In this article, we’ll try to answer some commonly asked questions about credit and debt.
What is credit?
The term “credit” implies that goods, services, or money are received in exchange for a promise to pay a sum of money at a later time. A “credit card” offers immediate access to services and merchandise to consumers who may or may not be able to make the full payment at once. Credit cards allow consumers the flexibility and leverage to make purchases with the promise of paying later.
When used properly, credit is an ideal financial tool. When used foolishly, credit can cost an exorbitant amount of money in interest and fees. The misuse of credit can also hurt an individual’s ability to purchase homes or cars, as well as endanger future financial stability.
How can consumers control credit and avoid debt?
Today’s consumers benefit significantly from the convenience of credit. Credit cards offer such benefits as frequent-flyer miles and cash-back bonuses, and they are especially useful for large purchases, emergency situations, identification, reservations, and protection from fraud.
Unfortunately, millions of consumers misuse credit cards beyond their financial means. The use of credit results in costly interest payments and late fees, impulse buying, overextended lifestyles, and unnecessary stress such as harassing telephone calls from collectors.
What is the debt-to-income ratio?
The debt-to-income ratio is an important concept. The ratio is calculated by dividing the amount of debt payments per month (excluding mortgage or rent) by the monthly gross income. For example, the debt-to-income ratio is 15% for someone who earns $3000 per month and pays $450 per month in credit card and loan payments (450/3000 = .15 or 15%). As a general rule of thumb, a personal debt-to-income ratio of less than 20% is considered safe. A ratio higher than 20% may be a sign of future financial trouble.
Ideally, individuals will carry little debt so that their income can be saved, invested, or spent on something of lasting value, rather than spending their disposable income on interest and late fees.
What’s the trouble with making minimum payments?
Consumers often mistakenly believe that making a minimum payment on a credit card is a reasonable financial move. In reality, minimum payments make only a very small dent into the original amount borrowed, which is called the principal. Picture, for example, a consumer who is $5000 in debt on a credit card that carries a 17 percent interest rate. The creditor requires only a minimum monthly payment of 2 percent, or $100. Of that $100, a mere $29.17 would be applied to the principal if the consumer made the minimum monthly payment. At that rate, it would take nearly 30 years-and cost thousands of dollars over the principal amount-for the individual to pay off the debt.
What about cash advances on a credit card?
Credit card holders often mistake cash advances (getting cash through a credit card) as free money. In fact, consumers must pay back the amount of the cash advance at a typically high interest rate, as well as a cash advance fee. For example, an individual who takes a credit card cash advance of $500 will ultimately pay back more than $600 if all payments are made on time within one year. (If any payment is late, late fees or higher interest rates may also apply.) People sometimes take out cash advances in order to pay off existing credit card balances, viewing this as a temporary solution to credit woes. In reality, this method of paying bills is one of the worst financial decisions a consumer can make, as it compounds the problem. The borrower will ultimately end up paying off the new debt at a higher interest rate, thereby losing even more money.
What are the alternatives?
People who find themselves in such situations may consider alternatives to costly cash advances. One option is to contact creditors, identify the problem, and attempt to negotiate a short-term arrangement that satisfies both parties.
There are instances, though when individuals may wish to consider rearranging their debts in order to obtain reduced interest rates or consolidate debts into one payment. An example is an unsecured debt consolidation loan. The purpose of obtaining this type of loan is to eliminate multiple credit card bills and receive favorable interest rates.
Another possibility that comes with some danger is a home equity, or secured, loan. What many people fail to realize is that by taking a second mortgage or home equity loan to pay off credit card debt, families may be putting their home at risk. The home serves as collateral to secure the loan, and can therefore be taken away if they default on their payments.
Consumers who choose to obtain a home equity or debt consolidation loan should immediately close credit card accounts and begin a spending plan.
Using credit wisely
The practice of using credit wisely involves:
- Paying off balances by the due date to avoid interest charges and late fees
- Charging only as much as can be paid for in one month’s time
- People who are unable to pay balances in full will benefit from paying off much more than the minimum amount on each statement and refraining from continued charging.