I have a four-part rule about good uses of credit. If you can answer yes to the following four questions, you are likely using credit wisely:
1. Is this loan/credit card part of my overall plan to build a good credit score?
2. Can I afford to pay this back?
3. Is this the best use of my time?
4. Is this the best use of my money?
Good Uses of Credit Question #1: Is this part of my overall plan to build a good credit score?
If you have more than five credit cards with high balances, new installment loans or mortgages, and a lot of credit inquiries, opening another loan or credit card might hurt your score. Opening a credit card or taking out a loan should be part of an overall credit strategy intended to help you build credit and increase your opportunities. New credit should never be a knee-jerk reaction to financial problem. More on that later.
Good Uses of Credit Question #2: Can I afford to pay this back?
This seems simple, but with the numbers speak otherwise. A study by the Federal Reserve reported that in July of this year, Americans owed a whopping $2,418.5 billion to creditors.
To determine whether you can afford to pay something back, you must know the ins and outs of your personal budget. I know that there`s nothing sexy about budgets, but if you do not have a grasp on your monthly income needs, you have no business using credit.
Creating a budget is relatively simple, and you can find oodles of information on the web about the process. In short, you need to log your expenses and then compare them against how much money you make. Any excess money can be saved, invested, or spent. Any deficits must be borrowed or charged. The goal of a budget is to locate any frivolous expenditure so you can increase the amount of money you have left over.
This step is simple, so much so that most people do not do it. But I promise you that if you do not have a budget, you will not make good uses of credit.
A budget allows you to determine whether a loan or credit card is a solution to a problem or simply a band-aid. Let`s say that you have $1200 in credit card payments each month, and that you can get a debt consolidation loan that allows you to pay only $800 each month. Obviously, this represents one of the good uses of credit.
But let`s say that you have $1200 in debt payments, and you take out a loan that allows you to defer interest for six months. Sure, this will give you a temporary reprieve, but in six months, you now have $1250 in payments. Unless you have an increase in income, this would not be a good use of credit.
Good Uses of Credit Question #3: Is this the best use of my time?
You must work to pay back every debt you owe. Let`s say you have a couple of magazine subscriptions that cost you $35 a month, both charges to your Visa. You rarely read these magazines, but you have them around just in case. If you make $17.50 an hour, you have just "spent" two hours of your life working to pay for your magazine debt (not to mention any interest you might pay).
Now imagine that you have two young children who love to spend time at the park with you. Do you think that working to pay for the magazines is the best use of your time? Wouldn`t you rather have a couple of extra hours at the park with your kids?
Of course, the choice becomes trickier if you are using this money to invest in your child`s future. Tucking $35 a month into an educational fund for your children might be a great investment of your time. This brings me to the final question.
Good Uses of Credit Question #4: Is this the best use of my money?
Remember that every time you use credit, you are spending money. And every time you spend money, you are simultaneously spending opportunities. Spending your last $5 on paying a credit card bill means you miss the opportunity to invest the money. Investing the money means that you miss the opportunity to put the money toward your vacation.
Making wise choices with your money (and with your credit) requires that you prioritize your opportunities. This is a careful balancing act. It`s easy to say that financing your children`s education is more important that financing your sock monkey collection. But if collecting sock monkeys makes you happy, brings you peace, and allows you to feel more fulfilled, you are likely a better parent due to your sock monkey collection. Now the choice becomes more difficult.
My suggestion is this:
1. Make a list of all of the expenses that you must pay for each month. We will call these the must haves. " This includes shelter, food, car insurance (or transportation to work), health insurance, and the like.
2. Make a list of the peace of mind " expenses. These are the things that you must fund if you want to get a good night`s sleep. This might include investments in your retirement account, your life insurance policy, your children`s tuition, and the like.
3. Make a list of the things that make your lifestyle more comfortable. Let`s call these lifestyle " expenses. These might things like a gym membership, hobbies, and anything else that you have become accustomed to.
Now take a look at your budget. If all of these are covered, great! And if you still have money leftover, even better. But if you don`t, you have to make some choices. Obviously, you should fund your must haves " first. Food and shelter for your family trumps all else. Once your must haves " are covered, begin funding your peace of mind " expenses, and so on.
Anytime you are preparing to charge lifestyle " expense, stop and ask yourself what opportunities are you missing. There`s nothing wrong with pampering yourself here and there, but making decisions without knowing the opportunity cost is probably not one of the good uses of credit.
Any opinions expressed on this website are those of the contributor and do not necessarily reflect those of The Student Operated Press