes, but it will definitely keep more money in your pocket.
How do I manage my credit card debt?
So, a good thing to know is that your credit card can be your friend instead of your foe.

However, it’s important to understand how credit cards work, what their benefits are, how to avoid pitfalls and how to make sure you manage them correctly. Here are some tips and tricks to help you manage credit card debt.

First of all, credit can be a great thing. Credit, in the form of consumer credit or credit cards allow you to borrow money in order to finance the purchase of something that may normally be out of reach. This is a great thing if you need to buy a new television, refrigerator or couch.

The downside of credit cards is that they can charge an exceptionally high rate of interest.

Currently, the average interest rate on credit card debt in the US is 15%. When you charge that against the average debt on a US credit card, which is about $15,000, the average American with credit card debt ends up paying $2,250 in interest every year. And if you miss a payment and your interest rate is raised to the penalty rate of 29%, you’ll be paying $4,350 per year in interest. Those are some very expensive televisions, fridges and couches!

Credit card debt can be debilitating, so here are some hard truths:
1. If you can’t save money, you really shouldn’t be using a credit card. How are you going to pay off your debt if you don’t have spare cash?
2. Pay as much as you can. If you’re only paying your minimum every month, try to find a way to pay more every month. It will pay huge dividends in the long run.
3. If you use a credit card, try to only use it for big purchases and have a plan to pay it off as quickly as you can.
4. Your goal should be to pay off your credit card in full every month. It means you pay NO interest. Wouldn’t that be great?!
Yes… Tough medicine… But it really will help keep a ton of money in your pocket.

So here are some tips to help you:
1. Set up an auto-pay. It will ensure you don’t miss a payment and have your interest rate shoot up. Consider paying your credit card once a week. By paying more frequently, you keep your average balance lower. It will help lower the interest you owe a bit (it is calculated on your average balance),
2. If you have a big purchase, pay it off fast, or even pay some of it before it appears on a bill. This will keep the interest you owe a little lower. It will also help you keep your credit score high. Credit agencies like it if you don’t use up all of the credit available, even for one-off purchases (in fact, they would prefer it if you use less than 30% of your available credit!)
3. Transfer your balance to a low or 0% interest card. Sometimes these low cards are hard to get if you don’t have a good credit rating. But if you can, shop around for lower rates. And if you do transfer your balance to a new card, make sure there are low transfer fees (which can be as much as 3% of the transferred amount). Try to pay off as much of your transferred debt as you can. Low rates are often temporary, so take advantage of them. And if you transfer to a new card, do not cancel your old card. Your credit score drops when you cancel a credit card. Keep the card, and use it infrequently.
4. Consolidate your debt. Banks will sometimes give you loans at much lower interest rates to consolidate all of your credit card debt. Unfortunately, they may ask you to cut up your credit cards when you take the loan! This will ding your credit rating because your available credit will suddenly drop. Try to get the consolidated loan and keep your cards (but don’t go back to old spending habits).
5. Use all of the benefits your card offers. Use the price matching, cash back, car rental insurance, extended warranties and loss protection that your card offers. Spend a day reading the benefits summary of your card. You may find interesting benefits you didn’t know about.
6. If you’re close to paying your balance off, pay it all off. If you have a $1,000 balance and pay off only $999, you’ll be charged interest on your average balance, which will be closer to the full $1,000, not the $1 of remaining debt.
7. Know these triggers for penalty rates: If you miss TWO minimum payments, your interest rate WILL be raised to the penalty rate (which can be as high as 29.99%) and will be applied to your ENTIRE balance. The good news is that if you make the next 6 payments on time, your bank MUST lower your rate to the non-penalty rate.
8. Know the triggers for higher interest rates. Your bank can raise your regular Annual Percentage Rate (APR) for reasons, like going over your credit limit, or missing just one payment. But your bank MUST tell you the reasons for the rate increase 45 days in advance of it being applied. This higher rate must be reevaluated within 6 months, and if appropriate, your bank must lower your rate within 45 days of the evaluation.
Owning a credit card can be a terrific thing. It is an amazing convenience and can have lots of great perks. But carrying a lot of debt on your card can be destructive to your financial well-being. Try to avoid putting debt on to your card if you can’t pay it back quickly. And if you do have a big balance, try to find savings elsewhere so that you can pay down your debt. Every dollar you pay down will result in a reduction of interest payments, and more money in your pocket.
How do I pay off my debts quickly?
Debt can be a terrific thing. It can open doors to things that are normally out of reach financially. Homes, for example would be almost impossible to afford if you had to pay for them in cash. And the best part about debt is that by using debt, you can actually enjoy those awesome things while you’re paying for them! What a terrific idea.

But debt is not free. You’re borrowing someone else’s money after all, and you’ll have to pay them something for that privilege. And over time, that cost can be substantial. So it’s always a good idea to try and pay off your debt and limit the extra cost in interest payments you have to give to your lender.

The most critical component of debt is its interest rate. The interest rate is the amount of money your lender is charging you to borrow their money. The higher the interest rate, the more you are paying to borrow. It’s also important to note that debt with a high interest rate has a tendency to grow if it isn’t managed properly and can often balloon out of control.

So if you want to deal with your debt, the first thing to do it take stock of all the debt you have. The first thing to do is look at all of your debt and try to figure out the interest rate you are paying on each pool of debt. Better yet, look for the Annual Percentage Rate (APR). This rate reflects not only interest, but also other fees that you are charged on your debt. APR is a more accurate measure of how much your debt costs. Most lender statements will list the APR.

Next, order your debt from highest interest rate to lowest interest rates. You’ll notice that there is a wide range of APRs. They can go from low single digits for mortgages to mid double digits for credit card debt.

In dollar terms the cost difference can be significant. Let’s look at $1,000 of debt. If that $1,000 debt is credit card debt, it can cost you between to $130 to $300 in interest payments per year. If that $1,000 debt is in a mortgage, it will only cost you $40 in interest per year. That’s a big difference.

So here is the key to paying down your debt: Attack your high interest debt first. In the above example, you will see that if you can pay down the principle on your mortgage by $100 this year, it will save you $4 in interest payments next year (and every year after that). If you reduce the principle on your credit card by $100 instead, it will save you $13 to $30 in interest payments next year and every year after that.

As you can see, paying down the principle on your high interest debt is a more effective way of paying down debt and reducing the interest you owe. Remember that if you pay down more high interest debt first, you will reduce more of your future interest payments, and have more money in your pocket each month.

So here are the keys to paying off your debt:
1. Focus on your highest interest debt first
2. Pay more than just your interest, pay down your principle
3. Don’t add more debt to the loan you just paid down
So make sure you’re attacking the principle that you owe. If you only pay the interest you owe, you are not paying down your debt and your monthly payments will remain the same. Ignore the “minimum due” line on your statement. Look instead at the “interest charged” line in your credit card and pay as much above that as you can.

Most importantly, make sure you don’t add more debt than to what you just paid down. The key here is to figure out how much principle you just paid off and not add more than that. For example, if you just paid $500 on your credit card debt, of which $100 went to interest, you just paid down $400 of your principle. So in the next month, do not spend more than $400 on your credit, otherwise your principle will have actually gone up, and you’ll owe even more in interest!

The hardest payment is the first payment. Set yourself a goal of paying down your principle. In the above example, if you can pay $500 on your credit card and limit your spending to $300 per month, then will have paid down your principle by $100.

But the amazing thing about paying down debt is that, its benefits can accelerate. So in the above example, in the next month, you will only owe $98.75 in interest. So that same $500 payment will pay off $101.25 in principle. After a year, that same payment is paying almost $115 in principle. And in less than 5 years, you will have completely paid off an $8,000 debt and you will have the $100 in interest and $100 in extra principle in your pocket every month. That extra $200 in your pocket every month can be used to pay down other high interest debt or put into savings.

Again, the first payment is the hardest. If you can manage paying down your principle in that first month, you should be able to do it every month. Just stick to your plan and keep paying down your principle.

If you want to know how long it will take to pay off your credit card debt, you can use this calculator from CreditCards.com. If you want to sort out the benefits of paying down student loans, try this calculator from StudentLoans.org, or this calculator from Finaid.org. For other installment loans try this calculator from CNN.

The benefits of paying down your debt quickly pay off with less money paid in interest and more money in your pocket. Win-win!
How do lines of credit work?

Life can be unpredictable. So it isn’t surprising that expenses can sometimes be unpredictable too. The kids’ braces will cost how much?? How could that knocking sound in my engine possibly cost that much to fix????

Sound familiar?

Wouldn’t it be great if you had a spare source of cash that you could tap into to get through those financial bumps in the road?

That’s where lines of credit come it. A line of credit is a pre-approved loan up to a set amount that sits waiting for you to use when needed. Once you tap into it, you use only what you need and you are charged interest only on the amount you use. If you don’t use it, you just pay a maintenance fee, and no interest.

It is similar to a credit card in that the debt can be used for anything. And as with a credit card, you pay interest only on what you use. The good thing about a line of credit is that the interest rate is usually lower than that on a credit card.

The interest charged on a line of credit depends mostly on what type of loan it is: secured of unsecured. A secured line of credit uses an asset as collateral against the value of the line of credit. Most often the collateral used is a home. These Home Equity Lines of Credit (HELOCs) are seen as lower risk by the lender because if the borrower defaults on the loan, the lender can make a claim on the home. So even if the lender doesn’t get their loan back, they will still possess something of value. And because these loans are seen as lower risk, they carry relatively low interest rates.

Unsecured lines of credit on the other hand, have no asset backing them, are considered higher risk and have higher interest rates. Even so, these unsecured lines of credit often have rates that are lower than many credit cards.

Lines of credit are terrific for people who have unpredictable sources of income or fluctuating expenses, particularly those who are self employed. When you have to outlay significant expenses before you get paid for a job, a line of credit can allow you to pay those expenses and bridge the gap until you get paid. It can be a lifesaver for independent contractors, small businesses and freelancers.

Lines of credit can also be good for people who have expenses coming in the future, but don’t know exactly how much they will be. Instead of getting a loan at a fixed amount, sitting on the loan for a few months and paying interest on the full amount, they can get a line of credit and use it only if they need it. It works something like overdraft protection and allows you to temporarily exceed the amount of money you have on hand to pay unexpectedly high expenses.

People need to qualify for lines of credit, and since the recent economic downturn, it is more difficult to secure lines of credit. They also have the potential to impact your credit score, so should be used carefully.

But because lines of credit carry interest rates that can be significantly lower than credit cards, they are a terrific alternative to high interest loans such as cash advances on credit cards. It may also sometimes make sense to pay off your high interest credit card debt with your line of credit if the interest rate is lower. Just make sure you don’t max out your credit cards again!!

Most banks offer lines of credit. Shop around for the best rates you can find. Rates are competitive, so you should be able to find good low interest offers.

And make sure you use the credit wisely. Because lines of credit don’t have set repayment structures, there is a tendency for people to use up a lot of the credit available, and not pay it back down. Make sure you only use the credit when it is absolutely necessary, and make a plan to pay it off once you have used it.

Debt can be a terrific help when you need it, but a huge burden if it becomes unmanageable.
I need to borrow money, where do I start?
Borrowing money is one of the most important financial events your life. It can open doors to things that are unavailable to you without help from lenders.

But before you start, you need to do some homework.

First of all, you need to understand how lenders look at you in terms of risk. The interest rate on your loan will depend on this risk assessment. But the lenders don’t really do this assessment themselves; they rely on third parties to assess risk. This is done by the three main US credit bureaus - Experian, TransUnion and Equifax. They offer credit scores on almost everyone in the United States.

The bad news is that secret algorithms at these opaque companies determine your credit worthiness. Often the data they have on you contain errors and mistakes, so sometimes your score can be inaccurate. And fixing these errors can sometimes be difficult and time consuming.

The good news is that the federal government has mandated that these organizations give you free access to your reports once a year. You can do this from the AnnualCreditReport.com web site. When you get your report, make sure all the information that each credit bureau has is accurate and there are no mistakes. If there are mistakes, get in touch with the credit agency involved and have it corrected immediately.

The one weakness to the reports is that they do not contain the “score” that your lender sees. The score is important because it will tell you where you fall on the credit worthiness scale. The lender will use the score to determine whether you get credit and what your interest rate will be. The score is also important to you because it will allow you to track your credit rating over time (so you can see what happens when you start paying your bills on time!).

In order to obtain your score, you need to pay some money. The cheapest way to do this is to get your score at the same time as you get your free credit report. You only need one. But make sure you get the same score from the same company every year. Each company has their own scoring system, so you cannot compare scores from one credit bureau to another. If you want to see how well you are managing your score over time, you need to look at the same score every year.

The score will come with an explanation of what it means. But essentially your score will suffer if you:
- Miss payments or are late with payments
- Use too much of your available credit
- Have a limited credit history
- Have only one type of credit
- Have lots of credit applications in a short time
It takes time to raise your credit score, so make sure you get a handle on it early!

So once you have a handle your credit worthiness, next you have to look the debt you’re interested in getting. The most important part of a loan to focus on is the interest rate. Interest rates can vary widely so you need to make sure you are getting the lowest rate possible.

Interest rates are how lenders compensate themselves for risk. The biggest risk to them is that a borrower will default on a loan and not pay it back. In order to cover themselves for this potential loss, they charge interest on the loan. The larger the risk, the more interest they charge.

Here are the two types of loans that typically come with lower interest rates: Secured loans and installment loans. Secured loans are loans that are backed with collateral. These loans are considered lower risk to lenders and come with lower interest rates because if the borrower defaults on the loan, the lender will take possession of the collateral. This is how mortgages work; using the house as collateral, which allows the lender to offer lower interest rates.

You can also get other secured loans. Car loans are secured, as are home equity loans. You can even get secured credit cards, where you put cash in an account that is held as collateral against the credit on your card. Secured credit cards are an excellent way for people who have poor credit to get a credit card and boost their credit score.

The other way to get a lower interest rate is by using installment loans. These are loans that have a fixed duration and set monthly payments. Because they are predictable and structured, they are easier to manage and pay off than revolving credit.

With installment loans, make sure you take on the shortest term (length of time) you can manage. It is true that the shorter the term, the higher the monthly payments will be. But a shorter term will also mean that you will pay less interest overall than a longer term loan.

So now that you have all the information about loans, what kind of loan should you get? It depends what you need the loan for. Let’s go over some possibilities:
- House: If you want to buy a house, you’ll need a mortgage. The most important thing to do is to shop around for offers. Only 50% of Americas do this! Even a half a percentage difference in your mortgage can save you tens of thousands of dollars. Focus on fixed rate mortgages. They are predictable, and your payments will not increase even if interest rates around you rise.
- Car: If you plan on keeping a car for the long term, buying a car using a loan is more economical than a lease. Rates can be extremely competitive, so make sure you shop around. Look to banks as well as car manufacturer for quotes. But be very careful of used car loans from small dealers. They can have extremely high rates.
- Student Loans: Make sure you look to federal loans first. Their rates are competitive, and most importantly they have far more avenues for restructuring and forgiveness (if you need it later) than private or state loans.
- Appliance: You would think that buying an appliance in installments would save you money right? It’s an installment loan with collateral after all… But no. Retailers seem to take advantage of consumers who need the credit and charge extremely high interest. Don’t be fooled by 0% offers (interest is often just deferred). Check the interest rate and compare it to your credit card. It may be cheaper to buy an appliance using your credit card and pay down the card balance as quickly as you can.
- Credit Card: Because credit card debt is unsecured, interest rates are quite high. Try to avoid running up your credit card if you can. Also shop around for low rates. Sometimes you can get a 0% rate if you switch cards. There is usually a fee associated with the transfer, but if you can pay down your balance before the offer expires, these transfers can be a great way to get rid of some debt. Also know your penalty interest rate and what triggers it. Your interest rate could jump from 15% to 29% if you miss one or two payments. Finally, avoid taking cash advances at all cost. The interest on these loans is extremely high.
- Consolidation Loan: These loans pool several of your loans into a single installment loan. These are a great way to reduce your debt burden. These loans allow you to take all of your high interest credit card debt and pool it into a single lower interest loan. Just make sure you don’t run up those cards again!!
So make sure you do the math on your repayment terms and understand the consequences of what happens if you miss a payment. And if you ever feel pressured to sign something you don’t understand – DO NOT SIGN! Ask questions, seek advice, and do the math until you fully understand what you’re signing – your future self will thank you!
I thought you said compounding was good!

Compounding is a terrific thing. Einstein himself said, “Compound interest is the eighth wonder of the world. He who understands it, earns it… He who doesn’t, pays it.”

Compounding happens when you earn interest on the interest you’ve already earned. It means that each month, even if you do nothing, you will get a little bit extra in interest deposited in your savings account because interest is calculated on not only your deposit but also all of the previous interest you earned.

The additional earnings that compounding can give you is significant. Let’s look at an example. Take a $1,000 bond paying 4% interest. Without compounding that money doubles after 25 years. With compounding, the money doubles after 18 years. That’s seven years sooner! That’s a big difference!

A great way to see compounding in action is through the Rule of 72. This rule tells you low long it will take for your money to double. All you do is take 72 and divide it by the interest rate you’re getting. The result will give you the number of years it will take to double your money. So at a 12% interest rate, with compounding your money will double in six years (72 divided by 12). Super easy!

Now let’s consider compounding’s dark side. What happens when you’re the one who OWES the money? Interest is now no longer your friend. Interest is your enemy. It gets charged to you every month, and if you fall behind in your payments, compounding can quickly multiply your debt and make it unmanageable.

These situations are called debt spirals. They happen when interest builds up and compounds. If you can’t make basic payments and at least pay the interest charged on your loan, the size of your debt will grow. Once the interest payments become unmanageable, the debt will balloon. Once this happens, the borrower is at the mercy of the lender, and the only options are restructuring the debt, or default…

If high interest rates are an overwhelming benefit to savers, high interest rates are equally as destructive for borrowers. High compounding interest rates on loans are the scourge of modern economies. From credit card debt to payday loans, interest rates can be astronomically high. For example, using the rule of 72, a credit card debt at 30% will double your debt in less than two and a half years if left untouched!

Payday lenders are even worse. They actually hide their interest rates by calling them “fees”. But if you actually go and calculate them as an interest rate (which you can do here), they can hit triple digits, which only get worse if you roll your debt into new loans or miss payments.

So prioritize paying down your high interest debt. Make sure you always cover at least the interest you owe. Also make a plan to not only pay the interest, but pay down the principal as well. If you are paying a penalty rate on your credit card, your bank MUST lower it after 6 consecutive minimum payments. Avoid payday lenders at all cost! And if you have a loan with them, prioritize paying it off as fast as you can.

Don’t let high interest rate debt get out of control. Try to keep all of your debt payments (plus rent) below 36% of your pre tax income. Statistics show that once you cross the 36% threshold, it becomes much more difficult to pay your debt. And if you have a lot of high interest debt, look at consolidating it with a personal loan for debt consolidation.

So now you know about the good and bad of compounding. Make sure you take advantage of the good and limit the bad!
Is there such a thing as good debt? (Yes!)

Debt can be a terrific thing. It can help you buy and enjoy things that are too expensive to buy outright. It is often the only way to make big purchases that would normally be out of reach, and pay for them over time. Enjoying things while you pay for them is an amazing idea, and one that has helped fuel modern economic prosperity.

But the burden of debt can also be debilitating. People can be so overwhelmed with debt that it affects their ability to pay for essentials. It can also be such a huge burden that it affects people’s mental well-being. In these cases, debt is far from a positive force, and is more like a curse.

So let’s talk about debt and focus on good debt and how to avoid the bad.

There are two things that define good debt. One is that it carries a low interest rate. The other is that it pays for something of value.

Mortgages

Let’s start with the best kind of debt. The best debt out there is a fixed rate mortgage. Interest rates on mortgages usually have the lowest rates of all debt. And when you pay off your mortgage, you’ll own a house, which (we all hope) will be worth at least what you paid for it. So you win with a low interest rate, and you win by buying a valuable asset. Just make sure that the payments are manageable.

Adjustable rate mortgages are a little less beneficial than fixed rate mortgages only because they are unpredictable. They may have lower current rates than fixed rate mortgages, but there is no way to tell what the rate will be in the future. If rates ratchet up, holders of adjustable rate mortgages could have trouble making their payments. Borrowers of adjustable rate mortgages need to make sure that they have enough spare income to cushion any possible future rate increases.

And avoid any exotic mortgages like interest only loans. They tease borrowers into signing with low initial payments then crush them with higher rates when the promotional period ends.

Car Loans

A small step down is a car loan. Car loan interest rates can sometimes be lower than mortgage rates. But, when you buy a car, it loses value very quickly. So the asset you buy will not be worth what you paid for it. But your car does retain some value, and if it comes with a low interest rate, it can still be considered good debt.

Also make sure you look at used cars. They can sometimes offer better value. Just make sure that if you finance a used car, don’t do it through small self-financed used car dealers. They can charge exorbitant interest rates.

Federal Student Loans

Federal student loans can also be considered to be good debt. Although you can’t actually put a price tag on what you gain from a college education, there is undeniable evidence that you will be significantly better off financially with a college education. Interest rates on federal undergraduate loans are usually quite low. So again, you get something of value at a low interest rate.

As a side note, some state and private loans can have severe restrictions with respect to repayment, rate reductions and forgiveness, so they can often fall into the bad debt category.

Home Equity Loans

Now we get into a grey area. Home equity loans. These are loans you take out against the value of your house. Right now they are only about 2 or 3 percentage points higher than fixed rate mortgages. But defining them as good or bad debt depends on what they are used for. Often times it is to renovate a house, which can add value to your home. Which is great. Other times it is used to consolidate higher interest debt. Which is also great. But a Discover Home Equity Loans survey found that the number one reason Millennials (30-34) take out a home equity loan is for… vacations! Ouch! We’d consider that bad debt.

Credit Cards

And at the bottom of the pile is credit card debt. Credit card debt comes with high interest, usually around 15% to 17% and usually pays for things that hold no intrinsic value (food, movie tickets, beer, shoes…). It makes little economic sense to carry credit card debt. Avoid carrying credit card debt if you can.

Payday Lenders

And at the bottom of the bottom are payday lenders. They charge exorbitant interest and fees, and their clients get stuck in never ending loops of short-term loans. Stay far, far away from these types of loans.

So if you are carrying debt, make a plan to pay down the highest interest debt first. You’ll have more money in your pocket each month that will no longer go to interest payments. Use this handy debt reduction calculator to make a debt reduction plan.

And make sure you shop around!! It’s crazy, but almost 50% of Americans don’t comparison shop for mortgages. Shop around for multiple quotes. It can save you a lot of money!
Should I invest now or reduce debt first?
Debt is something of a double-edged sword. On one hand, it offers you ability to buy something that would normally be out of reach financially and allow you to pay for it over time. But on the opposite side, debt comes with a cost. You are borrowing someone else’s money, and for that privilege, you need to pay money.

So when is debt too costly? If you have extra money on hand, when does it make more sense to pay off debt, and when does it make sense invest the money instead?

Well... It all depends on interest rates.

The line between bad debt and good debt depends entirely on how expensive that debt is. And the higher the interest rate on the debt is, the more expensive it is to hold. So debt that is considered bad, should be paid down, and if it is considered good debt, then the urgency to pay it down is lower.

So what is the dividing line between good debt and bad debt? A quick answer to that question is to say that right now, 6% or 7% is the dividing line between good debt and bad debt. But the issue is not as clear-cut as that. There are a lot of grey areas,

Instead, you should ask yourself if you should pay down your debt, or whether there is something “better” that you can do with your money? So instead of paying down your debt, is it a better idea to invest your spare cash?

To make that decision, you have to look at what kind of returns you can get from investing your money. If the returns you can get from investments are higher than the interest you pay on your debt, then investing your money may be a better option.

So what kind of return can you get from investing? That’s a big question. Historically, average annual returns of from the US stock market (including from dividends) has been around 11%. We’ll note here that this number is debatable, and depends on the time-line you use and how you measure “the stock market”. But over the long run, US equities have generated handsome returns.

But for the sake of argument, let’s temper our expectation of returns. Let’s say we are conservative investors and expect a 6% return. Let’s see how that impacts your decision about paying down debt.

Historically, credit card debt has carried a double-digit interest rate. Average rates hover around 15% and penalty rates can be as high 29%.

Let’s assume your credit card interest rate is 15% and you have an extra $100 that you can use to pay down the money you owe on your credit card. If you pay down your principle by that $100, it means over the next year, you would have saved the 15% interest that would have been charged on that $100, which would be $15.

If you instead took that $100, and invested it, and everything went according to plan and you earned a 7% return, you would have made $7. So you’re $7 richer than when you started. But remember that you didn’t pay down your credit card debt. So you paid $15 in interest you could have avoided had you paid down your credit card debt. So in this case, you’re $8 worse off than if you had paid down your credit card debt.

Any way you look at credit card debt, it is almost always better to pay down this high interest debt than it is to invest. There will be some years where stock market will preform above expectations, and will give you better returns than paying down your credit card. But these are definitely the exception, and over the long run, paying down credit card debt is the better option than putting that money into investments.

On the opposite end of the debt scale are mortgages. Because they are backed by the value of a house, they tend to be lower risk for the lender and offer some of the lowest interest rates of any debt. In this case, the savings you get from paying down an average mortgage is usually lower than the gains you get on an average year of investing. Again we say “average” because in some years this will not be the case. But over the 20 or 30-year span of a mortgage, it wouldn’t make sense to stay away from investing while you pay extra on your mortgage. (You should still always pay your monthly payments though!).

While the logic of paying down debt is clear on both extremes of interest rates, the logic is much less clear when the interest rate is somewhere in the middle. There are no rules when it comes to making decisions about debt with moderate interest rates. So here are some guidelines.
1. Check your gut. Look at how well you tolerate risk. If you can stomach the ups and downs of a bumpy stock market, then maybe investing your extra money in the stock market is a good idea. On the other hand, if a bumpy stock market will cause you undue stress, then paying down your moderate interest debt may be a better idea for you.
2. Go you like guarantees? The savings you make by paying off your mortgage are guaranteed savings. You know that if you pay down your debt, you will save money. There are no such guarantees in investing.
3. What does the future look like? If the market is in turmoil, or there is economic uncertainty on the horizon, think twice about putting more money into investments. Paying down moderate interest debt might be a better option.
Here’s an important note for people carrying student loan debt. If the interest rate on your loan is low, and you can manage the payments easily in your monthly budget, try to prioritize saving and investing. Starting investing early can have a huge impact on your future financial success.

Finally, remember that there are no guarantees with the stock market. There is no way to predict which way the market will go in the future. So there is no guarantee that investing in the stock market will get you a better return than paying down any debt. The stock market can (and does) go down. All you can say is that the historical odds are in your favor over the long run. So if you do decide to use your spare cash to invest, make sure it is for the long run so you can ride out the bumps.
What is an APR & why should I care?

What is an APR? For some people the term APR can send a shiver down their spines… What’s so frightening? APR stands for Annual Percentage Rate, and represents the cost of interest and fees charged by a lender on an outstanding loan. If you owe a lot on your credit card, APR is truly a frightening thing. The higher the APR, the bigger the chunk of money you will be sending to your lender every month.

Different kinds of loans will have different levels of APR. Generally, the riskier the loan, the higher the APR. So if you have a bad credit score, lenders will charge you higher rates because they consider you higher risk.

Lower rates apply to loans that are secured, or have assets attached to them. So car loans or mortgages often have low APRs, because if things go bad, your lender can always take back your home or car. But unsecured debt, like credit card debt, is much harder to collect if things go bad, because there is no asset attached to the loan. These types of loans have higher APRs.

But APR can be your friend too. When you are the lender, a high APR is terrific, because you’re the one getting the interest. Take your bank account for example. This is a basically a loan you make to your bank. They then take your deposit and lend your money out to others. For this right, your bank pays you interest, or an APR. Unfortunately, at this moment in time, because interest rates are so low, the APR your bank gives you will be extremely low.

One thing to be aware of is something called an APY, or Annual Percentage Yield. An APY takes the power of compounding into consideration. On bank accounts, compounding happens when you earn interest on the interest you’ve already earned. Compounding is the fuel on which finance runs. So if you get a 5% APR, which is given to you monthly, you will get compounding on the interest you already earned, kicking your 5% APR to an actual 5.11% APY earned. But be warned. If your bank quotes you an APY on your bank account, they are actually referring to the compounded return. The actual interest they will give you each month will be calculated using the lower APR! Sneaky!!

APRs can also vary. For adjustable rate mortgages, the APR can change year to year. These mortgages can be riskier for borrowers because there is a chance that rates can jump unexpectedly. At the moment, variable rates are lower than fixed rates, making them tempting… But things can change!

APRs on credit cards can also change, and usually in response to failed payments. These “penalty rates” can be as high as 29%. If this happens, know that your credit card company must lower your rates back down to the normal rate after 6 months of successful payments.

Finally, if you have multiple loans or lines of credit and you have extra cash, pay down your debt with the highest APR first. Generally anything over 6% or 7% interest is considered bad debt and should be paid off as fast as possible.

So now you know about APRs. The lower the better if you borrow, and the higher the better if you are the lender.
Why does my debt never go down?

If you’re finding that you can’t seem to dig out from under your debt, you’re not alone. There are trillions of dollars in mortgages, student debt and credit card debt in the US, so it’s not surprising that the burden of debt can be difficult to bear for many people.

Let’s start by trying to find out what a reasonable debt burden is. The most common measure of debt burden is called a ‘debt to income ratio’ (DTI). This is the percentage of your income that is used for debt payments. The generally accepted maximum ratio is having 36% of your income going to debt payments. Your mortgage alone should be no more than 28% of your gross income. Anything above these levels is considered a burden that could impact your quality of life.

DTI is easy to figure out. All you have to do is add up all of your monthly debt payments (student loans, car loans, mortgage and minimum credit card payment) and divide it by your monthly gross (before tax) income. That will give you your DTI. If you rent instead of holding a mortgage, you should include your rent in the calculation. Although this isn’t truly debt, it is a financial obligation that takes money out of your pocket. It won’t be a true DTI, but it will give you a fuller picture of your financial obligations

So what to do? If you have a mortgage and car payments which are putting you over that 36% threshold, there are only two things you can do: try to refinance your mortgage at a lower rate, or earn more money. Neither are easy options. But there are lots of web sites, like LendingTree, where you can price out new mortgages.

If you have credit card debt in the mix, there is definitely something you can do. If your credit card debt is pushing you over the 36% level, think about consolidating that debt. Credit card interest can range from 10% all the way to 30%. There are companies that will give you a debt consolidation loan that is structured with fixed monthly payments at a lower interest rate than you’re paying on your credit card. Just don’t rack charges back onto your card again!

If you are under that 36% DTI, and have credit card debt, think about increasing the amount you pay towards your credit card every month. If you are only paying the minimum, that amount is usually only interest and 1% of your balance. Just paying the minimum will mean years of payments and sometimes paying more than double your balance in interest. Minimum payments are not good enough. See how much you can add to your payment without hitting the 36% threshold.

Credit card debt is usually the highest interest debt you will hold. Paying that debt off first and fast will leave you more and more money in your pocket every month as your interest payments go down. Just make sure you don’t add more charges on to your credit card and end up where you started!

Debt can be hard to manage. But when you know what your debt level is, and build a strategy to reduce it, it’ll just be a matter of time before you see the light!

The information contained herein is solely for informational purposes and should not be construed, in any manner, as accounting, legal, tax, or investment advice from Amalgamated Bank. Investments or strategies mentioned on this website may not be suitable for you. Consult your investment, tax or other professional as appropriate with regard to your specific situation. Although the information provided to you on this site is obtained or compiled from a source we believe to be reliable, Amalgamated Bank does not guarantee its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation by Amalgamated Bank for the purchase or sale of any securities, insurance products, investments, or other products named.

Stay updated