Chapter 9: Money Trap
Agent Rick Dicker: ”You want to get out of the hole? First you’re going to have to put down the shovel.”
– Incredibles 2 (2018)
Debt is a like a drug. Start using it, and the debt cartel (banks) starts pushing more and more offers on you. Each deal comes with an enticement. Each payment seems small and manageable. Before you know it, you have thirteen charge cards, tapped into overdraft protection on your checking account, taken out a home equity loan and two car loans. Oh, and you’re still paying off your student loans and mortgage. You’ve stolen every penny from your future earnings to keep you head above water. The whole thing is at risk of tumbling down.
Before you reach that precarious state, make a point of getting out. There are no easy or quick ways to accomplish this, except the earlier you start the sooner it will be done. Sit down, face the problem, work out the numbers, and start chipping away at it.
This plan is the economically most effective: you pay down the highest cost debt as quickly as possible. You may see other plans that focus on psychological "wins", like paying off small debt balances first even if they have lower interest rates. At the end of the day what is most important is to have a plan that you stick to.
Make a list of all your debts as follows:
If your credit is good, or you have equity in your home, you can consider consolidating your debt into a single loan to lower your interest payments. Before you do, make sure you know how you ended up here and test your commitment to becoming debt-free. The last thing you want is to add to your debt.
Add up your minimum payments. Make sure these are paid on time. Now pull funds from other spending buckets. Cut your “Wants” spending to the bone for a few months. Stop all saving (except enough 401(k) contributions to get any employer match). Drain your savings accounts (except for an emergency balance). Pull money out of investments if you have them. Use every available penny to make additional payments, starting with the highest APR balances and working your way down (“planned payments” in the chart). Do this every month until the only debts you have left are student loans, mortgages, and car notes with interest rates less than 4%. Unbury.me is a calculator that can help you keep track.
Once these debts are paid off, stop using all but one credit card, preferably the oldest. Hide or even destroy the others. Close those accounts gradually over time, starting with the newest, to minimize the impact on your credit score. Also close any card accounts that charge annual fees. Make the card you keep difficult to access, as described above, but use it occasionally for some small recurring expenditures.
Pay for everything else with either a debit card or cash.
If you have overdraft protection on your checking account, have it removed. Make sure that your bank will reject debit transactions that are more than the balance in your checking account.
Freeze your credit (instructions later). By freezing your credit, you block inquiries to your credit report, which will keep you from being approved for instant credit offers and reduce the number of mail solicitations.
Strive to go back to saving 20% of your incoming money. This will be a lot easier once you no longer have interest payments on debt to contend with.
Sometimes nothing works. A situation is so dire that there is no obvious way out. It’s time to seek help. There is no shame in this, and it’s not the end of the world. The details are beyond this book, but one avenue to consider is a debt management program. These combine debts into a single monthly payment that pays everything off over three to five years. Counselors who put these programs together work for non-profit organizations. This doesn't mean they work for free; they may charge a fee and are also paid by the debtors.
It’s best to avoid debt settlement or debt relief companies who ask for monthly payments and then haggle with creditors with no guarantee that the debts will be paid off. It may be better to look into filing for bankruptcy and get about rebuilding quickly.
The original purpose of credit scores was to for lenders to determine whether it was safe to lend you money and how much interest to charge. A higher score got you more credit and lower interest rates. But credit scores are creeping into other walks of life. Landlords check them before renting a place to you. Some insurance companies are using them to figure how high a premium to charge you. And employers are increasingly reviewing them as part of vetting job candidates.
It is not surprising then that anxiety over credit scores has increased. Just remember that credit scores don’t judge you as a person. They don’t reflect your moral character. They are a statistical assessment of whether you have had credit and how you have managed it. Also remember that a high credit score should not be treated as a license to pile on debt.
Before approving you for a loan or line of credit, a lender will check your credit score. There are many different credit scores; the most widely used ones are calculated by Fair Isaac Corporation and are known as FICO scores.
FICO scores range from 350 to 850:
Your credit scores will determine how much you can borrow and the interest rate you have to pay. Here are some typical recent rates for a 36-month auto loan:
How are FICO scores calculated? The exact formula isn’t public, but here are the major factors that go into the mix:
The bizarre thing is that everyone wants to sell you your credit score! Fair Isaac does. It can be hard to find out your score without paying up. In addition to Fair Isaac, each of the three credit bureaus also calculate credit scores, and unless the information they have on you differs, these scores will probably be similar. There is no need to worry about differences of a few points between different scores. Also, some credit bureaus have begun to make scores available for free, as have some banks and credit card companies. And if you’re not squeamish about giving up your personal information and being bombarded with solicitations, credit monitoring sites such as CreditKarma or WalletHub.com will also provide you with scores for free. (Full disclosure: I’m squeamish.)
The credit reports that underlie the scores detail your past and present debt and payment record. You are entitled to receive a credit report from each of the three bureaus once a year for free. The easiest way is to go to www.annualcreditreport.com. You should do this and check the reports for accuracy. You can contest incorrect information and have it removed. One approach is to request one of the three reports every four months, which lets you review each bureau on a twelve-month cycle. Since the COVID-19 pandemic, all three credit bureaus have been offering weekly free credit reports. They may or may not continue doing this.
If you have a low credit score either because you haven’t had credit before or because of your past sins, start building a strong track record. This takes years. There are no quick fixes.
- Pay all you bills, on time, all the time
- (Re)build some credit. One way is to get a credit card in your name. If you can’t get a regular credit card, get a secured card which requires you to deposit some cash up-front. Spend only a little every month. For example, set up automatic payment of your cellphone bill using the credit card and then set up automatic payment of the credit card bill from your checking account on payday. Keep the card tucked away in a drawer and leave it there.
- Do not use more than about 25% of any credit line to keep your credit utilization low.
- Freeze your credit file at each of the three bureaus.
Your credit file is an open book. Many types of lenders can request it without your permission in order to “market” to you. It’s how credit bureaus make money – they sell your info.
While you can “opt out” of pre-screened offers, the best way to combat this is to freeze your credit file at each of the three bureaus. This prevents all “pulls” of your credit file. (It does not stop your credit information from being updated.) By law, the bureaus must offer this capability for free. They used to make it cumbersome to do. It’s easier since Equifax experienced a major privacy breach in 2017. But beware of attempts to push other paid “services” such as “credit locks” or “credit monitoring.” Insist on a freeze.
A freeze has three benefits: it protects your privacy and identity by preventing anyone from pulling your credit file without your permission, it reduces unwanted credit solicitations, and it is a barrier against the temptation of instant credit offers.
Before you apply for a major loan such as a mortgage or private student loan review your credit reports to make sure there are no errors on them. Then unfreeze your credit files for two weeks while you shop around for a loan. Avoid triggering a lot of credit inquiries from banks over a longer period as this could be bad for your score.