All debt is not bad. Some debt is good. It all depends on what the debt is used for. When debt is used the right way, it can help manage your money, leverage your wealth, buy goods and services you need, and handle emergencies.
On the flip side, if the debt is abused it can wreak havoc on your finances and destroy your life.
Good debt can be positive if it helps to:
- Build your net worth by purchasing assets that appreciate over time. A good example is purchasing a home.
- Buy products that will pay for themselves over time. An example is weatherizing your home to reduce your heating bill.
- Buy products that are essential to your daily life. An example is purchasing an automobile to transport your family and commuting to and from work.
- Invest in yourself to increase your earning potential by getting a college education or upgrading your skills.
- Pay for unexpected emergencies that you don’t have immediate cash to pay for. An example of this is not having health insurance or your car breaking down.
- Using debt for convenience and rebates/cash-back. Here we are talking about credit cards. When used properly credit cards can actually make you money if you pay off your balance every month.
Bad debt can devastate your life if you use it to:
- Purchase nonessential products and services that do not increase your wealth. These items depreciate in value or have very little value after purchasing. Examples of this are eating out, clothes, shoes, handbags, music CDs, vacations, etc. Paying for these items on credit over time is throwing money in the garbage. Most of these items are paid for by credit cards which can carry high-interest rates, especially if you have poor credit.
- Secure debt by using items as collateral, such as your home, that you don’t want to lose but you are uncertain if you can afford to pay back the debt.
- Have interest rate debt and make low monthly payments. Over time the value of the debt grows, which exceeds the value of the service or product you purchased. As an example, an item you initially purchased for $200 may end up costing you $350 by the time you pay all the interest.
- Using payday or cash advance loans that carry very high-interest rates and trap you into keep extending the loan because you can’t pay it off.
Good vs. Bad Credit Terms
Debt can come with good credit terms and bad credit terms. Good credit terms are typically given to people with good credit. They are offered lower interest loans, larger loans, and longer terms (time to pay off the loan).
On the flip side, people with poor credit are offered high-interest loans, smaller loans, and shorter terms. Additionally, people with poor credit are offered secured loans, which require them to put up collateral, such as their home or car, to get the loan. If they don’t pay off the loan the lender has to right to confiscate the collateral as payment.
Credit Repair
If your credit history is a complete disaster, you have set yourself up for a miserable financial life. It’s vital that you get this back on track as soon as possible. So how do you start to rebuild your credit? First, you must stop the bleeding. You must create a budget, get all your debt paid off, and complete bankruptcy (if this applies to you).
Rebuilding your credit isn’t difficult. It’s not rocket science. It just takes discipline and time. Your ultimate goal is to add positive information to your credit history with small new credit from reputable creditors, paying it off per the terms of your credit agreement, and then repeating the process with new additional credit.
Your goal here is to prove that you have the character and capacity to pay off your debt. As this improves, your credit score will increase. But this takes time. It’s not an overnight process. The years of poor credit can’t be solved quickly.
Keep in mind that this is a slow process, so don’t sabotage your credit rebuilding efforts by applying for numerous loans/credit cards. The process should be gradual over time.
As you are adding positive information to your credit history, the negative information on your credit history will start to fall off. Per federal law, negative information can only be on your credit history for no more than 7.5 years.
However, bankruptcy can stay on your credit history for 10 years and student loan defaults or failure to pay child support can remain on your credit history until the debt is paid. Also, federal tax liens will stay on your credit history until it’s paid and the lien released.
The Psychological Effect
If you are trying to rebuild your credit you may be fighting a losing battle if you have underlying reasons for your financial problems. If you are an impulse buyer, but when you are depressed or lonely, spend money on alcohol or drugs because you are addicted, addicted to gambling, etc., you need to first fix these problems first.
Rebuilding your credit before dealing with your psychological issues will be a waste of time. You may be successful short-term, but long-term you will fall back into the same trap.
Laying the Groundwork
Before starting the credit rebuilding process you must order a copy of your credit report from each of the 3 national credit reporting agencies (Equifax, TransUnion, Experian), then carefully review for any errors.
If errors are found, correct them immediately. You don’t want to rebuild your credit, only to find out months or years later than errors were on your credit report.
Once per year, you are entitled to a free copy of your credit history (per federal law) from each of the 3 credit agencies. To order your free credit report visit www.annualcreditreport.com or call 1-877-FACT-ACT. If you already received your free credit report within the past year, you will have to pay which costs about $10.
Why Your Credit Report is Important?
It is extremely important that you get your credit report because it is the same information that your current and potential future creditors will review to make decisions about loaning you money.
Your credit report gives lenders a good indication of whether or not you will pay off your debt. The more negative information on your credit report, such as accounts in collection, past-due account, accounts charged off as uncollectible, etc., the lower your credit score.
Your existing creditors may also use your credit information to determine if your interest rates should be increased, lower your credit limits or even cancel your credit. Whenever you apply for new credit, your credit history is used to determine if you should be approved or denied, your interest rate, and your credit limit.
Employers, landlords, and insurance companies also use your credit history to make decisions about you. If there is a long list of negative information on your credit history insurance companies may not insure you or charge you a higher rate, landlords will not rent to you and employers will not hire you.
Most negative information stays on your credit report for 7.5 years unless you resolve it. Tax liens will stay on your credit report permanently until you pay it and bankruptcy (Chapter 7 Liquation and Chapter 13 Reorganization) stays on your credit report for 10 years.
Your Credit FICO Score
Many creditors, landlords, insurance companies, employers also use your credit score in addition to your credit history to make decisions about you. Your credit score also called your FICO score, is determined by the information on your credit report. FICO was developed by the Fair Issac Corporation
Your credit score may change from month to month and is based on a variety of reasons such as:
- How do you pay your bills
- Loans you have
- Credit cards you may have opened
- Number of companies that checked your credit report
Your credit score is determined by 5 main factors:
- 1. Payment history to determine how you pay your monthly bills.
- 2. Current debt with loans and credit cards. 3 – Length of time you have had credit or how long you have had credit cards and loans.
- 3. The type of credit you have.
- 4. Credit inquiries on your credit report.
This information is then statistically analyzed to determine a numerical number between 300 and 850 which is ranked as follows:
- Excellent: 750 to 850
- Good: 720 to 749
- Fair: 660 to 719
- Uncertain: 620 to 659
- Poor: 300 to 619
The number represents the creditworthiness of a person, which is the likelihood that the person will pay their bills. Mortgage and auto loans usually use your score to determine the interest rate charged. The lower a consumer’s credit score, the higher the interest charged due to the consumer considered a higher risk.
The credit score is typically from one of the three major credit bureaus which include Experian, TransUnion, and Equifax. You are entitled to 1 free credit report within a 12-month period from each of the three agencies which are available at Annualcreditreport.com. The report doesn’t list your credit scores, which is available for a fee.
In some states, such as California and Colorado, you can get a free credit report within 30 days of being denied credit or receiving sub-normal credit terms from a lender, due to their credit rating.
You can increase your FICO score by improving your finances. Your FICO score will increase if you:
- Correct errors on your credit history
- Pay off your account balances
- Pay your debt on time
- Increase your savings
- Minimize the amount of credit you apply for