FUNDAMENTALS OF FINANCE
A Guide for Helping Professionals
Adam J. McKee
SECTION 3.1: Credit Scores and Cards
This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.
If debt is bad, then credit cards are the devil himself. Yet, in today’s high tech world, you have to have a credit card for pretty much everything. Amazon doesn’t take cash, and you can’t book a hotel for that out of town job interview without a card. And this problem gets more complicated when you think about credit scores. Make no mistake: Your life will be a lot harder and a lot more expensive if you try to avoid credit altogether. The consensus among financial advisors is that you must have credit, and you must learn to use it wisely. The easiest way to build good credit is the judicious use of a credit card account. The quickest path to financial ruin? You guessed it! Poorly managing your credit card accounts.
It is great to be a credit card company. No investment that we’ll talk about in this book will guarantee you the kinds of amazing interest rates that credit card companies earn. If I could give you advice on how to grow your retirement account at the rate those credit card companies are getting, I’d quit my job and start a hedge fund! They are getting absolutely rich, and I wish I could do that well with my investments. How are they making all that money hand over fist? People like you and me are sending it to them because we lacked the capacity for delayed gratification.
Understand that the credit card companies (and other financial industry players) have developed the Great Lie, and have run extraordinarily successful marketing campaigns to make us collectively believe it. Think about how fully you personally have been drawn into the myth. Can you even imagine living a life without debt? It is a matter of (forgotten) fact that cars can come without payments, homes can come without mortgages, and college degrees can come without student loans. It may be a fact, but most Americans don’t believe it on a visceral level. The average American household has over $16,000 in credit card debts. The national total is estimated to be over $780 Billion.
Why Credit Cards are Evil
I don’t think credit cards are actually evil, but most of them are because of the interest rate they charge. Let’s say you need a new transmission in your car. You shop around and find out to your horror that it’s a $3000 job. You borrow the $3000 from good old Uncle Bob, and you pay him back his $3000 by giving him $100 dollars every time you get paid (every two weeks) for 15 months. In a little over a year, you have satisfied your debt and have a low mileage transmission in your car. Sounds like a pretty doable scenario.
Let’s look at another scenario. Uncle Bob says you’re out of luck, he’s having a bad run of luck at the casino and doesn’t have the cash to loan you. You remember you have a credit card from First Sucker Federal Bank in your wallet, so you pay with that. Let’s say you can only afford to make the minimum payment every month. It will take you 329 (a little over 27 years) months to pay off your debt on a balance of $3000 with a 30% APR. In that time, you will pay $11,814.38 in interest charges.
When Credit Cards Aren’t Evil
Once you get your credit score up in the “great” category, you can get a card with a much less evil interest rate (a little over 10% is awesome for a credit card). But if you pay off the balance every month, then the rate is usually zero. That is where it is okay to use credit cards: When you can pay them off completely at the end of the month. I sometimes travel for work. They will not give me cash up front to pay for a trip. I have to keep receipts for my hotel, airline tickets, etc. I don’t want to use my cash for business trips! If I put all that on a credit card, I can get reimbursed and pay the credit card off without having to tie up my own cash.
Dave Ramsey’s View
As you may have already gathered, I have a great deal of respect for the writings and ideas of Dave Ramsey. Dave doesn’t have the aloof demeanor of a dry academic. He is passionate about his teaching, and he understands human psychology. I believe that it is his deep understanding of human psychology that causes him to recommend that you abandon credit and credit cards completely (except for perhaps a mortgage). His logic is that the only thing a person on the path to true wealth needs to buy on credit is a house. He doesn’t really like that idea of a mortgage but understands that a mortgage may be the most sensible alternative in some situations.
He counters my “high tech world requires credit cards” argument by saying that you can do all of the stuff that credit cards can do with a visa debit card that draws from your checking account. This is absolutely true, and I’ve tested that idea for years. As for mortgages, he says that there are still banks out there that make their own loan decisions and can assess your income and your assets and make a lending decision without a credit score. I think that for this to happen, you will need a lot of savings and have to do a lot of searching for a bank that will not worry about your FICO score. The arguments that you will pay more for car insurance and have trouble renting an apartment without a good credit score can be countered by simply acknowledging that the extra expense is worth it not to have the evil of credit cards present in your financial life.
The solution to the credit card dilemma may be as simple as being brutally honest with yourself about your own psychology. If you have an iron will and exude discipline, you may be better off holding a few credit cards that you never actually use. If you are prone to use the cards, it is far better not to have them. As with all important financial decisions, I encourage you to read everything you can find on the subject and make an informed decision based on your psychology and circumstances.
In today’s world, you hear a lot about credit scores and how important they are. According to Dave Ramsey, credit scores are really “I Love Debt” scores. They signify nothing but your ability to take on more and more debt. According to the folks at Fair Isaac Corporation (they invented the infamous FICO score), the single most important factor in determining your credit score is your payment history. In other words, do you pay your debts on time every time? That makes up approximately 35% of your score. The next biggest factor is how much you owe (about 30%). This can get really complicated because the formula looks at ratios. For revolving accounts (credit cards) the formula looks at how much of your available credit you have used. For installment accounts (mortgages) it looks at how much you still owe versus how much you borrowed.
The length of your credit history makes up about 15% of your score. In general, the longer you’ve had credit, the better your credit score will be. The idea is that if you’ve been managing debt for 30 years with no major glitches, you are a much better risk than someone who just graduated from college and has no real debt management experience. About 10% of your credit score will be a reflection of your credit mix. To get a really fabulous score, you will need an installment loan or two to go along with your credit cards. The last 10% of your credit score is new credit. New credit refers to opening new accounts. Research has shown that when people open a lot of new credit accounts in a short amount of time that a financial disaster is coming.
Getting Out of Debt
Mental health professionals will tell you that the first step in dealing with any problem is to admit to yourself that you indeed have a problem. If you keep doing the same old things, you will keep getting the same results. Face it: You got yourself into this mess. You are where you are right now financially as a sum total of the decisions you’ve made to this point. You are the only one that can get you out of it.
To understand the scope of the problem, you need to build a workable budget. The next step is to divert as many resources as you can into the elimination of debt. There are a couple of different approaches to how to attack the mountain of bills. Perhaps the best method from a mathematical perspective is to identify the highest interest debts and focus on paying off the highest one, then the second highest one, and so on. Perhaps the best method psychologically is to identify the debt you can pay off the quickest and do that. After that one is paid off, you spend the money you were spending on the first bill and the minimum payment on the second bill paying off that second bill. In this way, the amount of money that you are spending on paying off a single debt gets bigger and bigger each month as bills fall off of the list. Because of this increase, this method is sometimes called the “snowball method.” In my opinion, the key is mindset; you have to want to be debt free than you want the stuff you wasted the money on in the first place.
References and Further Reading
You can delve deeper into what makes up your credit score by visiting MyFICO.com.
I am hard on debt, and I think I am correct in giving that advice to the average person. Dave Ramsey is brutal about it, as you can tell from the cover of his book (see below):
For the business minded person who can turn debt into cash flow, debt is another matter. To understand the difference between the bad debt I preach against and “good debt” that builds cash flows, read the following book: