Become a Discriminating Debtor in 2006

Attention! Book Giveaway

Dear Friends,
Does this sound familiar?

You had a great holiday. Everyone on your list was wowed by the generous gifts you gave them. You felt that warm and fuzzy “Santa” glow.

Now you’ve just received your credit card statement and you’re having a similar reaction: shock and awe. How did you spend so much? When you go over each item you realize the amounts are correct. You just lost track of the total.

Adding insult to injury, due to a change in federal guidelines that takes effect at the end of this year, credit card issuers have increased the minimum payments required each month. You realize that most of your purchases are on credit cards charging more than an 18 percent interest rate!

Suddenly you feeling like Scrooge. You vow to never be so magnanimous again in your gift giving. After all, wool is just as warm as cashmere, right?

You promise yourself you’re going to pay off this debt and cut up your credit cards. Your New Year’s resolution is to live debt-free!

Not So Fast.

This may be the first time you’ve heard this from a Certified Financial Planning Practitioner (that’s what the letters “CFP” after my name mean), but – are you sitting down? -- here goes:

Debt Is Not Bad.

Fact is, all debt is not created equal. Some debt, such as a mortgage that helps you build wealth through home ownership, is actually positive. (That is, provided you haven’t taken out one of those ridiculous zero-percent-down adjustable rate mortgages that’s eating up 50 percent of your monthly income.)

The key is to develop a healthy relationship with debt.

In this column and the one that follows next week, I’ll be explaining some of the finer points of credit- especially how to improve your credit “rating” -- and how to manage your debt, instead of the other way around. Both issues have taken on increased importance in light of the new bankruptcy law that took effect in October. To assist you in this endeavor, 30 readers will receive a copy of one of two books written by credit expert Liz Pulliam-Weston: “Deal with Your Debt” and “Your Credit Score.” (Details on how to qualify are at the end of this article.)

You Are Not Alone

Despite the horror stories that grab the headlines, most Americans are not up to their eyeballs in debt. Myvesta, which describes itself as “a non-profit consumer education organization,” says Americans are paring back the amounts they carry on credit cards.

In its annual survey of consumer debt levels, Myvesta reports that in 2005, the “average American” owed a total of $2,328 on his/her credit cards- $300 less than the year before. (The average total balance is slightly higher in the West and lowest in the Midwest.)

Moreover, most of us are doing a fairly good job handling the debt we’ve taken on. According to www.myfico.com*, the granddaddy of consumer debt databases, “on average, today’s consumers are paying their bills on time.” Less than half of us have ever been reported as 30 or more days late on a payment. Only about one in four has had a loan or other account where the payments were more than 90 days late. Nearly half of us owe less than $5,000, excluding a mortgage.

But there is also a darker side to the statistics. 20 percent of us have had a lender close an account due to default. And while roughly 40 percent of credit card holders carry a balance of less than $1,000,” almost one out of four carries “more than $10,000 of non-mortgage-related debt.” In the third quarter of this year, delinquent payments on bank-issued credit cards hit an all-time high.

Furthermore, it’s hard to get a handle on how many people are just making the minimum payment each month, which guarantees that whatever they’ve purchased will end up costing many times the actual price.

Regardless of the actual numbers, it’s probably safe to say, if you’ve read this far [you’ve] got a debt problem, or are concerned about someone else.

'Good' Debt vs. 'Bad' Debt

“I see so much debt advice,” says Pulliam-Westin. “It’s well-meaning, but they’re not financial planners. They’re not looking at the whole situation. They only see debt as ‘evil’.”

This kind of attitude causes people to do stupid things such as cashing out a 401(k) when they leave their job in order to pay off their outstanding credit card debt. As a result, they lose the benefits of continued tax-deferred compounding, possibly incur a 10 percent penalty, and put their retirement at risk.

In other cases, says Pulliam-Westin, people are “driving themselves crazy paying off their mortgage and are not funding their retirement because they’re so focused on getting their credit cards paid off.”

As previously mentioned, some debt, such as a mortgage, is “good” debt because it helps you improve your financial situation.

Notice I said “mortgage” and not “home equity loan,” which Pulliam-Westin classifies as “bad” debt. If you’re tempted to take out that post-holiday home equity line of credit, think twice. “Unless you fix the problem that caused the over-spending, you’re not solving the issue that got you into debt in the first place,” says Pulliam-Westin.

She adds, “Your house is your long term wealth. You don’t want to waste it on short-term spending.”

If you are considering filing for bankruptcy, that’s another reason you don’t want to transfer your credit card debt to your home. Credit card debt can be erased in bankruptcy. But any debt that is “secured” by an asset -- your mortgage, a home equity loan, a car loan -- cannot.

Debt “consolidation” loans, which are heavily hyped as the solution to Holiday Spending Hangover, are “a bad idea in most cases,” according to Pulliam-Westin. “People deep in debt are searching for the magic bullet, but these loans can make the problem worse.”

That’s because they often come with high costs and expensive late payment fees. “Usually they just stretch out the term for repaying the loan, so you end up paying more.”

Her advice: before you sign on the dotted line, reach out to your creditors. If you’ve been a good customer -- which means that you have no history of late payments, you don’t max out the card, and your general credit rating is good -- “you can often negotiate a lower interest rate on a bank-issued card.”

If you really feel a debt consolidation loan is the best remedy, check out what’s available through your local credit union. That’s where you typically find the best terms. Surprisingly, not all credit unions are tied to a particular employer anymore.

Another tactic is to take advantage of those “balance transfer” offers that come through the mail. I locked in one that allowed me to move my high interest rate credit card debt to another card (at 4 percent interest), for no transfer fee. In addition, the interest rate is guaranteed not to increase until the balance is paid off, unless I miss a payment.

This strategy is not a good idea, says Pulliam-Westin, “if all you’re doing is using one low rate offer just to postpone paying off your debt. However, if you use a low rate offer as a way to get rid of that debt more quickly and don’t keep transferring your balance from card to card,” it makes sense.

The key is to make at least the same monthly payment the higher rate card required so you’re paying down the principal faster. To avoid the possibility of your payment arriving past the “due” date, which would trigger a higher interest rate, arrange to have payments electronically made from your checking account on a pre-set day each month.

In case you haven’t guessed, credit card debt is Pulliam-Westin’s least favorite type of debt, mainly because it’s so expensive. She recommends that credit card accounts be the first you pay off. “Except if you’re unemployed. Then just pay the minimum and conserve your cash,” she says.

The average annual percentage rate (APR) on a “standard” bank-issued credit card hit 13.5 percent at the end of 2005, according to a survey by BankRate.com. That’s because the rate on these cards is tied to something called the “fed funds rate,” which the Federal Reserve has been raising for more than a year. Click here to see the rates (pdf document).

As you’re probably well aware, the interest rate on most department store cards is almost twice the rate on bank credit cards.

Adding Up The Pain

Starting this year credit card issuers have to spell out how much just paying the minimum monthly amount is going to cost you. For instance, say you have a $5,000 balance on a card with an APR of 18 percent. Your minimum payment is 2.5 percent of your monthly balance.

According to the calculator at http://www.bankrate.com, which has a slew of other useful calculators, your initial minimum payment would be $125. Of this amount, $75 is going toward interest; you’re only making a $50 dent in your actual principal.

Because it’s based on your balance, each month your required minimum payment declines slightly. This probably makes you feel good. “Hey, I’m making progress!” Until it dawns on you several years into this process that you’re still making payments. In fact, paying just the minimum every month means your bill will take 26 years to pay off. On your $5,000 debt, you will have paid $7,115 in interest!

By plugging other numbers into the calculator, you can see the impact a higher payment can make. For instance, if you could increase your payment to a fixed $200/month, you’d be rid of this debt in two and a half years and your total interest would be $1,314

Next week: Why -- even if it has a hefty interest rate -- you might not want to cancel a credit card once your balance is paid off. We’ll also look at what goes into your credit score and how to improve it.

To win a copy of either “Deal with Your Debt” or “Your Credit Score” (I get to pick which one you receive), send me an email via the link below explaining how you’d use it or why you need it. You must:

1. Write “Debt Book” in the subject line, and

2. Include your U.S. Postal Service mailing address. Entries that do not include this will be automatically deleted.

Here’s to a “smart debt” New Year!

Gail

*“FICO score” is term commonly used to describe your credit rating. It comes from the company that pioneered credit scoring back in the 1950s. The name has nothing to do with “fairness.” Pulliam-Westin explains it just so happens that the last names of the two founders were “Fair” and “Isaac.” “FICO” is an acronym for the “Fair Isaac Company.”

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com , along with your name and phone number.

Click here to visit our Debt Management page.