Don’t Make these Financial Mistakes

The world is going through a very difficult phase. Everywhere we are hearing that we need to get adjusted to the ‘new normal’. Nothing is normal as it used to be. Children are not able to go to schools.   Most people are working from home.  Healthcare professionals are working day and night for the recovery of people who get COVID-19.  In this situation, it’s quite natural that the economic situation is not good. Many people have lost jobs or are facing pay cuts and experts are predicting that an economic recession will set in.  We don’t have any control over this situation. But, what we can do is safeguard our finances, as much as we can, and avoid financial mistakes during this COVID-19 financial emergency.

Here are a few financial mistakes you should avoid.

Satisfying Wants to Avoid Boredom

Have you been browsing online shopping websites and ordering items? Is it because you need them or just to avoid boredom?

When the lockdown started, people were stockpiling grocery items. Now focus has shifted to buying items like clothes, books, entertainment things, and so on. So, in both situations, people are overspending.

But, now is not the time to do so. Rather, you should try to save as much as you can. We will discuss how to save more later in this article.

If you are getting bored at home, nurture a hobby (hopefully an inexpensive one). Do something which you’ve always wanted but didn’t get time to do so. If you wish, you can also do some online jobs as per your liking.

Following the Same Budget

Are you following your budget? You might say that you’re following it and saving. Good! But it’s a mistake. You’ll ask why? Because it’s necessary to re-assess your budget in light of the current situation and make modifications if required. If you’ve done that, well done!

If you still have income, it is time to save as much as possible. Doing so, you can be prepared for any future rainy days. If you save more, you won’t have to worry as much about losing your job. You know that you’ll be able to sustain yourself for a few months.

You can practice frugal budgeting to save more. Frugal budgeting doesn’t mean you’ll have to compromise with eating healthy or compromise with your life; it means to cut unnecessary expenses and increase your savings.

Overspending that Doesn’t Fit in your Budget

It is better to avoid buying big-ticket items during this time. Try to delay satisfying your wants for the time being.

To illustrate the previous point, let me highlight a survey conducted in January 2020 in Nebraska by First National Bank of Omaha.  It showed that about 50% of people in our country have a pay check to pay check lifestyle. So, it becomes quite tough to meet daily necessities when they face job loss, which has happened during this pandemic.

Therefore, you should try to have a good cash reserve. To do so, you need to save more and keep the amount in a high-yield savings account.

Check out how these ways to save more that you might be overlooking:

  • Stop eating out and have nutritious homemade food which is healthier too
  • Have a list when you go grocery shopping and don’t buy anything extra
  • Switch to debit cards if that can help you reduce your expenditures
  • Cancel your gym membership and work out in fresh air
  • Check out your magazine subscriptions and cancel if you rarely read them
  • Opt for bundling offers of television and internet
  • Opt for public schooling of kids instead of private schools
  • Start envelope budgeting to save more
  • Set temperature of water heater to 120 degrees to save electricity
  • Clip coupons and use them to save money

Using your Emergency Fund for Daily Necessities

Emergency funds are for rainy days. But, don’t touch it if you can manage without it.

Check how much you have in your emergency fund. Will you be able to sustain for about 6 months without a pay check? If not, try to have that amount in your emergency fund.

Do not touch your fund unless it’s an emergency. And, if you have to use it, try to save the required funds after the situation becomes normal and you start getting your usual pay check.

Every month, try to save a definite amount in your emergency fund. And, the account should be easily accessible so that you can withdraw funds whenever you need it.

Of course, if your emergency savings is the only thing between you and not paying your bills, you can start spending it.

Not using Available HSA funds

Instead of using your emergency fund for medical treatment, use your pre-tax HSA (Health Savings Account) funds. You can use the funds to get treated or tested for Coronavirus if required. You can even use the funds to consult a therapist if you’re anxious or depressed during this pandemic.

Delaying Filing your Taxes if You’re Eligible for a Refund

As per the CARES (Coronavirus Aid, Relief, and Economic Security) Act, the federal tax filing deadline has been extended to July 15, 2020, including any estimated tax payments for 2020. But, if you’re eligible for a refund, file your taxes.

As per IRS, the average refund is about $2,908 this year. It can help you to cover your living expenses or even make debt payments during this pandemic.

Not Paying the Entire Amount on your Credit Cards

It is a mistake to make only the minimum payments on your credit cards. If you do so, you’ll have to pay the interest on the outstanding balance every month. Therefore, it is always better to pay the entire balance on your cards every billing cycle if you possibly can. So, before swiping your cards, check out whether or not you’ll be able to make the entire payment in the billing cycle.

Also, use your reward points if you’re ordering things online; otherwise, your reward points may expire.

If required and if the creditors agree, you can take out a balance transfer card and transfer your existing balance to the new card. Usually, a balance transfer card comes with an introductory period of zero or low-interest rate. So, repay the transferred balance within that period.

However, after making the payment, do not cancel your existing cards especially if they have a long credit history.  If you cancel cards, the credit limit and the history of credit will reduce thereby affecting your credit score negatively.

Getting Panicked and Selling Stocks

Selling stocks after a stock market decline is one of the major financial mistakes that often people commit. They sell stocks when the market is down. But, have faith. The market will surely recover. Do not touch your investment portfolio at this time. The market recovered even after the economic crisis of 2009. However, it may take a bit more time. So, do not sell stocks right at this moment.

Another thing that the financial advisers always tell not to do is check your portfolio every day. It will make you stressed. Instead, if you have an additional amount after meeting your necessities, you can invest it in stocks as the prices are low.

Withdrawing from Retirement Accounts without Considering the Cons

The CARES Act has made it quite easy to withdraw funds from your retirement accounts, such as IRAs (Individual Retirement Account) and 401(k)s.

Here are a few advantages of withdrawing funds:

  • You can borrow up to $100,000 from your 401(k) plan.
  • You can withdraw $100,000 from any qualified retirement plan without having to pay an early withdrawal penalty.
  • You have 3 years to repay the amount without paying any income tax on the withdrawn amount.

The main advantage of starting to save early in such retirement accounts is to take advantage of compound interest. However, if you withdraw, you’ll lose the benefit to some extent. So, weigh the pros and cons before opting for this.

Not Reviewing your Financial Condition with your Financial Advisor

It is not a good idea to skip reviewing your financial situation with your financial advisor. It is rather more important at this time to have a clear view of your financial situation.

Discuss with your financial advisor how you need to maintain your investment portfolio and what moves you need to take. Talk about your financial goals and how you’ll implement them.

Taking on Debts without Thinking about How to Manage

Mortgage rates are comparatively low. You may feel the urge to take out a loan to meet your daily necessities if you’re facing financial problems. However, it is better not to take out additional debts that you can’t handle.

However, if you’re already having difficulty managing your existing debts, you can consolidate your debt. You don’t have to meet with a debt consolidator in person. You can just call a good consolidation company and seek help.

Sitting in Front of a Screen

At last, I would like to mention that it is quite important to stay physically and mentally healthy during this time. So, do not be stressed. Restrict your screen timing and have some me-time. Do something which you like. Nurture a hobby. Use this opportunity to spend time with kids and family members.

Enjoy quality time and take help from your family members to manage finances efficiently. Not committing these mistakes can help you have a better financial future.

About Good Nelly

Good Nelly is a financial writer who lives in Milwaukee, Wisconsin. She has started her financial journey long back. Good Nelly has been associated with Debt Consolidation Care for a long time. Through her writings, she has helped people overcome their debt problems and has solved personal finance related queries. She has also written for some other websites and blogs. You can follow her Twitter profile.

Good Debt vs Bad Debt: Key Characteristics

Not all debt is bad! The specific definitions of good debt vs bad debt will vary from person to person. For people who plan to retire very early and live on a limited income or for people who know that they have a hard time paying their bills either for lack of money or organization skills, most debt is likely to be problematic.  For other people, taking on debt is less of an issue.

One of my followers was thinking of expanding his business and was concerned that taking on debt would be harmful. As part of helping him with his thinking, I identified general characteristics that distinguish good debt vs bad debt. He ended up selling his business instead of expanding it, but I am sharing my insights in this post. These characteristics may not apply to your particular situation, so be sure to think about them in the context of your own situation and temperament.

Characteristics of Bad Debt

Here are five characteristics of debts that I would consider bad.

You Don’t Understand the Terms

Loans and other sources of borrowing, such as credit cards, all have different terms. It is important that you understand the terms of your debt. For example, some loans, mortgages in particular, have adjustable rates. That is, the interest rate that you pay on your loan will change as a benchmark interest rate changes. If the benchmark interest rate increases, your loan payments will also increase.

Credit cards also can have interest rates that change. A teaser rate is an interest rate that applies to credit card debt for the first several months to a year. After that initial period, the interest rate charged on credit card debt can be very high.

Another example of a loan provision that can be problematic is a balloon payment. Some loans, including some mortgages in the US and many mortgages in Canada, have balloon payment provisions. For the initial period of time (often five years for Canadian mortgages), you make payments on your loan as if you were re-paying the loan over 30 years. However, at the end of the fifth year, the entire balance of the loan is due. The Canadian mortgage I reviewed requires the lender to re-finance the loan at the end of the fifth year, but at an interest rate that reflects the then-current interest rate environment and your then-current credit rating. In effect, that loan has an adjustable interest rate that depends not only on a benchmark interest rate but also changes in your credit score.

I consider any debt for which you don’t fully understand the terms, best avoided by reading the entirety of the loan document, as bad debt.

You Can’t Afford the Payments

When you enter into a loan agreement, you will be provided with the amount and timing of loan payments. With credit cards, the payments are usually due monthly and are a function of how much you charge and the card’s interest rate. Any debt that has payments that don’t fit in your budget is bad debt.   I would even take it one step further and say that any debt that has payments so high that you aren’t able to save for emergencies, large purchases and retirement is bad debt.

High Interest Rate

Some types of debt, such as credit cards and payday loans, have very high interest rates. The definition of a high interest rate depends on the economic conditions. Currently (around 2020), I would say any interest rate of more than 8% to 10% is high. By comparison, when I was young in the early 1980s, the interest rate on a 10-year US Government bond was more than 15% and mortgage rates were even higher.

If you have debt with high interest rates, you will be better off re-paying them as quickly as possible as you can’t earn a high enough investment return on any excess savings to cover the interest cost. That is, the investment return you can earn on the money, especially after tax, is going to be less than the interest rate you pay on the debt. In that case, it doesn’t make financial sense to invest any excess cash but rather you will be better off by using any excess cash to pay off the debt.

Depreciating Collateral

In many cases, debt is used to purchase something large, such as a boat, a home or a car. When you make a large purchase, the item you bought is considered collateral and the lender can take the collateral if you don’t make your loan payments.

The value of some items goes down (depreciates) faster than the principal of the loan. If you default on your payments when that happens, the lender is allowed to make you pay the difference. Determining whether your purchase is something that will retain its value or will depreciate quickly is a good test of whether it is financially responsible to use debt to make the purchase. If not, I would consider the purchase a poor use of debt.

No Long-Term Benefit

Many other purchases for which debt, such as credit cards and payday loans, is used have no long-term benefit. For example, if you buy a knick-knack for your home with a credit card and don’t pay the balance when the credit card is due, you will be paying interest for something that has no long-term benefit to you. I consider using debt for items or experiences with no long-term benefit to be bad.

There is a gray area. If you use debt to buy clothes that are required for your job, the clothes themselves don’t have a long-term benefit, but they could be considered as creating the ability to go to work and earn money.   As such, while I would normally consider clothes as a poor use of debt, I can see how work clothes that allow you to increase your income might need to be financed for a month or two on a credit card.

Characteristics of Good Debt (vs Bad Debt)

The first requirement of good debt is that it doesn’t have any of the characteristics of bad debt. That is, good debt:

  • Has terms you fully understand.
  • Fits in your budget, especially if your budget also includes saving for retirement, large purchases and an emergency fund.
  • Is one that has a reasonable interest rate.
  • Isn’t backed by depreciating collateral.
  • Is used for something with long-term benefit.

There are many ways in which a debt can create a long-term benefit. I’ve mentioned buying clothes required for a job that allows you to earn money, in particular a lot more money than the cost of paying off the debt.

Your Primary Residence

Most people borrow, using a mortgage, to purchase a home.   The market values of homes generally increase over long periods of time, though there are periods of times when the market values of homes decrease. In addition, there are a lot of carrying costs of owning a home, such as insurance, property taxes, maintenance and repairs. However, by owning a home, you don’t have to pay rent which, in theory, covers all of the costs of home ownership.

I think that buying a house is a good use of debt as long as the mortgage meets all of the criteria identified above. Although not specifically related to the use of debt, you might want to think carefully about buying a home (with or without debt) if you plan to live in it for only a short period of time. The transactions costs of buying and selling a home are high and you increase the likelihood that the value of the house will decrease if you own it for only a few years.

Your Car

Using debt to buy a car is also quite common. If you are using the debt to cover the cost of your only mode of transportation and you need it to get to work, it can be a good use of debt. Again, you’ll want to check that it has the other characteristics of good debt identified above.   Using debt to buy a car that is more expensive than you need or leads to loan payments that are higher than you can afford is not as good a use of debt.

Your Education

Many people use student loans to pay for college. From an economic perspective, student loans can be either good or bad. The criteria for evaluating the student loans are:

  • Will the increase in your wages will cover your loan payments?
  • Will you earn enough after graduation to allow the loan payments to fit in your budget?

For example, let’s say you can earn $30,000 a year if you don’t go to college and $40,000 if you get a degree. If you borrowed $50,000 a year for four years at 5% with a 10-year term, your payments would be more than $25,000 per year.

First Criterion

Over the term of the loan, your increase in wages ($10,000 per year) is less than your loan payments. Over your working life time, the return on your investment in your student loans is about 3.5%. The return on investment is positive, so the use of debt could be justified using the first criterion.

Second Criterion

It might be very difficult to cover the $25,000 of annual student loan payments on annual wages of $40,000 a year. If you are willing and able to live on $15,000 a year until your student loans are re-paid, they could be considered a good investment economically.

A smaller amount of debt or a larger increase in salary will improve the economic benefit of student loans. If you are considering student loans to finance your education, you’ll want to look at their economic costs and benefits carefully.

Your Business

When you start your own business, you often need to invest in one or more of equipment, inventory or a place to run your business.  Many people borrow money to make these initial investments. Starting a profitable business can be a very good use of debt, as it provides you the opportunity to increase your net worth. However, 30% of businesses fail in the first year and 50% fail in five years, according to the Small Business Administration, as reported by Investopedia. If you borrow money to start a small business and it fails, you will often still be liable for re-paying the debt, depending on whether you had to personally guarantee the loan or if the business was able to procure the loan.

Investing

There are at least a couple of ways you can use “debt” to invest.

Don’t Pre-Pay Your Debt

The most common way to use debt to invest is to invest extra money rather than using the money to pre-pay your mortgage or other debt. Whether it is good or bad to use this “debt” to increase your investing depends on several factors and your financial situation:

  • The longer the term on your debt, the better the choice is to invest instead of pre-paying your debt. If your loan payments only extend over a year or two, it is more likely that your investments will lose money making you worse off than if you pre-paid your loan. Over long periods of time, your investment returns are more likely to be positive.
  • The lower the interest rate on your debt, the better the choice it is to invest instead of pre-pay your debt. If the interest rate on your debt is higher than you can expect to earn on the investments you would buy (after considering income taxes), you will almost always be better off pre-paying your loan. If your interest rate is low, e.g., less than 3% or 4%, you are more likely to earn more in investment returns than the interest cost on your debt.
  • You have another source of income to make your loan payments if your investments decrease in value. For example, if you were planning to retire in the next few years, pre-paying your debt is more likely to be a better decision than investing. On the other hand, if you plan to have other sources of income besides your investments for the next 10 or more years, you might be better off investing rather than pre-paying your debt.

Investing on Margin

Another way you can use debt to invest is to buy your investments on margin. Under this approach, you borrow money from the brokerage (or similar) firm to buy your investments using your existing invested assets as collateral. In many cases, you can borrow up to 50% of the value of your existing assets. So, if you have $100,000 of stocks, you could borrow $50,000 to make additional investments.

The drawback of buying investments on margin is that the lender can make you re-pay the loan or a portion of it as soon as the value of the assets you own (the $100,000 of stocks in my example) decreases to less than twice the amount you’ve borrowed. Unfortunately, the amount you borrowed may have decreased in value at the same time while the amount you borrowed as stayed constant. As such, buying investments on margin is considered very risky and should be done only by people who fully understand all of its ramifications.

Final Thoughts on Good Debt vs. Bad Debt

Debt, when used carefully, can greatly improve your life and your ability to earn money. However, if you take on too much bad debt, it can lead to significant financial problems. This post has provided a framework to help you decide whether any debts you have or are considering are likely to be good debt vs bad debt.

The Best Ways to Pay Off Your Debt

The Best Ways to Pay Off Your Debt

The best way to pay off your short-term and revolving debt depends on your priorities and what motivates you.  Two of the common approaches for determining the order in which to re-pay your loans discussed in financial literacy circles are the Debt Snowball and Debt Avalanche approaches.

Both of these methods apply when you have more than one debt that needs to be re-paid.  If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, making the minimum payments as often as you can to avoid finance charges which will be added to your principal in addition to the interest charges on any portion of your balance you don’t pay.

In this post, I’ll describe how the two debt-repayment methods work using some illustrations.  I will then help you understand which approach might be better for you.  For more information about the fundamentals of debt, check out my posts on loans and credit cards.

What’s Included and What’s Not

The debts covered by this post include credit cards (one kind of revolving debt), personal loans, car loans and other bills that are overdue. While longer-term loans, such as mortgages, are referenced in the budgeting process, I haven’t included them in the debt re-payment examples. If you have unpaid short-term debt, you’ll want to keep up with the payments on these longer-term loans first, but don’t need to pre-pay them. For this discussion, I will assume that you intend to re-pay all of your debts to your current debtholders. That is, you haven’t dug a hole so deep you need to declare bankruptcy and you don’t feel you’ll benefit from transferring some or all of your high-interest rate loan balances to one with a lower interest (i.e., debt consolidation).

Debt Snowball

Dave Ramsay, a well-known author on financial literacy topics, proposed the Debt Snowball method for paying off your debts.  Under this method, you do the following:

  1. Identify all of your debts, including the amounts of the minimum payments.
  2. Make a budget. (See this post for more on budgeting generally or this one for the first of a step-by-step series on budgeting including a helpful spreadsheet.) Your budget should include all of your expenses excluding your short-term and revolving debts but including the payments you plan to make on your longer-term debts (e.g., car loans and mortgages).
  3. Determine the total amount left in your budget available to re-pay your debts, remembering that you need to be able to pay for the total cost of all of your current purchases before you start paying off the balances on your existing debt. If the amount available to re-pay debts is less than the total of your minimum payments, you may need to look into your options to consolidate or re-structure your debts, get them forgiven or declare bankruptcy.
  4. Otherwise, make the minimum payment on all of your debts except the smallest one.
  5. Take everything left over in your budget from step (3) and reduce it by the sum of the minimum payments in step (4). Use that balance to pay off your smallest debt. After you fully re-pay the smallest debt, you’ll apply the remainder to the next smallest debt and so on.

Debt Avalanche

The Debt Avalanche method is very similar to the Debt Snowball method, except you re-pay your debts in a different order.

The first three steps under the Debt Avalanche method are the same as the first three steps under the Debt Snowball method.  It differs from the Debt Snowball method in that you pay the minimum payment on all of your debts except the one with the highest interest rate at any given time instead of the one with the smallest balance.

Examples

I’ve created the two examples to compare the two methods.  In both examples, I have assumed that you use a different credit card or pay cash for all new purchases until your current credit card balances are re-paid.  That is, to make progress on getting out of debt, you need to not only make extra payments on your existing debts, but also not create additional debt by borrowing to pay for new purchases.  It’s tough!

Example 1

In this example, you have two debts with the balances due, interest rates and minimum payments shown in the table below.

Example 1Balance DueInterest RateMinimum Payment
Debt 1$1,50020%$30
Debt 250010%10

You have determined you have  $100 available to pay off these two debts.  The minimum payments total $40 in this example, so you have $60 available to pay off more of the principal on your debts.

Example 1: Debt Snowball

Under the Debt Snowball method, you will use the additional $60 a month you have to pay off Debt 2 first, as it has the smaller balance.  That is, you will pay the minimum payment of $30 a month on Debt 1 and $70 a month on Debt 2 for 8 months, at which point Debt 2 will be fully re-paid.  You will then apply the full $100 a month to Debt 1 for the next 17 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 25 months and will pay $428 in interest charges.

Example 1:  Debt Avalanche

In Example 1, you will use the additional $60 a month you have to pay off Debt 1 first under the Debt Avalanche method, as it has the higher interest rate, whereas you used the additional amount to pay off Debt 2 first under the Debt Snowball method.  That is, you will pay the minimum balance of $10 a month on Debt 2 and $90 a month on Debt 1 for 20 months, at which point Debt 1 will be fully re-paid.  You will then apply the full $100 a month to Debt 2 for the next 4 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 24 months and will pay $352 in interest charges.

Example 2

In this example, you have five debts with the balances due, interest rates and minimum payments shown in the table below.

Example 2Balance DueInterest RateMinimum Payment
Debt 1$1,00010%$40
Debt 25000%25
Debt 310,00020%100
Debt 43,00015%75
Debt 57505%30

You have $500 available to pay off these debts.  In this example, the minimum payments total $270, so you have $230 available to pay off the principal on your debts in addition to the principal included in the minimum payments.

Example 2: Debt Snowball

Example 2 is a bit more complicated because there are more debts.  As a reminder, under this approach, you apply all of your extra payments ($230 in this example) to the smallest debt at each point in time.  In this example, you will make the additional payments on your debts in the following order:

Debt 2

Debt 5

Debt 1

Debt 4

Debt 3

It takes only two months to pay off Debt 2 and another four months to pay off Debt 4.  As such, you will have fully re-paid two of your debts in six months.  In total, it will take 43 months to re-pay all of your loans and you will pay $5,800 in interest.

Example 2:  Debt Avalanche

In this example, you will make the additional payments on your debts in the following order:

Debt 3

Debt 4

Debt 1

Debt 5

Debt 2

It turns out that Debt 2 is fully re-paid in 20 months even just making the minimum payments.  Debt 5 is paid off 7 months later again with only minimum payments, followed by Debt 1 2 months later.  As each of these debts is re-paid, the amounts of their minimum payments are added to the payment on Debt 3 until it is fully re-paid after 39 months.  At that point, the full $500 a month is applied towards Debt 4 which then takes only 2 additional months to fully re-pay.  In total, it will take 41 months to re-pay all of your loans and you will pay $5,094 in interest.

Comparison

Dollars and Sense – Two Examples

Looking at the two examples, we can get a sense for how much more interest you will pay if you use the Debt Snowball method instead of the Debt Avalanche method.  The table below compares the two methods under both examples.

Example 1Example 2
Interest PaidMonths of PaymentsInterest PaidMonths of Payments
Snowball$42825$5,80043
Avalanche352245,09441
Difference7417062

In these two examples, you pay more than 10% more interest if you use the Debt Snowball method than the Debt Avalanche method, leading to one or two additional months before your debts are fully re-paid.

Dollars and Sense – In General

The difference in the amount of additional interest depends on whether your debts are similar in size and the differences in the interest rates.  I’ll take that statement apart to help you understand it.

  • If the debt with the lower interest rate is very small, you will pay it off quickly.  As a result, there is only a very short period of time during which you are paying the higher interest on the larger loan under the Debt Snowball method.  As such, there will be very little difference in the total amount of interest paid between the two methods in that case.
  • If the debts all have about the same interest rate, it doesn’t really matter which one you re-pay first, as the interest charges on that first loan will be very similar to the interest charges on your other loans.

Dollars and Sense – Illustration

The graph below illustrates the impact of the differences in interest rates and sizes of two loans on the difference in the total interest paid.  To create this graph, I took different variations of Example 1.  That is, you have two loans with outstanding balances totaling $2,000 and the interest rate on the larger debt is 20%.

 

How to Read the Axes

The interest rate on the smaller loan was calculated as 20% minus the increment shown on the axis labeled on the right.  That is, the interest rate on the smaller loan for scenarios near the “front” of the graph was 18% or 2 percentage points lower than the 20% interest rate on the larger loan.  Near the “back” of the graph, the interest rate on the smaller loan is 0% or 20 percentage points lower than the interest rate on the larger loan.

The loan balance on the smaller loan divided by the total debt amount of $2,000 is shown on the axis that goes from left to right.  The small loan is $40 (2% of $2,000) at the far left of the graph and increases as you move to the right to $960 (48% of $2,000) on the far right.  Note that, if the small loan exceeded $1,000, it would have become the bigger loan!

The Green Curve

The green curve corresponds to the total interest paid using the Debt Snowball method minus the total interest paid using the Debt Avalanche method.  For example, at the front left, corresponding to the small loan being $40 with an 18% (=20% – 2%) interest rate, there is a $2 difference in the amount of interest paid.  At the other extreme, in the back right of the graph (0% interest rate on a small loan with a balance of $960), you will pay $167 more in interest ($308 versus $140 or more than twice as much) if you use the Debt Snowball method rather than the Debt Avalanche method.

What It Means

Interestingly, moving along only one axis – that is, only decreasing the interest rate on the small loan or only increasing the size of the smaller loan – doesn’t make very much difference.  In the back left and front right, the interest rate differences are only $15 and $22, respectively.  The savings from the Debt Avalanche method becomes most important when there is a large difference in the interest rates on the loans and the outstanding balances on the loans are similar in size.

Sense of Accomplishment

For many people, debt is an emotional or “mental-state” issue rather than a financial problem.  In those situations, it is more important to gain a sense of accomplishment than it is to save money on interest.  If you are one of those people  and have one or more small debts that you can fully re-pay fairly quickly (such as Debts 2 and 5 in Example 2 both of which were paid off in six months under the Debt Snowball method), using the Debt Snowball method is likely to be much more successful.

Key Points

Here are the key points from this post:

  • A budget will help you figure out how much you can afford to apply to your debts each month.
  • If you can’t cover your minimum payments, you’ll need to consider some form of consolidation, re-financing or even bankruptcy, none of which are covered in this post.
  • If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, but making the minimum payments as often as you can to avoid finance charges.
  • You will always pay at least as much, and often more, interest when you use the Debt Snowball method as compared to the Debt Avalanche method.
  • Unless you have two or more debts that are all about the same size and have widely varying interest rates, the total interest you will pay is essentially the same regardless of the order in which you re-pay them.  As such, if the sense of accomplishment you get from paying off a few debts will help keep you motivated, using the Debt Snowball method may be the right choice for you.
  • If you have two or more debts that are all about the same size and have disparate interest rates, you will want to use the Debt Avalanche Approach.  Because the balances are all about the same, it will take about the same amount of time to re-pay the first loan regardless of which loan you choose to re-pay first!  As such, it is better to focus on the interest you will save by using the Debt Avalanche approach.

 

The Scoop on Credit Scores

Credit scores are one of the most important financial numbers.  Credit scores not only affect the interest rate you pay when you borrow, but also your ability to borrow and other important financial transactions. It has been a long time since I’ve borrowed money, so I talked to Cody Jensen, a consumer loan officer at Missoula Federal Credit Union, to get the most current information.  In his role as a loan officer, Cody spends a lot of time educating young borrowers, so he was a terrific resource.  Here is a summary of the interview (with a few tidbits I found on line to expand on a few of his points).

What are Credit Scores?

Most lenders and vendors use the national score calculated by Fair Isaac Company.  It is a number between 300 and 850 that measures your creditworthiness and is sometimes called FICO score.

How are They Used?

Your credit score affects whether you can get a loan (see this post for more about loans) and, if so, the interest rate you will pay.  The lower your credit score, the higher the interest rate you will be charged.

Your credit score also impacts other financial transactions, such as:

  • Landlords use it to evaluate whether to rent to you.
  • The amount that you will pay if you lease a car (see this here for more on leases).
  • Most companies issuing you a contract, such as cell phone providers and cable companies, use it to decide whether you have to pre-pay for your services. That is, if you don’t have a high enough credit score, you will need to pay in advance for your services or make a significant deposit.
  • In many jurisdictions, car and homeowners/renters insurers use it as a rating variable. The lower your credit score, the higher the insurance premium you will have to pay, all other things being equal.

What is a Good Credit Score?

The thresholds vary between categories depending on the user of the information. The chart below shows the approximate distinctions considered by many vendors.

What Determines My Credit Score?

According to Investopedia, there are five factors that determine your credit score:

  • Payment history – Do you pay your bills on time. Timely payment for a long period of time will improve your credit score.
  • Credit utilization – The ratio of the amount you owe to your credit limit on credit cards.While you want a score that is more than 0% (i.e., using your credit cards is good), as the ratio increases above 30% your credit rating will decrease.
  • Length of credit history – The length of time you have used credit, either through student loans, other loans or credit cards. The longer you have used credit, the higher your score will be.
  • New credit – The amount of recent increases to your credit (e.g., new credit cards or loans). Once you have established credit, taking on additional loans or credit cards will lower your score.
  • Credit mix – The types of credit you use. Using different types of credit, such as loans and credit cards, improves your score.

The chart below shows the weights given to each of these factors.

What Can I Do to Improve my Credit Score?

Whether you are just getting started with credit or have an established credit history, here are some things you can do to improve or maintain your credit score:

  • Pay your bills on time. As indicated above, paying at least the minimum payment on your credit cards and making your full installments on any loans by their due date combine to be the biggest contributor to your credit score.
  • Wait until you have a couple of years of experience on your record. By taking the time to establish your credit experience before taking out a loan, you can reduce your interest rate or increase your ability to get a loan.
  • Get a secured credit card. If you are just getting started or need to re-build your credit, you can use this type of credit card.
    • When you open the account, you need to put down a security deposit that is higher than the limit on the credit card, often 110% of the credit limit. For example, if you get a card with a $1,000 credit limit, you’ll need to give the issuer a security deposit of $1,100.  This deposit will be returned when you close the account.
    • Ask someone else to co-sign on the credit card. In this case, the card becomes a shared secured credit card.
    • To improve your credit score, you’ll want to pay off all your charges every month.
    • You will establish a strong payment history, which improves your credit score, by using the secured credit card regularly for a period of time.
    • A secured credit card doesn’t count as a loan so it doesn’t hurt the credit utilization part of your credit score.
  • Make sure there is a balance on your credit card on the last day of the calendar month.
    • That’s when FICO checks your balance, so it is the date on which credit utilization is calculated.
    • You can then pay it off when your bill is due to improve your payment history and avoid interest payments.
    • You score will improve if your balance is between 3% and 30% of your limit on the last day of the month.
  • Check your credit information as maintained by the credit bureaus (Equifax, Experian and TransUnion). This information includes all of your loans and credit cards, your outstanding balance at the end of each month and your payment history.  You are allowed to request your credit report (but not your credit score) for free from each bureau once a year.  If you want it more often than that, you need to pay a fee. You can either enter the information on Annual Credit Report.com’s web site or print a form and submit it by snail mail.  I know a few people who have found mistakes (usually due to identity theft or confusion with a person with a similar name) that have hurt their credit scores. There is a process by which your credit report can be corrected, though it isn’t always easy.

What Are the Causes of Low Credit Scores?

Obviously, not paying your credit card bills or re-paying loans will lower your credit score.  Other factors that can lead to a lower credit score are:

  • Late payments. Again, whether you make your payments on time is the biggest factor in determining your credit score.
  • Too much debt (including credit cards and student loans). If you take on too much debt, you are less likely to be able to re-pay it.  When you have so much debt you can’t keep up with your payments, credit utilization will be too high and payment history could become poor.  These two factors alone drive 65% of your credit score.
  • While a divorce itself does not lower your credit score, some aspects of unwinding the finances can put downward pressure on credit scores.  In many marriages, the couple acquires debt based on their combined income.  For example, many couples rely on both incomes to secure a mortgage for a home.  If the couple gets divorced, they now need two households and neither one has sufficient income to pay off their joint mortgage or other debts.

How Do I Find Out My Credit Score?

Many banks and credit card companies will provide you with your credit score for free.  When I log into my bank’s web site, I can see my FICO score.  You can also pay one of the major credit bureaus (Equifax, Experian and TransUnion) for your credit score.