Perspective Matters
In this post I'm going to talk about what credit is, when you should use it and what you should be aware of before you do.
In simple terms, credit is the amount of money that a lender is willing to lend you. Typically, you and the lender will enter into a contractual arrangement defining the terms of the loan. It will state how much the lender is willing to loan you, how much interest you will pay, and how you will repay the loan. The contract will also provide details on the consequences of the borrower not honoring the terms. For example, if you haven’t made a scheduled loan payment by the due date, how many extra days to pay will you be given before the payment is considered late, the consequences of being late with a payment, and at what point the borrower may be declared in default. It will also provide details about the lenders’ choices and how to respond if the borrower defaults.
In some types of loans, the lender will put constraints on how you use the money or how you must pay it back. For example, the documents associated with borrowing money from the bank for a real estate purchase will state very clearly the exact property that you are allowed to use the money to buy. If for some reason you don't buy that property you can't just substitute another property without expecting the bank to require you to start the application process all over again. At the other extreme would be an unsecured personal loan. You might have to state what you're not going to do with the loan, for example you won’t use the money to purchase stocks or bonds or other securities, but you don't have to even know what you're going to use the loan for.
Some loans will allow you to repay them early and save on your total interest paid while others could require you to pay a penalty if you want to pay it off early.
You'll notice I used the word unsecured earlier. Loans are either secured or unsecured and that refers to whether or not you have pledged a specific thing that you own as collateral for the loan. If you have pledged your house, your car or your comic book collection as collateral for the loan and you don't make the payments the lender has the right to take the collateral from you and sell it to cover the repayment of the loan. A loan with collateral is known as a secured loan. If you don’t have to provide collateral, the loan is unsecured.
The interest rate you will pay on a loan can be affected by several things. Some questions to consider:
Is the loan secured or unsecured?
How long do you have to repay the loan?
Is it a revolving loan, meaning that you can borrow money, pay it back and borrow it again as many times as you want within a specific period of time?
What's your credit history and score?
Do you have a relatively secure source of ongoing income?
Why do you have to pay interest on a loan? Interest is the cost that you pay to use somebody else's money to do something you want to do. Think about it this way; money is a resource that has a limited amount of availability. Everyone that has it gets to decide what they want to do with it but generally you can only do one thing with each dollar. You can buy something that you consume like a meal or a vacation, you can buy something you're going to use but is expected to decline in value over time as it ages like a car, you can save it for something you might need later, you can buy something you're going to use and is expected increase in value over time like your home or you can invest it into something that you think will make money for you.
If you are borrowing money, you are getting it from someone who has chosen the last option, investing it in something they think will make money for them. They're going to charge you for the use of their asset.
There are certain guidelines about when it makes sense to use someone else's money and when it's a bad idea. If you borrow money you use it for something, and after paying back what you borrowed you have more than you would have had without the loan, then that's a smart way to use credit. For example, if you borrow money to buy real estate that you think is going to go up in value and after paying back the loan the real estate is worth more than you paid for it, AND the increase in the value is more than the interest you paid on the loan that's a good use of credit.
There are some other factors to consider in determining the cost of the loan that are a little bit more complex and I won't go into a great amount of detail here, but I'll give you a couple of examples. When you borrow money to buy your own home you may be able to take a deduction on your tax return for some or all of the interest you pay on that loan. Any tax benefit you get from paying the interest reduces your total cost of taking the loan so you would make an adjustment when calculating the cost of the loan compared to the final value of the real estate.
Another example might be deciding whether to pay cash for a car or use a loan. There are a couple of things to consider such as:
if you don't use cash to buy the car, what would you do with the cash instead, and
if you sell the car after you pay off the loan how much would you get for it?
Let's look at an example:
Option one: you buy a $30,000 car with cash and in five years you sell it for $10,000. Without taking any time value of money calculations into consideration you have reduced your cash by $20,000. You can think about that as the net cost of the car. Now you compare that net cost of borrowing to buy the car.
Option 2: you buy a $30,000 car with a 10% cash down payment ($3,000) and borrow the balance of the purchase price ($27,000) using a five year loan with an interest rate of 7%. Again, you sell the car at the end of five years for $10,000. In this case you pay $3000 cash when you buy the car, you pay another $32,077.94 in car payments over the five years and then get $10,000 back when you sell the car. Your net cost is $25,077.94. The additional $5,077.94 compared to Option 1 is the interest you have paid to use someone else’s $27,000.
With option 2 it matters whether you actually have $30,000 available to pay cash or not. If you have the cash, then you also have to add into the equation what you will do with the other $27,000 if you choose to take the car loan. For example, if you had an opportunity to put that $27,000 into a five year CD paying 3% it would earn about $4300 over the five years. That would offset some of the interest costs, making your net cost of financing about $778. (I’m not factoring in any taxes, but you get the idea.)
I know this is a lot of math; you don't have to figure it all out on your own if math is not your strong suit. You can find calculators on the Internet to help you figure out the math as long as you know what things to consider. Of course, if you don't have the cash to make buying the car with cash one of your options that's a different conversation. That gets into the subject of savings habits which is beyond the scope of today's post.
A general rule to keep in mind is it using credit to buy something that is likely to increase in value is good debt and using credit to buy something that is either going to be consumed, experienced, or decline in value is bad debt. Use cash in situations that would create bad debt and you'll keep your net worth growing.
The last thing I'll touch on is credit scores. There's a lot of debate about how these are calculated and how they're used. It's something that is constantly changing. Think of it this way; a credit score is a way for somebody who doesn't know you to try to guess about the likelihood that you're going to pay them back if they lend you money. The only way someone can form an opinion about whether you're likely to repay money you've borrowed is by looking at how you've handled your financial obligations in the past. It's hard to have a good credit score though if you've never had any financial obligations such as rent or a utility bill or a loan to pay back. Here’s a link with some ideas on how to build credit from Experian, one of the more well-known and often-used credit reporting companies. Also, click here for the article from the Federal Trade Commission on understanding your credit. The article also includes information on how to get your credit report for free.
There are lots of advertisements these days about how to increase your credit score but please be careful. One of the problems I think in our society today is that there's a lot of marketing that emphasizes short term versus long term rewards and is focused on people who don't have a lot of experience with borrowing or investing. Students are sent solicitations for tempting purchases using debt that may be easy to get, but the focus is on low monthly payments instead of the interest rate. “Get these fancy speakers for only $39.55 a month,” but when you read the fine print on the last page, you’re spending $1500 to buy speakers, then borrowing at 30%, making payments for 10 years, and by the time you’ve finished you’ve spent more than $4700!!
The focus is also on immediate gratification. As human beings we are all biologically predisposed to have a hard time delaying getting what we want. There always seems to be some temptation and some messaging that says, “why wait until you can afford this - you deserve it now.” That sets up an emotional dynamic with money that can quickly become very unhealthy. The implication is that you're making a judgment decision about what you deserve instead of focusing on what you can afford. Remember, very little in this world is truly free; there are always trade-offs to consider. There's a lot more profit to be made in tempting you into purchasing something today using credit than there is an encouraging you to delay that purchase until you save up enough money to buy it with cash.
As always, consider meeting with a Certified Financial Planner® professional to help you understand how to use credit most effectively in your situation, and to help you plan for a secure financial future for you and your family.
Neither Prism Planning and Solutions Group nor Insight Advisors provide tax advice, and nothing in this communication should be treated as such. This communication should not be interpreted as a recommendation for a specific investment or tax-planning strategy. We are providing this material for informational purposes only. We have made every attempt to verify that information contained in this communication is accurate as of the date published but make no warranties. Before making any decisions related to your own tax and/or investment situation you should consult the appropriate professionals.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.