In the consumer economy, credit is pretty easy to obtain. That often leads to problems for those who don’t know how to use it wisely. At the other end of the spectrum, some people avoid using credit altogether. Smart people use smart credit strategies to maximize their financial position.
Credit provides leverage to help consumers build assets and wealth. In honor of March being National Credit Month, here’s the lowdown.
Why do most Americans need credit?
Now that credit scores are national, standardized, and organized by the three credit-reporting bureaus, it’s become a popular measuring tool. Before 1989, credit scores were localized affairs and used mainly for just obtaining loans or credit cards.
Today that’s no longer the case because credit scores aren’t just for lenders anymore. It’s essential to monitor your score since there can be a lot riding on it. In today’s world, it’s necessary to have one in the first place.
Americans who don’t have at least one credit card will likely find themselves disadvantaged in various financial situations. Not only when it comes to arranging for a mortgage to buy their house but also in finding a job and renting an apartment.
Landlords and employers often request a check on the applicant’s credit history. Some consider the lack of a credit score even worse than a bad one. Good landlords may not rent to someone with no credit at all.
Most Americans must build a retirement nest egg through contributions to a retirement plan. Still, a significant source of household wealth remains the family home. Buying a house for cash is beyond most people’s means, so financing through a mortgage is critical. A history of good credit means a much lower interest rate added to the principal cost than a higher rate for someone with poor or no credit at all.
That’s why young adults need a credit card and learn to use it responsibly by paying off the balance every month to avoid interest charges. That’s the best way to start a history of good credit, as well as avoiding the pitfalls of having too much revolving debt.
Maximizing the use of credit cards
As long as you pay off the card balance each month, the amount due doesn’t continuously increase with interest payments. Using credit cards can help consumers build wealth.
In addition to making money, wealth depends on not losing money or giving up too many gains. If someone gains unauthorized access to your card, it’s easier to dispute a transaction compared to a debit card.
Make money with your credit by finding cards that provide rewards that match your lifestyle. If you do a lot of traveling (and will resume after the coronavirus pandemic), then a card that offers travel rewards makes a lot of sense as long as the annual fee doesn’t wipe out the reward.
When you have good credit, it’s easy to find a credit card with low or no fees that give you rewards on your purchases. Cashback is a great reward, but many cards these days offer points instead. You can still benefit from the points rewards because you can exchange points for various merchandise and gift cards. Now you’ve got presents for birthdays and holidays covered.
Smart credit as leverage
While credit cards are one example of credit, they don’t provide you with any leverage because you pay the balance every month. Using different credit types to buy assets gives you the ability to invest more without paying the entire amount upfront.
What kinds of assets does credit help you leverage? Technically vehicles are listed as assets on the balance sheet, but they depreciate quickly. Taking out a loan to buy a car doesn’t provide you with an asset.
However, taking out a loan (mortgage) to buy a property or taking out a loan (student loans) to increase your human capital will help you accumulate wealth when used correctly.
Being smart about leverage allows you to invest in something that you can’t afford to pay for entirely right now but will be able to in the future (given some reasonable assumptions). Using leverage to buy an asset (or capital) that you won’t be able to maintain in the future sets you up for potential disaster. Keeping it reasonable helps ensure the loan amount won’t wreck your finances down the line.
Using credit for smart timing
For example, initially, interest-only (IO) mortgages were used for people who logically expected enough income in the near future that would then allow them to pay down the principal. A typical example (at least here in California) is a Hollywood director who could expect millions from one film released after nine months. The IO loan helped them buy a decent house now rather than wait a year for the money to come in.
These loans weren’t intended to finance too much house for people who didn’t expect they’d be able to afford the payments. Of course, IO loans aren’t the only ones that can be misused. You’ve probably heard of the phenomenon known as being “house-poor,” where the housing and associated payments eat up most of the homeowner’s income.
Sometimes that’s due to something unexpected like job loss. But sometimes, it’s due to a mortgage that’s larger than the homeowner can reasonably expect to carry for 15 or 30 years. While layoffs and recessions aren’t predictable, the amount of income you need to sustain a mortgage and associated housing payments is.
Using smart credit for better returns
Home equity loans make sense when you’re making improvements to the home that will increase its value. They make less sense when you’re taking the money out to buy something.
Similarly, refinancing a mortgage is a great idea when either rates have dropped or your credit has improved to the point where you can substantially save on payments. It’s a bad one when you’re trying to take money out for a purchase because you don’t have any other cash available. Especially an investment that doesn’t result in ownership of an asset.
If you’re building a business that’s likely to grow and prosper, taking out a business loan to get through those first lean years is an excellent use of leverage. It works with investment real estate, too. Many lenders will allow you to use the property’s expected rental income to increase the loan principal.
Making sure that the amount is within reason applies to student loans as well. Taking out a 6-figure loan to pay for school may make sense when you’re entering a field, like medicine, where you’ll be richly rewarded with hundreds of thousands of dollars a year. But it’s way too much for a job where the average income is only in the five figures annually.
Using credit wisely and as leverage to accumulate capital and build assets is an integral part of a smart financial plan. Debt isn’t necessarily a bad thing, as long as you manage your credit exposure and avoid incurring unnecessary interest charges.
Good credit is necessary for the modern world, so having at least one credit card paid off monthly is helpful for many financial decisions.
Are you thinking about refinancing a mortgage or investing in property? Feel free to give us a call at 619.255.9554 or send us an email to set up an appointment.
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