The new year provides the opportunity to improve your credit worthiness. Credit is one of the primary engines that runs the American economy and households. It gives individuals, corporations, the government and other organizations the ability to buy goods and services today, but pay later. One must understand, however, that when you borrow money, you are giving up the use of money you will earn in the future.
As you begin the new year, here are some things you should be aware of when managing credit and debt:
A. Debt-to-limit ratio. The debt-to-limit ratio is used to determine how well you manage your credit card debt. You should not charge more than a third of the limit of your credit card and definitely no more than 50 percent of the limit. This computation can be made by dividing your credit card loan limit into your outstanding balance. You may ask why does this matter. In the computation of your credit score, the amount of credit used against your credit card limit affects your score. A key factor in computing your credit score is your outstanding debt. In fact, 30 percent of your credit score is driven by the level of your outstanding debt. This means that as you reach the limit on your credit card loans your credit score decreases.
B. Debt-to-income ratio. The debt-to-income ratio is calculated using your net take-home pay and total monthly debt payments, excluding rent/mortgage. Your total monthly debt payments, excluding rent/mortgage, should not exceed more than 20 percent of your net take-home pay. This is calculated as follows -- divide your net take-home pay into your total monthly debt payments (car loans, student loans, credit cards, consumer loans and other personal loans). If the result is 20 percent or less you are fine; however, if the result is above 20 percent, you have too much debt. As a result, your chances of acquiring new debt are limited. You should begin to immediately liquidate your outstanding debt by increasing your monthly payment on the lowest balance account until complete liquidation; then use the amount previously used to liquidate the first loan to increase the monthly payment on the next lowest outstanding loan balance. This should be continued until you have brought your debt-to-income ratio down to 20 percent or below. Of course, you also can use tax refunds, bonuses and other unexpected income to liquidate your loans to improve your debt-to-income ratio and credit score.
If you are already debt laden, there are options to use for debt relief. You may seek the services of a non-profit credit counseling agency -- The National Foundation for Credit Counseling has offices and affiliates in most cities located throughout the United States. Non-profit credit counseling agencies may suggest that you establish a debt management plan. With a debt management plan the agency will negotiate with your creditors to lower monthly payments and possibly lower your interest rate, which will enable you to consistently make timely monthly payments using your current income. However, you may be able to create your own debt management plan by calling your creditors to work out new payment arrangements that you can afford and pay consistently.
Another option is debt settlement where the creditor agrees to allow you to pay less than the amount outstanding. This option is not one that I would recommend because it has a major impact on your credit score. In fact, your credit score could decrease by more than 100 points. This occurs because you did not make the full payment of the loan as agreed. Moreover, debt settlements remain on your credit report for 7 years.
The last option is bankruptcy. This is the most serious option available because of the impact it has on your credit history. Chapter 7 bankruptcy normally allows you to walk away from most debt and prevent garnishment of your wages. Chapter 13 bankruptcy sets up a plan to repay all outstanding debts in full over a 3- to 5-year period. These actions can stay on your credit report up to 10 years.
You want to keep in mind the importance of maintaining good credit and debt management as both will allow you to have greater access to credit when needed. But more importantly, it gives you the advantage of acquiring any new loans at lower interest rates, which decreases the outflow of your household income. Make a commitment this year to pay your bills on time, reduce your outstanding debt, charge less than the maximum on your credit cards, only apply for credit when needed and do not use credit to satisfy a want.
Theodore R. Daniels is the Founder and President of the Society for Financial Education and Professional Development (SFEPD). Founded in 1998, SFEPD is a non-profit organization whose mission is to enhance the level of financial and economic literacy of individuals and households in the United States and to promote professional development at the early stages of career development through mid-level management.