How to recognize bad debt overload

Calculating how much debt you have relative to your annual income is a
useful way to size up your debt load. Ignore, for now, good debt — the loans
you may owe on real estate, a business, an education, and so on.
I’m focusing on bad debt, the higher-interest debt used to buy items that
depreciate in value.

To calculate your bad debt danger ratio, divide your bad debt by your annual
income. For example, suppose that you earn $40,000 per year. Between your
credit cards and an auto loan, you have $20,000 of debt. In this case, your bad
debt represents 50 percent of your annual income.

bad debt
----------------     = bad debt danger ratio
annual income

The financially healthy amount of bad debt is zero. Not everyone agrees with
me. One major U.S. credit card company says — in its “educational” materials,
which it gives to schools to teach students about supposedly sound
financial management — that carrying consumer debt amounting to 10 to 20
percent of your annual income is just fine.

When your bad debt danger ratio starts to push beyond 25 percent, it can
spell real trouble. Such high levels of high-interest consumer debt on credit
cards and auto loans grow like cancer. The growth of the debt can snowball
and get out of control unless something significant intervenes. If you have
consumer debt beyond 25 percent of your annual income, see Chapter 5 to
find out how to get out of debt.

How much good debt is acceptable? The answer varies. The key question is:
Are you able to save sufficiently to accomplish your goals?

Borrow money only for investments (good debt) — for purchasing things that
retain and hopefully increase in value over the long term, such as an education,
real estate, or your own business. Don’t borrow money for consumption
(bad debt) — for spending on things that decrease in value and eventually
become financially worthless, such as cars, clothing, vacations, and so on.

Difference between Bad Debt and Good Debt

Why do you borrow money? Usually, you borrow money because you don’t
have enough to buy something you want or need — like a college education. If
you want to buy a four-year college education, you can easily spend $100,000,
$150,000, or more. Not too many people have that kind of spare cash. So borrowing
money to finance part of that cost enables you to buy the education.

How about a new car? A trip to your friendly local car dealer shows you that
a new set of wheels will set you back $20,000+. Although more people may
have the money to pay for that than, say, the college education, what if you
don’t? Should you finance the car the way you finance the education?

The auto dealers and bankers who are eager to make you an auto loan say
that you deserve and can afford to drive a nice, new car, and they tell you to
borrow away (or lease, which I don’t love either). I just say, “No! No! No!”
Why do I disagree with the auto dealers and lenders?

For starters, I’m not trying to sell you a car or loan from which I derive a
profit! More importantly, there’s a big difference between borrowing for something
that represents a long-term investment and borrowing for short-term
consumption.

If you spend, say, $1,500 on a vacation, the money is gone. Poof! You may
have fond memories and even some Kodak moments, but you have no financial
value to show for it. “But,” you say, “vacations replenish my soul and
make me more productive when I return. In fact, the vacation more than pays
for itself!”

Great. I’m not saying that you shouldn’t take a vacation. By all means, take
one, two, three, or as many as you can afford yearly. But that’s the point:
Take what you can afford. If you have to borrow money in the form of an outstanding
balance on your credit card for many months in order to take the
vacation, you can’t afford it.

How to correct credit report errors

If you obtain your credit report and find a boo-boo on it that you don’t recognize
as being your mistake or fault, do not assume that the information is correct.
Credit reporting bureaus and the creditors who report credit
information to these bureaus often make mistakes.

You hope and expect that, if a credit bureau has negative and incorrect information
in your credit report and you bring the error to their attention, they
will graciously and expeditiously fix the mistake. If you believe that, you’re
the world’s greatest optimist; perhaps you also think you won’t have to wait
in line at the Department of Motor Vehicles, post office, or your local bank at
noon on payday.

Odds are, you’re going to have to fill out a form on a Web site, make some
phone calls, or write a letter or two to fix the problems on your credit report.
Here’s how to correct most errors that aren’t your fault:

If the credit problem is someone else’s: A surprising number of personal
credit report glitches are the result of someone else’s negative
information getting on your credit report. If the bad information on your
report is completely foreign-looking to you, tell the credit bureau and
explain that you need more information because you don’t recognize the
creditor.

If the creditor made a mistake: Creditors make mistakes, too. You need
to write or call the creditor to get them to correct the erroneous information
that they sent to the credit bureau. Phoning first usually works
best. (The credit bureau should be able to tell you how to reach the
creditor if you don’t know how.) If necessary, follow up with a letter.

Whether you speak with a credit bureau or an actual lender, make notes of
your conversations. If representatives say that they can fix the problem, get
their names and extensions, and follow up with them if they don’t deliver as
promised. If you’re ensnared in bureaucratic red tape, escalate the situation by
speaking with a department manager. By law, bureaus are required to respond
to a request to fix a credit error within 30 days — hold the bureau accountable!

Telling your side of the story

With a minor credit infraction, some lenders may simply ask for an explanation.
Years ago, I had a credit report blemish that was the result of being
away for several weeks and missing the payment due date for a couple small
bills. When my proposed mortgage lender saw my late payments, the lender
asked for a simple written explanation.

You and a creditor may not see eye to eye on a problem, and the creditor may
refuse to budge. If that’s the case, credit bureaus are required by law to allow
you to add a 100-word explanation to your credit file.

Sidestepping “credit repair” firms

Online and in newspapers and magazines, you may see ads for credit repair
companies that claim to fix your credit report problems. In the worst cases
I’ve seen, these firms charge outrageous amounts of money and don’t come
close to fulfilling their marketing hype.

If you have legitimate glitches on your credit report, credit repair firms can’t
make the glitches disappear. Hope springs eternal, however — some people
would like to believe that their credit problems can be fixed.

Remember — if your problems are fixable, you can fix them yourself, and you
don’t need to pay a company big bucks to do it.

How to improve your credit report and score

Instead of simply throwing money into buying your credit scores or paying
for some ongoing monitoring service that you may not pay attention to
anyway, take an interest in improving your credit standing and score.
Working to boost your credit rating is especially worthwhile if you know that
your credit report contains detrimental information.

Here are the most important actions that you can take to boost your attractiveness
to lenders:

Get all three of your credit reports, and be sure each is accurate.
Correct errors (as I will explain in my next post) and be especially sure to
get accounts removed if they aren’t yours and they show late payments
or are in collection.

If your report includes late or missed payments more than seven
years old, ask to have those removed. Ditto for a bankruptcy more than
ten years ago.

Pay all your bills on time. To ensure on-time payments, sign up for
automatic bill payment, which most companies (like phone and utility
providers) enable you to use.

Be loyal if it doesn’t cost you. The older the age of loan accounts you
have open, the better for your credit rating. Closing old accounts and
opening a bunch of new ones generally lowers your credit score.

But don’t be loyal if it costs you! For example, if you can refinance your
mortgage and save some good money, by all means do so. The same logic
applies if you’re carrying credit card debt at a high interest rate and want
to transfer that balance to a lower rate card. If your current credit card
provider refuses to match a lower rate you find elsewhere, move your
balance and save yourself some money.

Limit your debt and debt accounts. The more loans, especially consumer
loans, that you hold and the higher the balances, the lower your
credit score will be.

Work to pay down consumer revolving debt (such as on credit cards).