Financial Planning 101: Part 4
Debt & Credit— Using It Wisely

by Gerald Townsend, Financial Editor
April 2009

Is credit a good or bad thing? Observing the economic carnage of the past year and a half and the current borrowing and spending plans of the federal government, one is tempted to view all forms of debt as bad things that should be avoided. After all, the zero-down payment and easy-to-refinance mortgages contributed to the housing bubble-bust that is now plaguing the country. Consumers, businesses, and yes — the government — borrowed and spent themselves into a deep hole. So, what’s the answer? Debt and credit are a key part of our modern society, but the misuse or overuse of them results in problems for families, businesses, and nations.

Debt is a wonderful servant, but a lousy master. Let’s examine how to keep it as our servant.

Patience
Incurring debt allows you to acquire something today and pay for it in the future. Big-ticket purchases, such as a home or car, require you to borrow, unless you just inherited a tidy sum. However, consumers routinely run up their credit card balances on non-essential items instead of having the patience to wait until they could afford them. The penalty for this inability to defer gratification can be severe, with stressed budgets and sleepless nights.

Leave a Buffer
Even for the home and car purchases, many consumers overextended themselves and ended up with debt payments that could only be met if both spouses continued working and often only if anticipated salary increases materialized. When one spouse lost their job and the other saw their income stagnate, the monthly debt payment suddenly loomed very large. Life is uncertain and presuming on the future is dangerous. Leave a buffer — a margin — in your personal finances.

Establish a Credit History
When you need credit for a purchase, lenders rely on reports provided by credit-reporting agencies in order to evaluate your request. If you have never borrowed before, you have no credit history and may be turned down by the lender, regardless of your finances. How do you develop a credit history? Start small and seek credit from a retail store card, a gas card, or overdraft protection on your bank account. If necessary, you could obtain a "secured" credit card, which is a credit line you fully secure by depositing money in advance. The credit card issuer has no risk. Once you have established a regular pattern and history of payments, you can request that the secured card be replaced by a normal unsecured card.

If you are a parent or grandparent you have a wonderful opportunity — and responsibility — to help your child or grandchild establish and maintain their credit history as well as understand how to properly use credit.

Check Your Credit
Lenders rely on credit reports, but reporting agencies can make mistakes. You can obtain a free credit report every 12 months from each of the three main credit bureaus. Call 877.322.8228 or go online to annualcreditreport.com.

What impacts your credit rating? There are many factors and agencies differ, but an excessive number of accounts, a history of late payments, a high total debt relative to income, and a flurry of recent inquiries would all be negative.

If you do find an error in your credit report, contact the reporting agency. They have 30 days to complete a reinvestigation.

Cash Flow
The first step toward longevity is survival, and the first step in debt management is having cash flow sufficient to service your debt. Success or failure sometimes depends on the terms and structure of the debt. For example, perhaps you would prefer a 15-year mortgage, but the 30-year mortgage brings your monthly payment into the affordable range. The lower adjustable-rate mortgage appears attractive today, but will you be able to afford the payments once it rises? If you can make a larger down payment on a home mortgage what impact will that have on your interest rate as well as your ability to avoid private mortgage insurance?

For credit cards, do you know how your interest is calculated? Does the credit card company charge interest on new purchases? Do you have a grace period before interest is charged? Finally, remember that all debt must be repaid, and as Benjamin Franklin noted, "Creditors have better memories than debtors."

Gerald A. Townsend, CPA/PFS, CFP^®, CFA^® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com