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Understanding & Managing Debt to Your Advantage

In a debt-based society like the US, understanding debt, its power as well as its shortcomings are key to the overall financial planning and your personal finance. Debt surrounds us everywhere, either from financing a car to using a credit card, to buying a home or even furnishing that home. Debt, or credit history of it, even follows us in unexpected places, like renting a home or getting a job. It’s everywhere and even if some don’t like it, it’s best to be understood.

Understand debt for what it is. In a system of trust based on debt management as what the credit history (or credit score) clearly does, if you want to build ‘trust’ in the system, you better know how to use debt. That starts from how to build it, where to start up, how to use it, how to benefit from it and lastly how to not get trapped by it.

As mentioned above, your credit history and the score derived from it, is used widely in our society. But few know how that score is really made up. Notice below the different components of your FICO (credit) score noticing the big weight percentage to your ‘payment history’ and ‘amounts owed’. The other parts make the whole of the score, being your ‘length of history’, the ‘credit mix’ of the types of credit you have and if any ‘new credit’ or inquiries have been made.

FICO Score_InvestEd Advisory

Using credit wisely is key to reaping the benefits of debt. But first, let’s mention that one of the main and big benefits is the opportunity to do and have something without having all the money upfront. Think of all the missed opportunities if you couldn’t access debt for your college education, or if you couldn’t buy a home due to not having all the cash upfront needed (who has $300K+ in cash laying around anyways), or not being able to afford a decent car to get you to your job, or even having the money needed to start a good business. There would be a lot of missed opportunities for sure, and it would have been much worse than having no credit available at all.

 If used wisely debt can even increase your returns & opportunities. Debt is used by companies worldwide, even if they have the cash available. If at a low interest rate, debt can support businesses (or even your small business) as they expand and invest into their businesses that would produce higher returns than the cost of debt. Companies and investors alike even use debt to increase their returns, but to note here they are also increasing some of the risk too, if the debt is not easily paid.

Using it wisely mainly falls into 2 categories, 1) before getting into debt and 2) after getting into debt. The ‘before’ category mainly pertains to keeping debt within your means, not over-borrowing and then later not being able to keep up with payments. Usually, we base the affordability based on your income, where we recommend no more than 28% of your gross income to go towards the home-payment (including mortgage payment, taxes, home insurance, and condo fees, if any) and a total of 36% of your gross income towards all debt payments including home.

The ‘after getting into debt’ category mainly deals with what to do now that you already have debt. First, look at the mix of debt you have, what term is it, short or long-term debt, fixed or variable rates and especially what the interest rates are. Then prioritize the debt with higher interest rate first, like credit cards or high-rate store cards, versus low and fixed interest rate like mortgage or even a low interest car loan.

 Payoff wisely

As long as you make a plan to pay off high-interest rate loans within a reasonable amount of time, you will save money and also have available to save & invest afterwards. But even here, there could be couple of different thoughts to go with. One, known as the ‘avalanche debt payment method’ prioritizes the loans with the highest interest rate first, as we should, where we will save the most if reducing such loans. The other method, known as the ‘snowball debt payment method’ focuses on paying the smaller size balances first, thus giving you small wins (closing debt accounts) and moving into larger ones. While the ‘avalanche’ method is the rational approach in saving the most interest/money, the ‘snowball’ method also has psychological wins, making you feel closer to the goal of being debt free, one less debt account at a time.

 Don’t fall for the trap

Debt gets a bad reputation mainly of the ‘hangover’ and effects of over-borrowing or ‘debt abuse’. Many tend to not use debt wisely, not keep it under control or within the means (their income) and at times see the issues of such mismanagement. Interest rates increase significantly if you delay or miss payments; if you completely can’t pay the debt typically goes to collection, sometimes borderline harassment, and affecting your credit history, your credit score and thus the opportunity to get any debt on favorable (low-interest) terms. Not falling for the ‘trap’ is just keeping debt under control, only when needed and for items that typically add value to your life (education, home, car) and reducing it for spontaneous and discretionary spending if you cannot afford it outright.

 Debt is all around us and while there could be negatives of too much debt, there are many benefits if used wisely, as mentioned above. After all as with many things, balancing the good of it while avoiding the bad of it, is key to properly managing your debt.