Credit is an inescapable part of personal finance for most Americans, but many people learn at an early age just how easy it is to make credit mistakes — and how detrimental those mistakes can be.
Broadly speaking, credit is the provision of money, goods, or services by one party to another, with the expectation of future repayment plus interest.
There are various forms of credit and a myriad of underlying terms and conditions among them. For many people, consumer credit is most familiar. This is personal debt, which people incur to facilitate the purchase of goods and services. Credit cards are a prime example of consumer credit.
While debt is widespread and fairly common in developed, consumer-driven economies, anyone new to credit should strive to avoid the pitfalls outlined below.
Having access to credit is not a reason to forgo managing your finances in a fiscally-responsible fashion (think budget). Overspending will always lead to problems, and this is exacerbated by the burden of compound interest on borrowed funds.
Using Too Much Credit
Using a large proportion of your credit capacity can be damaging to your credit score. Ideally, you should strive to carry a debt balance of no more than 30 percent of your limit on any individual borrowing arrangement and in aggregate.
For a person with two credit cards, each with a $5,000 limit, this means maintaining a balance of $1,500 or less on each card. In total, this equates to a debt balance of $3,000 or less ($3,000 / $10,000 = 0.3).
Making Minimum Monthly Payments
Thinking it is acceptable to make the minimum monthly payment on your credit card is extremely problematic. This approach does little to reduce the principal amount borrowed, and it paves the way for interest charges to compound significantly. From a financial perspective, the minimum-payment approach is invariably “one step forward and two steps backward.”
Beyond the pitfalls mentioned above, new borrowers must be focused on making timely payments on their debt. This seems obvious, but it can’t be stressed enough. Late and missed payments can have a devastating effect on your credit profile.
When to Consolidate Your Debt
Debt consolidation is a phrase that describes a refinancing initiative. It entails taking out a new loan to retire multiple existing loans.
Under the right circumstances, the process can be highly beneficial. It makes the most sense when the borrower can achieve a lower interest rate than the weighted average rate charged on existing loans.
It can be even more worthwhile when the borrower can simultaneously structure a loan term that is shorter than or equal to the weighted average length of existing debt arrangements, thereby guaranteeing a lower long-term cost of borrowing.
Beyond the economic benefits of a lower rate and/or shorter term, consolidation can be a smart way to more efficiently manage debt. After all, a single loan is easier to plan around than a handful of debts with varying payment terms and conditions.