As we continue our back to basics series, we’re going to talk about debt. We interview the founder of the blog, Dear Debt, We Need to Break Up.
Melanie Lockert of Dear Debt who paid off $81,000 in student loan debt joins us to discuss all things debt related.
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What is APR?
When you borrow money, whether you are using a credit card or taking out a mortgage, the amount you borrow is not the amount you will have to pay back (unless you pay off your credit cards in full every single month for life).
You will also pay interest, this is the cost to borrow money. The interest you pay on a credit card is APR, the annual percentage rate. The average APR for a credit card is about 16%. Credit cards have a set APR so your credit score doesn’t impact the rate you pay.
Not all APR is the same though. There may be one for balances you carry, it may increase if you miss a payment, taking out a cash advance against the card may have a different APR than the balance APR and there is no grace period on a cash advance. It starts accruing the moment you take the cash.
Nerd Wallet has full reviews of credit cards and lays out all the terms. Their site is easier to read than credit card fine print so if you are looking for a credit card, do your research there.
If you have a credit card with an annual fee (not necessarily a bad thing if the cost of the perks you use add up to more than the fee but there are plenty of good rewards cards that don’t have fees) you may be able to get it waived if you are in good standing.
It doesn’t hurt to call and ask. If your fee is because the card is a secured card you were using to build credit, ask if you can upgrade to a non-fee card without closing the account (closing accounts hurts your credit score, more on this below).
If you have a premium rewards card with a fee and the company won’t waive it, you may be able to downgrade to a card with no annual fee, a Chase Sapphire Preferred to a Chase Sapphire for example without closing the account.
Paying Off Debt is an Emergency
You must have a plan to pay off debt, just throwing money pell mell isn’t efficient. There are two methods to pay off debt, snowballing and stacking. We wrote an article on this with lots of details and the pros and cons of each.
The short version is that snowballing means paying off the debts in order of lowest to highest dollar amount. Stacking is paying them off in order of highest to lowest interest rates. Strictly from a money saving standpoint, stacking makes the most sense because it saves more on interest.
Melanie offers two more methods, pay off the debt that pisses you off the most, maybe a loan you took out with an ex or the loan that keeps you up at night.
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Your Credit Score
Your credit score is made up of six factors; payment history, utilization, derogatory marks, the length of credit history, total accounts, and credit inquires. We wrote a detailed article on credit scores.
The best possible credit score is an 850 but it’s almost mythical and there is no reason to chase it. If you have a score above 760, that is good enough to get you the best interest rates on loans or to be approved to rent an apartment. If you’re at 760, use your personal finance energy on something else like investing rather than tinkering with your score.
If you have poor or no credit, you can fix and build it. The easiest way to do it is to take out a credit card. Again, go to Nerd Wallet and do some research, don’t just apply for any card. Each time you apply for a credit card or a loan, your score takes a hit. A small, temporary hit but a hit all the same and we’re trying to improve our credit.
Nerd Wallet will tell you the cards you are likely to be approved for. Only apply for those so you will have less chance of being turned down and still having taken a ding to your score. If you can’t get a traditional card, apply for a secured card.
A secured card works just like a regular credit card but the lender holds a deposit from you. The amount may be the same as your credit limit or your limit may be a bit higher. Not all secured cards report to the credit reporting agencies (the information they have on you is what your credit score is made of) so make sure you choose on that does.
Some secured cards charge a fee but not all, so find one that doesn’t. You can also apply for store credit cards but it’s not ideal. If the card can only be used in the store that issued it, give it a miss. Buying clothes or other unnecessary things every month in order to build credit is not really a great money habit. If the card can be used anywhere, it can help build credit. You can use it for necessities like groceries or utilities and then pay it off in full each month.
If you are simply trying to build credit, putting fixed expenses on a credit card and setting up auto-pay can be a good way to do so; it ensures that you’ll never miss a payment. If you are trying to repair bad credit, it may be better to pay every bill manually.
It makes you more mindful of your money. If you’re afraid you’ll forget to pay a bill on time, set up alerts on your phone for each one two days before the due date and at a time when you will be in front of your computer to actually pay it.
Go through your credit card charges each month. There could be double charges or fraudulent charges that need to be addressed. Using Mint is the easiest way to do this because then all of the transactions for all of your cards will be in the same place.
Is There Such a Thing as Good Debt?
To some people in personal finance, Melanie, and Dave Ramsey among them, the answer is no. Others consider student loan and mortgage debt “good debt” because it’s a debt taken on as an investment; a student loan is an investment in your education and career and a home is a financial investment (especially if it’s a rental property).
Bad debt is consumer debt, credit card debt, personal and payday loans. Debt with high interest. You want to get rid of this debt as quickly as you can. This kind of debt is an emergency. If you have credit card debt, the cheapest way to get rid of it is to use a 0% APR balance transfer card.
These cards allow you to transfer the balance of your high-interest cards to the new card and pay no interest for the term of the offer, some cards have a 0% APR period lasting up to twenty-four months. This gives you time to pay off the principle without paying interest.
Some have transfer fees but you can find a few cards that don’t. Be aware of the term ending. Any remaining balance you have not paid off at the end of it will be charged the regular APR and that could be higher than the card you transferred the balance from.
You can also get a loan from a peer to peer lender like Lending Club and use it to consolidate your debt. You use the new loan, which will have a lower interest rate than your current loan or credit card APR, to pay off the high-interest loans.
You can also work with a non-profit credit counselor. They can help you to make a budget and a debt management plan. For a fee, they will also work with your creditors to lower your interest rates and set up a repayment plan.
Credit is a Tool
Credit cards in themselves are nothing to fear. They are a tool that when used correctly can help you build credit. You might think you don’t need credit, that you can just go through life paying for everything in cash. But not having credit makes life more difficult. Some landlords won’t rent to you without a credit history, it will be hard to get a loan for a car or mortgage.
Yes, you can pay cash for those things although you will need a lot of cash to do it, but even if you have that much, a big chunk of your wealth is no longer liquid. Sure you can pay for an entire year of rent in order to convince a landlord to rent you an apartment but what if your car breaks down or you need furniture for the apartment? I guess those things would have to wait until you saved up money again.
Bankruptcy: The Last Resort
Bankruptcy is not an easy solution if you have a lot of debt. It costs money, it follows you around for years, and it carries a lot of stigma. But if things are so bad and you can’t see another way out, it may be an option.
There are two types of personal bankruptcy; Chapter 7 and Chapter 13. In a Chapter 7 or “straight bankruptcy” scenario, you agree to turn over all your nonexempt assets to a Chapter 7 trustee, who subsequently sells your assets and distributes the money to your creditors.
Chapter 13, or “reorganization,” allows you to keep your property, such as a mortgaged house or car, as you pay creditors over a period of three to five years with a single monthly payment.
Not at debts can be discharged including child support payments, alimony, fines, taxes, and some student loan obligations. Bankruptcy will stay on your credit report for up to 10 years, affecting your ability to buy or rent a home, and will likely result in higher interest rates on future loans.
Try the other options we listed above, balance transfers, a peer to peer loan, credit counseling, sell anything you can, get a second job, whatever you can do to avoid bankruptcy. But if it is the only choice left, it’s better than hurting yourself. It’s just money.
Debt is an Emergency
It’s so much harder to build wealth and achieve financial independence when you are dragging around debt. If you have high-interest debt, start making a plan today to get it paid off as quickly as you can so you can stop paying debt and start growing your money.
Dogfish Head SeaQuench Ale: A sour brewed with lime, black limes, and sea salt.
Dear Debt: Melanie’s blog.
Dear Debt: A Story About Breaking Up With Debt: Melanie’s new book.
Tool Box: All the best stuff to manage your money.
Simple Wealth: Research and evaluate rental properties.