The world is full of don’ts. Don’t run with scissors, don’t wear seersucker after Labor Day — and please, do not feed the bears.
Some rules are designed to preserve social order by imposing stigmas on unseasonal attire while others are necessary to avoid potential stabbing or mauling catastrophes. All attempt to avert crises that may arise as unintended consequences of our actions.
As often as the rules of style, camping and crafting are broken, so too are financial rules transgressed. The penalties for doing so vary in severity between the ramifications for wearing summer white at Halloween and fleeing from a grizzly bear demanding snacks.
But breaking these rules for borrowing can leave you hemorrhaging money, and that doesn’t ever look good.
Here are rules to live by to keep more of your money where it belongs — in your wallet:
1. Do save money while repaying debt
There’s a lot of talk on whether borrowers should repay debt while saving or forgo saving to pay off debt faster.
Depending on the depth of the hole you’ve dug, it can take years to get out of debt. So some savings must be established and maintained to establish a healthy bottom line.
At a minimum, put in place an emergency fund to prevent further borrowing in case of a rainy day. Most experts recommend stashing enough cash to cover between three and six months worth of expenses. Some say you can get away with less, but no one ever went wrong saving too much money.
It’s a balancing act for sure, but one that can be accomplished by a little math and strict adherence to the overriding personal finance dictum that you must live below your means.
“There isn’t any magic to this. Everyone has a certain amount of income, and the only way to save money or pay off your debts is to spend less than your income,” says Adele Brady Bolson, CPA and member of the AICPA’s National CPA Financial Literacy Commission.
2. Do find the best interest rate
High-interest rates can kill any repayment momentum. For instance, imagine making a monthly payment of $300 on a $10,000 credit card balance. If you find a card with a 4.9 percent interest rate card, that debt can be repaid in 36 months. But if your card sports an 18 percent rate, it’ll take 47 months — nearly a year longer — to pay it off.
High-interest rates take a similar toll on loans of all stripes. But the difference may seem negligible on the surface. For instance, consider the monthly payment of a 60-month car loan. If you get a loan for $20,000 at 7 percent, the payment would be $396. At 10 percent, the payment is about $425. That’s a difference of $29. While it may not seem like much, that money could be put to better use buying other items or, even better, saved. If you invest the money monthly in a fund earning 8 percent on average for five years, you’ll have a neat sum of $2,130 tucked away.
But smart loan shopping doesn’t stop with the interest rate, says Bolson. “Look at any fees that are associated with the loan. You may find a great loan at only 6 percent interest, but if they tack a bunch of fees on top of it, the effective rate may be more than the 8 percent loan you’re comparing it to.”
Don’t shop in one place — shop around for the loan that will save you the most money.
3. Do read the fine print
Many smart people have been unpleasantly surprised by loan details obfuscated by legal terminology or excruciatingly small fonts. Avoid joining that club by investing in a magnifying glass and familiarizing yourself with the terms and conditions of your loan.
For instance, during the infamous, and ongoing, mortgage meltdown, resetting adjustable-rate mortgages caught plenty of homeowners off-guard and many lost their homes.
In a financial literacy poll last year, 34 percent of Americans didn’t even know what kind of mortgage they had. In this year’s poll, Americans exhibited slightly more knowledge, with 26 percent in the dark about their mortgages.
While that’s a glaring omission of financial self-knowledge, many less egregious sins are paid for every day, for instance, when potential borrowers disregard the universal default clause buried deep within credit card contracts or prepayment penalties on loans.
If you can’t read every page of the loan contract, hire someone who can (a lawyer who’s trained to understand that legalese may be a good choice). It’s better to know about any contingencies that might arise and how they could affect your situation if you do end up signing on the dotted line.
4. Do pay on time, every time
“Never miss a payment, never make a late payment, never make a short payment,” says Gail Cunningham, senior director of public relations for the National Foundation for Credit Counseling.
“And if you do, I have a mental image of a red flag being raised in the bank over your account,” she says.
Though emergencies and accidents do come up, avoid paying late if at all possible. If you must do so, prioritize your creditors. In extremely tight months, skipping the cell phone bill or the cable bill will have a less deleterious effect on your credit report than skipping the credit card bill.
“Just one late payment can lower your credit score by 100 points,” says Cunningham.
Paying credit cards late can cause an avalanche of bad news, including fees and higher interest rates.
5. Do remember borrowed money is not free money
If you earn $50,000 and you have a card with a credit limit of $10,000, it may seem like you’re swimming in money. But your credit limit shouldn’t be confused with income or money waiting to be spent. Relying too much on borrowed money can have you devoting increasingly large chunks of future income to paying off loans.
Debt is slavery, says Mike Mihalik, author of “Debt is Slavery: and 9 Other Things I Wish My Dad Had Taught Me About Money.”
“People may think that equating debt to slavery is extreme, but for many people, the main reason they go to work is to make the payments on their car, house or plasma TV,” he says.
“Debt often traps people in jobs they may not even enjoy. They have become slaves to their debt,” Mihalik says.
Not only does borrowing cost interest and fees, but it deprives you of future opportunities. Instead of servicing debt you could be buying different items or investing.
In other words, your past-self is robbing your future-self — which is a good reason not to borrow frivolously.
6. Don’t borrow frivolously
Debt can be divided into two piles: the good debt and the bad.
“Borrow money only for good long-term purposes, like to get an education, to buy a car, to buy a house, to finance a business,” says Bolson. “Those are all good reasons to borrow money. And you would expect to pay off that loan before you’ve reaped all the benefit from it.”
Borrowing for fancy meals, not-so-fancy meals, or transient pleasures, such as vacations, falls squarely into the bad debt category. The bills for these purchases will haunt you long after that post-vacation glow fades.
Clothes also count among bad debts, though it could be argued that young people launching a career may need to use a credit card to get a decent interview suit and some clothes for work.
Be careful, though, and avoid putting anything too trendy on credit if you carry a balance.
“Many people are still paying off clothes they’ve already given to Goodwill,” Mihalik warns.
7. Don’t fall victim to bad loan products
Good borrowing can improve your financial prospects, such as a stable mortgage that leads to a paid-for home or a low-interest rate car loan for a vehicle that gets you to work. People can make poor decisions when it comes to these loans, but the products themselves can hardly be blamed.
Not so with some other lending instruments. There are a few that are designed to quickly and permanently separate you from your money. Payday loans and car title loans are among the worst offenders, with very few redeeming qualities and many penalties.
Each of these high-interest, short-term loans spells trouble and can cost much more than the original amount borrowed. The best way to avoid borrowing trouble is to stay away from these bad products like you would a rubber check from a known criminal.
8. Don’t carry a balance — or at least aim to eliminate them
The Financial Literacy survey conducted on the subject of debt management found that 45 percent of Americans carry a credit card balance from month to month. Thirty-three percent had a car loan and 20 percent owed money on a home equity loan or line of credit.
Most experts recommend paying down loans as quickly as possible. If it’s feasible to pay off a car loan, student loan or even a mortgage early, do it, says Mihalik.
For revolving debt like credit cards, it’s best to exploit them (rather than be exploited) by paying what is owed by the due date.
“There are people who use credit cards as they are intended to be used, in my opinion — as a convenience — and then they pay them off at the end of the month,” says Bolson.
“For those who use credit cards responsibly, they can really pay you back,” she says.
9 Don’t extend loans too far or borrow more than you can pay back
Obvious? Yes. But it’s an oft-overlooked rule to borrowing. A common error that befalls borrowers is focusing too much on the monthly payment and disregarding the fact that they will have to make that payment for the next 72 months of their lives, in the case of lengthy car loans.
A lot can happen in 72 months that may preclude the ability to make car payments.
“Ultimately, you’re responsible to pay off the entire loan amount,” says Mihalik.
“Very few people have the money to pay cash for a home, so it’s usually necessary to take out a mortgage. However, there’s a caveat — people must make sure to get value for their money and not overextend their finances,” he says.
The general rule of thumb for borrowing for a home is that the payments should not take up more than 25 percent of your take-home pay.
Most consumers should not have a debt-to-income ratio of more than 20 percent, excluding mortgage payments.
To find your debt-to-income ratio, add up all of the monthly payments you make for nonmortgage debt. Then divide the total by the net monthly household income, and voila, you have your debt-to-income ratio.
Though it’s not a guarantee of perpetual fiscal solvency, keeping debt within those limits, or close to it, should make financial decisions much less stressful and less likely to lead to disaster — something that all good financial rules should do.