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Remember that old Clint Eastwood film? While it was never clear who was best, worst or ugliest, if you apply that title to the debt game, there won't be many questions. Debt truly can be good, bad and ugly. The basic proposition is that someone borrows money from someone else. If it were only that simple. Next come questions about the rate of interest charged, the time, the terms, the security, and the ability to pay it back. It is the oldest financial game in recorded history, oft criticized in the Bible and the Qur'an.
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Recognizing that the great business school libraries in the world devote thousands of cubic feet of space to books on debt when we only have a couple of pages, let's take a look at debt, add some spice from the internet, and see if we can identify some helpful rules of engagement. Fasten your seat belts. Features Principal-this is the amount of money you are borrowing. It is here that fees can be added, such as for originating the loan (covering the costs of processing) and discounting the rate (buying down the rate to below the cost of the money born by the lender). It can also include interest if it is later determined that your rate is below the cost of the money to the credit issuer (sometimes called "negative amortization"). We'll cover more about these costs when we discuss something called "APR." Time-this is the time that you are allowed to owe the money. But again, wait. It can mean the time of the underlying note that can be different than the amount of time you have to pay it back. Sometimes loans can be based upon the traditional 30 years, but your obligation to pay the loan back might be something less.
Risk-The risk to the lender is directly converted to the rate of interest. The higher the risk, the higher the rate. Risk translates to comfort that the debt will be paid off. Comfort can come from the borrower's contribution of cash to the deal, often called equity. It also comes from the terms of the deal that can include a security interest in the thing that is being purchased, such as a mortgage that ties the loan to the purchase of real estate or a UCC filing that ties the debt to the purchase of a thing, like a car, truck or refrigerator. If the debt accrues through a credit card purchase, there is often no security other than the confidence that the borrower will pay it off. In each one of these scenarios, the risk is significantly influenced by the borrower's credit score.
There are three basic scores, one each from Equifax, TransUnion and Experian. Mortgage lenders usually use the middle score for their lending. A good score is 700+. A middle score is 660 to 700 or so. Ugly? Interest-This is the rate of interest applied to the principal over time. But yet again, wait. Is it simple interest or compound interest? Simple interest is that rate applied to the principal. Period. A rate of say 8% on a debt of $1,000 creates an interest obligation of $80 after one year. Compounding however involves the application of the rate of interest on the unpaid interest obligation on top of the principal. For example, a monthly compounded interest adds the accumulated interest to the principal each month. Compounded daily? Each day's interest is added to the obligation. Read the fine print on your obligation, often found in small print on the back of the documents! Rate basics-Here's where you go to find today's rates (WARNING-these rates can be somewhat distorted by the reporting lenders so rely upon them at your peril): Prime Rate Navy Marine Corps Relief APR-This deserves special attention. It is the Annual Percentage Rate applied to the loan. It includes the rate of interest, of course, and the fees added to the deal such as origination, discount, and any other junk fees that can be lobbed into the deal. In the Truth in Lending Act, Federal law committed lenders to announce the APR in all of their loans, almost-there are some fees that don't count such as legal fees and other charges from third parties. It is also not impossible that a great deal has an APR significantly higher than the underlying interest rate. For example, you can "buy the rate" on a loan with the discount points significantly boosting the APR.
The key is the break even point where the discount points are "purchased" by the rate that can be significantly below market rates. Let the math drive your bus-take the payments, all of them, and stretch them out through the last month of payment. Compare the answers to all choices you are reviewing and let the math dictate the selection. Debt to Income-Lenders don't stop at credit scores, security, and cash into the deal (equity). They also want to know about your ability to pay off the debt. If you have a sterling credit score, and you put plenty of cash into the deal, they will still want to know if you can cover the monthly payment. For this measure, the lender will examine your credit report to see what trade lines are demanding monthly payments. They call this the Debt to Income ratio. Note that a Trade Line is one that reports your monthly payments to the credit bureaus, such as credit cards, car loans, and mortgages. What is not reported as a trade line is your rent, medical bill, electricity, phones, water and other utilities, unless you are guilty of missing enough payments to earn a dreaded "derogatory" on your credit report.
Acceptable Debt to Income ratios can be as high as 60% but normally hover around 45% to 50% and below. For example, if the value of the asset being purchased goes up, and the lender gives you a loan for 100% of the deal, your return on investment can be extremely high, maybe even infinite if there are no carrying costs. Note that if your asset increases in value more than the cost of the interest, you are coming out ahead by using debt. Navy Marine Corps Relief offers another genuinely "good" debt-the rate of interest is a user-friendly 0.00%. Honest. The loan has to be for any of the following: 1. Emergency Transportation, 2. Funeral Expenses, 3. Medical/dental Bills (patient's share), 4. Food, Rent, and Utilities, 5. Disaster Relief Assistance, 6. Child Care Expenses, 7. Essential Vehicle Repairs, or 8. Unforeseen Family Emergencies. Those cover the basics of life other than a house mortgage or the purchase of a vehicle. The Bad What happens if the value of the item you purchased with debt goes down, such as a house, car or pogey bait? The cost of the debt is added to the loss of value of the thing you bought. Another bad thing is when you find yourself buying the laundry with credit rather than your debit card (debit cards tap the cash in your checking account-no money, no laundry). This often leads to too much debt, higher rates, and lower credit scores. Debt is available for use, not abuse. The Ugly Debt can be truly ugly when it suffocates you financially.
We discussed pay day lending in "Greed is Good?" (MCG October, 2006). Another ugly dimension in debt is the use of automatic withdrawals where you give the lender your written blanket consent for them to pull cash out of your credit card or checking account without any further communication. The problem is this: what if the product or service they promised does not work for you as promised? Quite often you must cancel the account and move your business to another lender! It is a paperwork nightmare to disentangle yourself from this mess. Another "ugly" is a credit score below 600-toxic waste when it comes to credit. Finally, the dreaded "BK" or bankruptcy which usually entails ten long years in financial purgatory before your credit report fails to show the derogatory.
There are places you can go for help if there is trouble. The Navy Marine Corps Relief is always a good place to start for cash assistance. If you get into deeper trouble from a grumpy creditor, you could need legal protection. Examine the Fair Debt Collection Practices Act, the Fair Credit Reporting Act and the related state laws that apply to you (the specific acts I just mentioned are all federal i.e. national whereas the state laws are state by state). Quite often there will be a problem associated with creditor's efforts to collect on your debt. Do not under any circumstances fail to check with a credit attorney if problems erupt! Poorly educated humans are often managing the paperwork at the creditor's office and a good credit attorney can often smoke out an error-and all it takes is one. The Big Secret-if there is an error, your legal fees are always paid by the defendant-the judge has no choice. It doesn't take much to be a winner and you can clean up your credit report and possibly walk away with damages. Never mind that you are chasing a small amount of money or a simple record correction.
Your lawyer will be paid a reasonable rate on the hours spent and could walk away with $10,000 to $20,000 (a typical fee) for winning your case, all paid by the defendant. Note that I am not encouraging you to skip town on your debts-there is help waiting to protect you from critical cash shortfalls and abusive creditors. The rest is up to you-use but don't abuse your debt privileges. Your Golden Rule This has been a whirlwind tour through debt and I hope these basics have helped-there is much much more to know. If you are considering a financial course correction for yourself, give some thought to establishing this Golden Rule when it comes to debt-use debt for appreciating assets only-houses or your mind (education), but not vehicles that depreciate or groceries or dry cleaning or candy and cigarettes at your local gedunk.You remember the golden rule, right?
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Package 1
Recognizing that the great business school libraries in the world devote thousands of cubic feet of space to books on debt when we only have a couple of pages, let's take a look at debt, add some spice from the internet, and see if we can identify some helpful rules of engagement. Fasten your seat belts. Features Principal-this is the amount of money you are borrowing. It is here that fees can be added, such as for originating the loan (covering the costs of processing) and discounting the rate (buying down the rate to below the cost of the money born by the lender). It can also include interest if it is later determined that your rate is below the cost of the money to the credit issuer (sometimes called "negative amortization"). We'll cover more about these costs when we discuss something called "APR." Time-this is the time that you are allowed to owe the money. But again, wait. It can mean the time of the underlying note that can be different than the amount of time you have to pay it back. Sometimes loans can be based upon the traditional 30 years, but your obligation to pay the loan back might be something less.
Risk-The risk to the lender is directly converted to the rate of interest. The higher the risk, the higher the rate. Risk translates to comfort that the debt will be paid off. Comfort can come from the borrower's contribution of cash to the deal, often called equity. It also comes from the terms of the deal that can include a security interest in the thing that is being purchased, such as a mortgage that ties the loan to the purchase of real estate or a UCC filing that ties the debt to the purchase of a thing, like a car, truck or refrigerator. If the debt accrues through a credit card purchase, there is often no security other than the confidence that the borrower will pay it off. In each one of these scenarios, the risk is significantly influenced by the borrower's credit score.
There are three basic scores, one each from Equifax, TransUnion and Experian. Mortgage lenders usually use the middle score for their lending. A good score is 700+. A middle score is 660 to 700 or so. Ugly? Interest-This is the rate of interest applied to the principal over time. But yet again, wait. Is it simple interest or compound interest? Simple interest is that rate applied to the principal. Period. A rate of say 8% on a debt of $1,000 creates an interest obligation of $80 after one year. Compounding however involves the application of the rate of interest on the unpaid interest obligation on top of the principal. For example, a monthly compounded interest adds the accumulated interest to the principal each month. Compounded daily? Each day's interest is added to the obligation. Read the fine print on your obligation, often found in small print on the back of the documents! Rate basics-Here's where you go to find today's rates (WARNING-these rates can be somewhat distorted by the reporting lenders so rely upon them at your peril): Prime Rate Navy Marine Corps Relief APR-This deserves special attention. It is the Annual Percentage Rate applied to the loan. It includes the rate of interest, of course, and the fees added to the deal such as origination, discount, and any other junk fees that can be lobbed into the deal. In the Truth in Lending Act, Federal law committed lenders to announce the APR in all of their loans, almost-there are some fees that don't count such as legal fees and other charges from third parties. It is also not impossible that a great deal has an APR significantly higher than the underlying interest rate. For example, you can "buy the rate" on a loan with the discount points significantly boosting the APR.
The key is the break even point where the discount points are "purchased" by the rate that can be significantly below market rates. Let the math drive your bus-take the payments, all of them, and stretch them out through the last month of payment. Compare the answers to all choices you are reviewing and let the math dictate the selection. Debt to Income-Lenders don't stop at credit scores, security, and cash into the deal (equity). They also want to know about your ability to pay off the debt. If you have a sterling credit score, and you put plenty of cash into the deal, they will still want to know if you can cover the monthly payment. For this measure, the lender will examine your credit report to see what trade lines are demanding monthly payments. They call this the Debt to Income ratio. Note that a Trade Line is one that reports your monthly payments to the credit bureaus, such as credit cards, car loans, and mortgages. What is not reported as a trade line is your rent, medical bill, electricity, phones, water and other utilities, unless you are guilty of missing enough payments to earn a dreaded "derogatory" on your credit report.
Acceptable Debt to Income ratios can be as high as 60% but normally hover around 45% to 50% and below. For example, if the value of the asset being purchased goes up, and the lender gives you a loan for 100% of the deal, your return on investment can be extremely high, maybe even infinite if there are no carrying costs. Note that if your asset increases in value more than the cost of the interest, you are coming out ahead by using debt. Navy Marine Corps Relief offers another genuinely "good" debt-the rate of interest is a user-friendly 0.00%. Honest. The loan has to be for any of the following: 1. Emergency Transportation, 2. Funeral Expenses, 3. Medical/dental Bills (patient's share), 4. Food, Rent, and Utilities, 5. Disaster Relief Assistance, 6. Child Care Expenses, 7. Essential Vehicle Repairs, or 8. Unforeseen Family Emergencies. Those cover the basics of life other than a house mortgage or the purchase of a vehicle. The Bad What happens if the value of the item you purchased with debt goes down, such as a house, car or pogey bait? The cost of the debt is added to the loss of value of the thing you bought. Another bad thing is when you find yourself buying the laundry with credit rather than your debit card (debit cards tap the cash in your checking account-no money, no laundry). This often leads to too much debt, higher rates, and lower credit scores. Debt is available for use, not abuse. The Ugly Debt can be truly ugly when it suffocates you financially.
We discussed pay day lending in "Greed is Good?" (MCG October, 2006). Another ugly dimension in debt is the use of automatic withdrawals where you give the lender your written blanket consent for them to pull cash out of your credit card or checking account without any further communication. The problem is this: what if the product or service they promised does not work for you as promised? Quite often you must cancel the account and move your business to another lender! It is a paperwork nightmare to disentangle yourself from this mess. Another "ugly" is a credit score below 600-toxic waste when it comes to credit. Finally, the dreaded "BK" or bankruptcy which usually entails ten long years in financial purgatory before your credit report fails to show the derogatory.
There are places you can go for help if there is trouble. The Navy Marine Corps Relief is always a good place to start for cash assistance. If you get into deeper trouble from a grumpy creditor, you could need legal protection. Examine the Fair Debt Collection Practices Act, the Fair Credit Reporting Act and the related state laws that apply to you (the specific acts I just mentioned are all federal i.e. national whereas the state laws are state by state). Quite often there will be a problem associated with creditor's efforts to collect on your debt. Do not under any circumstances fail to check with a credit attorney if problems erupt! Poorly educated humans are often managing the paperwork at the creditor's office and a good credit attorney can often smoke out an error-and all it takes is one. The Big Secret-if there is an error, your legal fees are always paid by the defendant-the judge has no choice. It doesn't take much to be a winner and you can clean up your credit report and possibly walk away with damages. Never mind that you are chasing a small amount of money or a simple record correction.
Your lawyer will be paid a reasonable rate on the hours spent and could walk away with $10,000 to $20,000 (a typical fee) for winning your case, all paid by the defendant. Note that I am not encouraging you to skip town on your debts-there is help waiting to protect you from critical cash shortfalls and abusive creditors. The rest is up to you-use but don't abuse your debt privileges. Your Golden Rule This has been a whirlwind tour through debt and I hope these basics have helped-there is much much more to know. If you are considering a financial course correction for yourself, give some thought to establishing this Golden Rule when it comes to debt-use debt for appreciating assets only-houses or your mind (education), but not vehicles that depreciate or groceries or dry cleaning or candy and cigarettes at your local gedunk.You remember the golden rule, right?
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