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Back to Basics

Understanding Debt

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What is Debt

Debt as defined by dictionary.com is:

something that is owed or that one is bound to pay to or perform for another

Essentially when you are taking on debt someone has agreed to give you something in return for something else to be paid at a later time. The lender agrees to take on a certain amount of risk and you agree to pay them a certain amount extra, interest, for them taking on that risk.  The debts you owe can range from the .25 you owe your cube mate to the $250k you owe your mortgage company, hopefully your cube mate isn’t charging interest.

Types of debt

Personal Loans

Personal loans are those loans you have made or have been made to you by family members or friends. These loans are typically loosley arranged and may or may not have defined interest terms or payback requirements. Seemingly this type of loan would be ideal but experience shows that loans to and from family and friends can put undo stress on relationships with dangerous side effects.

Student Loans

Hopefully you are, or will be, lucky enough to make it through school without taking out any loans, if not than you are going to fall into this boat. Student loans can be subsidized, where the government pays your interest while you are in school, or unsubsidized where it accrues until you start paying. Either way student loans aren’t necessarily a bad thing. You are financing your future, I don’t like paying it but I am glad I went to college.

Mortgages

The mack daddy of all debt.  A mortgage is essentially a loan for a piece of property that is secured by the property. What this means is that if you dont’ pay back your debt, they take back their house.  Typically mortgages have been seen as an investments which is “guaranteed” to increase in value. As we have all witnessed this couldn’t be further from the truth. Don’t buy a house for an investment unless it is really just an investment property.

Credit Cards

Credit card, or plastic money, are little portable debt tallying machines. A credit card is a method for getting a short term loan for something you are going to purchase. You are given a plastic card, an exorbitantly high interest rate, and a spending limit.  The credit card company hopes you do two things, 1.) max out the card and 2.) carry a balance. That way they continue to make money off of you. I like to have my card just because I have always had it, we use it for any large purchase but we never carry a balance on it we just collect the points.

Payday loans

These are the devil, no seriously they are the devil. I won’t even describe them here other than to say they make credit cards look like the saints of the debt world.

Good Debt vs. Bad Debt

Lets start with the fact that debt, no matter what kind, is still debt. You OWE soemone money and THEY have some type of leverage against you for it. In this sense all debt is bad debt, however, there is definitely debt that is OK and debt that is bad. The OK debts are things like your house which will eventually increase in value and your student loans which will eventually help you get a job. In some select cases it may even be OK debt if it is on a credit card, don’t tell Dave Ramsey I said that, it all depends on the WHY and the WHAT, not the WHERE.

Bad debt is debt associated with flipant spending for unnecessary items. Credit card debt is the biggest drain on the American household and yet so many people just can’t wait to swipe that AMEX or VISA for that new Coach bag, or the hottest new trend. These types of debts are typically referred to as consumer debts and should be avoided. If you can’t pay for it, don’t buy it just save your money and get it later.

Photo: (kevinkrejci)

This article is part of the Suburban Dollar Back to the Basics series. I plan to cover remedial personal finance topics which aren’t as sexy, or typically covered, in the personal finance blogosphere. My hope is for people to get a better understanding of basic personal finance without boring you to death, hopefully you will be able to share these posts with family and friends to get them into personal finance and have a good foundation of knowledge.

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Understanding Your Credit Score

Your credit score is essentially a number which should depict the creditworthiness of any given individual. Contrary to popular belief there is more than one credit score as each vendor will typically use their own calculation to arrive at your magic number. This mystical magical number may seem unimportant early in life but can have a large impact on you ability to buy a home, a car, get credit cards, or even get a job.

Your credit score is fluid, it changes as you history and your situation changes. What you got today may not be what you score tomorrow. This is especially true if you miss a payment or suddenly take on a large amount of debt. The most commonly used and commonly referenced score is the FICO score. The FICO score was created by Fair Isaac Corporation and measures key parts of your creditworthiness. FICO scores fall within the range of 300-850 with the higher your score the more creditworthy you are. A score of 720 or higher is pretty much going to get you the best rates on your loans.

Components of a FICO Score

Your Fico score consists of five major components which affect your net score to varying degrees.

Payment History (35%)

How you have paid on your debts in both the past and the present is the largest factor in determining your score. They don’t just take into account whether you were late or not this component consists of several factors like:

  • how long the payment was past due,
  • how often you were past due,
  • on how many accounts you were past due,
  • were their any liens of judgments against you, and
  • how long it has been since you were last delinquent (late).

Amounts Owed (30%)

Not only do they care about how you pay but they care about how much you owe. Factors they consider within this portion include:

  • Total number of accounts with balances,
  • proportion of available to used revolving credit lines,
  • proportion of original loan to owed amount on some installment loans, and
  • in some cases they may even consider a lack of a certain type of balance

Length of Credit History (15%)

While not as important as your payment history or the amounts you owe it is still seen as more important than the remaining factors. The longer your credit history the better you will be looked upon by the score gods. Keep in mind however that they also look at the amount of time since the last account activity so a dormant account may not be a huge help to you.

New Credit (10%)

This area is a little more obscure, here they take into consideration how many account you have recently opened,  the number of credit inquiries on your account, as well as the time since you had credit inquiries.

Types of Credit (10%)

The final category relates to the types of credit accounts you have on your report. Here is where they would take into consideration having only credit cards or having credit cards and a mortgage.

Where you can get your credit score

Your credit score doesn’t need a baby sitter, if you are practicing good solid financial management principals and you are paying or debts on time than you are going to end up with a decent score. If you have a high amount of outstanding debt than work to decrease the debt and don’t take on any new debt. If you aren’t looking to buy a house or get a loan than odds are this score is meaningless to you at any given time. The best thing you can do is to regularly check your credit reports to ensure the reports are accurate.  You can check your credit report by visiting annualcreditreport.com where you can obtain your credit report from each of the three major bureaus (see instructions here).

If you are still interested in finding out that magic number than you are going to have either opt in to receive it when you order your free report (they charge) or you could sign up for one the credit monitoring/score sites that are out there. Two of the biggest ones lately have been FreeCreditReport.com and TrueCredit. Just watch out for fees as these are usually monthly recurring costs.

This article is part of the Suburban Dollar Back to the Basics series. I plan to cover remedial personal finance topics which aren’t as sexy, or typically covered, in the personal finance blogosphere. My hope is for people to get a better understanding of basic personal finance without boring you to death, hopefully you will be able to share these posts with family and friends to get them into personal finance and have a good foundation of knowledge.

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Be Frugal, Not Cheap

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A key method for spending less than you earn is to cut your costs on the things you buy every day. Reducing expenses and paying less than retail for the items you normally buy is commonly referred to as being frugal. Frugality is often confused with being cheap and in many cases the two terms converge and the line between them becomes blurred. I personally feel the big difference between being frugal and being cheap is that cheap people are just inconsiderate. When you start to pinch every penny and cut out all fun you have started to cross the line. If you start passing on the office envelope every time someone retires you have crossed the line.

The key to frugality is to look for the best value in what you are buying. I like to buy store brand black beans because the price is lower and to me the flavor and quality is the same. I won’t buy store brand peanut butter because the flavor isn’t what I want out of it. When you are being frugal you want to maximize your dollar with costing you in opportunity or productivity costs. You could spend your entire Sunday comparing ads and driving back and forth across town to get the best deals on everything you buy, or you could find the lowest cost for the majority of your purchases and shop at one place.

Simple Ways to be Frugal Without Being Cheap

Cook at home: I am not saying to don’t go out to eat, but cook at home more often and cut back on going to out to eat. If you want to save more on eating at home try to plan your ingredients to maximize their usage. For instance you could make three meals out of one chicken. Another great way to cut back on the costs in the kitchen is to make at least one meal per week without any meat.

Bring a bagged lunch to work: There are a lot of people who eat out for lunch almost every day at the office. I am one of those people. I work from home though so I am not in the office that much, if I were I would probably be broke. If you are in this boat than you are probably costing yourself a lot more than you really need to. I am not saying never go out to eat, just cut back or even just start drinking water when you go out.

Hit the local library: a while back I decided I was going to test out our local library system here, after I did it I realized I was insane for not doing it earlier. With a little bit of patience I can read any book I want without having to pay for it. Of course the key here is to make sure you return the book on time but I have been lucky so far.

Watch your utilities usage: There are a ton of ways you can save on your utility bills like switching from incandescent to fluorescent light bulbs, installing a programmable thermostat, cutting down on vampire power, and washing your clothes with cold water can all save you a lot more than you would initially think.

Start a garden: While I am not completely convinced you will save money by growing a garden like I did I see the potential. Next year I am going to focus on vegetables I can can myself and save for later. Another great thing you could grow is fruit. Fruit can get expensive so if you can get your own berry bushes and fruit trees going you can really maximize your return on investment.

If you get a raise hide it: This isn’t exactly a frugal tip but it works great. If you don’t need the money don’t ever let it hit your bank account. The last time I got a raise at my office I increased the amount of my 401k contributions to match my raise. I didn’t need the money at the time and by taking it out before it hits my bank account I am never going to miss it.

Adopting a frugal, or moderately frugal lifestyle in conjunction with working to increase your income will increase your positive cash flow and allow you to reach your goals of financial freedom quicker.

Photo: (coneslayer)

This article is part of the Suburban Dollar Back to the Basics series. I plan to cover remedial personal finance topics which aren’t as sexy, or typically covered, in the personal finance blogosphere. My hope is for people to get a better understanding of basic personal finance without boring you to death, hopefully you will be able to share these posts with family and friends to get them into personal finance and have a good foundation of knowledge.

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Spend Less Than you Earn

August 24, 2009

This could be the simplest, most overlooked, bit of financial advice ever provided. I have not ever read a book or met an advisor who thought it was going to be a great idea to spend as much as, or even worse, more than you earn. This is a true basic principal of managing your […]

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Managing a Checking Account

August 13, 2009

Saving is kind of a set it and forget it process, once you get your accounts setup and your transfers in place there isn’t much, if any, account management that needs to take place. A checking account, however, requires you to actively manage and track your funds. The most basic form of checking account management […]

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