Financial Planning - Credit & Borrowing
When preparing a financial plan, it's important to realize how credit and borrowing affect your ability to realize your dreams. Whether it's a new home, a special vacation or a child's college education, the ability to manage debt often means the difference between getting what we want and not. Since very few of us have the amount of cash required to buy a house or to pay college tuition, we have to borrow the money. Yet managing debt is something that many people learn to do by making mistakes. Unfortunately, those mistakes can be costly and can lead to the death of your financial dreams. Understanding the role good and bad debt play in a financial plan will enable you to make better choices when it comes to long-term goals and short-term gratification.
Good Debt vs. Bad Debt
A mortgage can be good debt. At best, the money that's borrowed has the potential of increasing in value if the value of the house increases; at worst, the money goes towards building capital and overall wealth. A car loan can be good debt if it allows the borrower to increase the amount of money he or she makes and provides payment-free transportation after the debt it paid off. Good debt then, is defined as debt that provides the potential of an increase in value or builds capital and wealth.
Bad debt does just the opposite. It finances items that are either used up immediately or do not increase in value. Bad debt comes in the form of credit card debt, payday loans, or more generally, any high-interest debt. Even though credit cards are a necessity given how purchases are made online, rental cars are reserved, and hotel rooms are booked, using a credit card to purchase meals, clothes, and a $4 cup of coffee will eat away at the future earning potential of that money.
But mortgages and car loans can also be bad debt if they're higher than the borrower can afford. For example, a couple earning $150,000 per year would be wise to purchase a house that keeps their monthly mortgage payment below $2,500 per month. This will allow them to comfortably save for retirement, a child's college education, and establish a reserve funds of at least 12 months of expenses. Certainly we'd all like a new home with a gourmet kitchen, but those who buy a house they can afford will likely be much better off in the long run.
What is My Credit Score and Why Does it Matter?
Your credit score is a number that indicates how likely you are to make credit payments on time. Your credit score affects both the types of loans you will get and the rates you'll pay on those loans. In general, the higher the credit score, the more likely a borrower is to get approved for a loan and to get a lower interest rate.
Mortgage lenders, car financing companies, insurance companies, and cell phone service providers, will do a thorough credit check before making a decision on how much credit to allow and at what rate. Credit card companies review credit status on a regular basis to determine the rate that will be charged and whether the line of credit should be increased.
In the past, a low credit score only affected a borrower's ability to obtain a loan. But today, a low score may prevent the borrower from getting an apartment or even a job. Some insurance companies also check credit scores prior to setting rates on life, health, and car insurance policies. Prospective employers now routinely check credit scores to make sure a potential applicant isn't in such dire straits that he or she could present a liability to the company.
There are three primary credit reporting agencies: Equifax, Experian, and Trans Union. Each calculates a credit score based on information provided by lenders. There are five parts to a FICO score. Payment history accounts for approximately 35% of the score. The best way to keep this portion of the score high is to make payments on time. The amount owed accounts for about 30% of the credit score. If the amount owed is more than half of the total amount of credit, the score may be reduced. Length of credit history counts for approximately 15% of the score. Older people who've had more opportunity to establish credit typically have a higher score in this regard than younger people. New credit makes up about 10% of the score, as do other factors.
Knowing your credit score and taking steps to get a higher credit score can have a huge impact on financial planning. For example, a person with a low score of 580 to 600 might pay a full 3 points more for a mortgage than a person with a score between 720 and 750. The difference between 8.5% and 5.5% on a $100,000 loan is a difference of $2,400 per year. That's money that could be saved in a retirement account or put away for a child's education.
Paying Off and Managing Debt
While it sounds simple, it's important not to spend money you don't have. A credit card limit isn't money in the bank. It's a line of credit that should be used only for those items that can't be purchased with cash. For example, it would be impractical to withdraw $3,000 from a bank account to purchase a flat-screen TV. But if a large ticket item is purchased with a credit card, be sure there's cash in the bank to pay the bill in full when it arrives.
Paying off loans in the order of highest to lowest interest rate is one of the easiest ways to manage debt. Use bonuses, cash from an extra job, or an inheritance to pay down debt. Credit card debt should usually be paid off first, followed by car loans, student loans, and a mortgage. Although before you pay off your mortgage, you might want to speak to your tax professional to determine whether or not the loss of any current mortgage interest tax deductions will result in an increase in your marginal tax rate.
Sitting down with your spouse to develop a plan for debt management and establishing a budget will help with both your short-term financial goals and those that have been set for the long term. For those who are nearing retirement, paying off debt is a crucial step to take prior to starting a life without a paycheck. Debt, even in the form of good debt like a mortgage, will eat away at a monthly savings account faster than any other type of spending. Set a course of action for debt management and stick to it. The less you can rely on debt, the better.
While we've covered the basics of financial planning here, there is much more to implementing a financial plan. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Financial Planning Guidance
- Financial Planning Guide — The complete guide to financial planning.
- Financial Advisors — Understanding how to work with a financial advisor.
- Investment Guide — Explore various investment options to grow your nestegg.
- Insurance Guide — Explore which insurance coverages your really need.
- Tax Considerations — In-depth discussion of how to minimize tax burden.
- College Savings — Explore various ways to safe for a child's college education.
- Financial Planning FAQ — Frequently asked questions about financial planning.