Get To Know Your Finances
Find Out Your Credit Score
Your credit score is a numerical representation of your creditworthiness—think of it as a report card for the way you have handled debt in the past. Having a sterling credit score (FICO scores above 740 are considered very good and above 800, exceptional) will help you qualify for the lowest interest rates.
On the flip side, having a low score can prevent you from getting credit altogether. The majority of your credit score (65%) is based on your payment history and how much of your available credit you use. To maximize your score, avoid late or missed payments on any of your credit accounts and keep your utilization—meaning the percentage of your credit limit you use—below 10%.
Keep in mind that having a high credit score does not necessarily mean you are in a good position to take on more debt. It is entirely possible to have near-perfect credit and live paycheck to paycheck. On the other hand, it is also possible to have a mediocre credit score because you’ve been careless about paying bills on time, and yet still have a healthy nest egg saved for retirement and room in your budget for borrowing.
Having a high credit score is essential because it can help you save thousands of dollars in interest payments, but it is critical to understand that it is not the most important financial metric in deciding whether you should borrow.
Before applying for any loan, it’s essential to have a solid grasp of your current financial situation, how much money you earn each month now and how you spend it. The flow of dollars in and out of your bank account paints a clear picture of your ability to manage money responsibly—and how much room you have in your budget to, for example, make a new monthly debt payment or save more now for a down payment on a home.
When you do apply for a loan, lenders will assess your ability to repay them, based on factors including your income and expenses, current outstanding debts, credit history and credit score.
The prudent approach is to do a self-assessment first, to make sure you’re a strong applicant, which will be rewarded in the form of lower interest rates. Are there adjustments you can make now in your monthly spending to make room in your budget for something more important to you?
While mortgages, student loans and business loans are considered examples of “good” debt, credit card debt and other forms of consumer borrowing usually fall in the “bad” debt category. Spending on the latest electronics, home decorations or travel may contribute to your current lifestyle, but taking on credit card debt for these splurges won’t increase your wealth.
The average annual interest rate on credit cards is nearly 20%, which means any balance you carry will quickly compound and grow if you don’t pay it off quickly. To put that figure into perspective, financial experts usually say that you can expect your investments in the stock market to generate average annual returns somewhere between 6% and 10%—meaning that your credit card debt will likely grow much more quickly than your investments.
Even student loans don’t always make sense. Does the program you will borrow to attend have a track record of placing its graduates in positions with salaries that allow them to repay their student loans comfortably? Look at average graduate starting salaries and placement rates for the programs you are most interested in attending. Once you compare your expected earnings with the estimated monthly loan payment, you will get an idea if you will be able to make it work.
While house prices are appreciating rapidly now, even buying a house (with all the transaction costs that involves) may not make sense if, for example, you may be moving soon for your career. Not all life decisions can or should be made strictly with finances in mind, but it’s prudent to look at all the financial angles when deciding when and how much to borrow.
Know When Debt
Makes Sense …
… And When Debt
Doesn’t Make Sense
Know When Debt
Makes Sense …
… And When Debt
Doesn’t Make Sense
… And When Debt
Doesn’t Make Sense
Know When Debt
Makes Sense …
Broadly speaking, it’s worth borrowing money to buy an appreciating asset, to invest in your personal development or to refinance to lower your interest rate on existing debt. Financial experts often like to divide debt into two different camps: good debt and bad debt.
Good debt is a loan that will help you grow your income or build wealth. An example is taking out a loan to buy a small business or borrowing for a college or graduate degree that offers more lucrative employment opportunities.
Mortgages are also viewed as good debt because they can help you acquire an appreciating asset at a relatively low interest rate. Owning a home may also increase your quality of life by allowing you to live in a safer neighborhood, send your kids to better schools or shorten your commute. However, that doesn’t mean that taking out student loans or a big mortgage is always a good idea.
Know How Much
You Can Borrow
Figuring out how much money you can afford to borrow can be confusing because there are many considerations, ranging from your lifestyle and financial goals to your income. While there is no quick-and-easy rule to follow, many lenders adhere to a maximum debt-to-income ratio of 36% when making lending decisions. This ratio looks at your total debt payments and compares them with your income.
is the maximum debt-to-income ratio many lenders adhere to when making lending decisions
This percentage is based on your monthly debt payments and not the total amount of outstanding debt. But you can use the 36% rule to back into how much aggregate debt this translates to by using an online loan payment calculator. For example, if your monthly income is $6,000, and you are hoping to take out a mortgage, you could be expected to afford total monthly debt payments equal to 36% of your income, or $2,160. If you assume an average interest rate is 4% over 20 years, this will imply maximum potential borrowings of $356,447 at your current income level—assuming, that is, you have no other debt.
While each situation is unique, sticking to this rule of thumb is a good way to avoid becoming overburdened by debt and to gauge your likelihood of qualifying for a loan.
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