OCTOBER 2006 :: CONSUMER ED

The Basics of Debt
The Good, the Bad and the Overwhelming

Debt is a very simple concept: You borrow money you don't have to buy something you otherwise can't afford to pay for now. The purchase might be small, such as $1 drink at McDonald's, and you stick it on your credit card because you're out of cash. Or the purchase can be huge, such as a $250,000 house for which you take out a 30-year mortgage.

In either transaction you are the borrower, and the person or company who lent you the money is the lender. The amount of money you borrowed is the principal, and you repay it with interest, the charge the lender imposes for giving you access to money you otherwise wouldn't have. You have anywhere from one month (with a credit card) to several decades (with a mortgage) to repay the money.

In many instances, debt can be a means to a valuable end, particularly when used prudently to purchase things that hold long-term value, such as an education, a home or a small business. Even borrowing to buy a car can be wise as long as you are smart about it.

But debt can also tear your life apart. It can destroy friendships and marriages. It can rob you of your retirement savings and cause you to lose your home. It can leave you dependent on the basic income that Social Security provides and leave your spirit crushed. In 2004, more than 1.56 million personal bankruptcy filings were made by an estimated 2.06 million individuals and couples, their lives now altered in many ways.

In short, debt is both benevolent and malevolent. Deciding which form it takes in your life is entirely up to you.

Good Debt

Good debt improves your life for a long time. That last phrase, "for a long time," is key. Good debt includes the following:

l An affordable home. Homeownership is the basis of much wealth in America, and the home is often the single most valuable asset Americans own. Unless you win the lottery, inherit a sizable sum or rob a bank and get away with it, you'll probably need to take out a loan to buy a house. You don't want to buy a home that is ultimately more than you can afford. If you are ever strapped financially, making your mortgage payment, plus the requisite homeowner's insurance and property taxes, could prove too much. You could ultimately lose your house in a foreclosure when the lender steps in to reclaim property for which you are no longer able to pay.

l Education. The value of a college degree can't be overstated. The earning power you attain over a career will far outshine the original cost of the degree, even if the cost is $100,000 or more. Yes, it's true that numerous high-school dropouts and some people who never went to college ended up very successful, but they are the exception, like the tiny sliver of high-school athletes who made it to the pros.

l Rental or investment real estate. As the old cliche says, "They're not making any more land." Historically, real estate has been a sound investment-as long as you're not buying into wildly speculative markets. Using debt to buy a piece of property that you can rent out for more than the cost of your monthly loan payment is a proven strategy for accumulating wealth and generating income.

l A car. This goes against the conventional wisdom of many professional financial planners who argue that a car, because it is a depreciating asset (one that loses value over time) is not a good use of debt. But in most cases, a car in modern society is a necessity. It provides an improved standard of living by allowing people access to better jobs or better neighborhoods than they would otherwise have access to if they relied solely on mass transit.

Bad Debt

Basically, if you consume it, if it loses value over time, or if you have to feed it, it's bad debt. That's the simplistic definition, and it includes meals, vacations, a fill-up at the gas station, groceries, toys, an iced latte, a new flat-screen TV, a new goldfish, flowers for the front yard-essentially all the random consumer stuff people charge to their credit cards every day.

For the most part, these are items you should pay for with cash. The reason is that cash keeps you in tune with your finances. If you start your week with $50 in your wallet and on Monday you spend $17 on lunch, a battery for your watch, and a coffee on the way back to the office, you know you have $33 left for the rest of the week. But when you put those transactions on a credit card, it just doesn't register as real. They are easily forgotten because they're so numerous and relatively small. But over time, even in just a single month, the forgotten $12 here and the $9 there can add up to hundreds or thousands of dollars owed to American Express or MasterCard.

What is worse, if you can't pay the full amount, part of what you owe rolls over to the next month and accumulates interest charges, increasing your balance. Soon you may find yourself in a vicious cycle in which your income doesn't keep up with your expenses. That load of debt can grow larger and at some point control your life.

But, as noted above, that is the simplistic view. In reality, using a credit card to make some of those purchases isn't in itself bad. Not moderating your spending during the month and not paying your full balance when the credit-card bill arrives is where debt goes bad.

How Much Is Too Much?

Let's concentrate on bad debt here. In short, you're bumping up against the bounds of prudence when your bad-debt load hits 20% of your take-home pay-and something near 15% is more conservative. That means if you bring home $40,000 a year after taxes, your bad debt shouldn't exceed a cumulative $8,000, or $6,000 if you're playing by the 15% rate. That figure includes your credit-card debt as well as several other potentially bad-debt accounts, like home-equity loans, store charge cards, and auto leases and loans.

To calculate your debt-to-income ratio, tally your total annual debt payments for all your bad debt. Then divide that number by your annual income. The resulting number represents the level of debt you're carrying.

Sticking with the $40,000 income, assume you have a monthly car lease of $350, a store charge card on which you're paying $25 a month, three credit cards with combined minimum monthly payments of $112, and a home-equity line of credit you took out to pay for a vacation on which you now pay $300 a month. Your total monthly obligation is $787, or $9,444 a year-the equivalent of 23.6% of your take-home pay. That's too much.

The ideal amount of bad debt (isn't it obvious?): zero.

Is it possible for Americans to achieve financial success and stability without taking on debt? Write to letters.classroom@wsj.com.

CREDIT REPORTS AND CREDIT SCORES

It used to be that our Social Security number defined us. These days it is increasingly our credit report and credit score.

Not only are they used for the obvious purchases—a new house, a new car—but TXU Energy in Texas in 2004 floated the idea of using credit scores to determine utility rates charged to certain customers, imposing higher rates on customers who had previously fallen behind on telephone, power, or cable TV bills. The energy company temporarily suspended the plan after receiving much grief from regulators and consumer advocates.

Nevertheless, that episode shows how pervasive reliance on credit scoring has become. For that reason it is imperative that consumers not only strive to maintain a respectable credit history but be vigilant in ensuring that their credit reports and credit scores accurately reflect that history. One wrong entry can take money out of your pocket when lenders charge you higher interest rates—or utility companies charge you higher rates—simply because your credit score is lower than it should be.

Credit reports are provided by one of three companies: Equifax, Experian, and TransUnion. Though they all do the same thing, the information they have isn’t necessarily identical. One might show a payment delinquency, for instance, that the other two don’t.

Credit scores are provided by Fair Isaac Corp. in the form of your FICO score. That score is based on the information in your credit reports and is calculated based on a proprietary mathematical formula. It defines you in terms of the credit risk you represent to a lender.

Every time you apply for credit, be it a home loan or a Circuit City credit card when you purchase a surround sound speaker system, lenders buy a credit report and examine your credit score to determine how worthy a borrower you are. The higher your score, the lower the risk you are. Conversely, the lower your score, the greater risk the lender assumes. To compensate for the risk that you ultimately won’t make good on your obligation to pay for the surround sound system, the lender jacks up the interest rate it charges you. So the lower your score, the more you ultimately pay.

IMPROVING YOUR CREDIT

As an Eddie Murphy character, paraphrasing Nietzsche, said in the movie Coming to America, “One cannot fly into flying.” That’s applicable to repairing the blemishes on your report

that aren’t errors. Those blemishes take time to repair. Basically, there’s no quick way to fly.

Those dings stick around for seven years—ten years if you have filed for bankruptcy. But you can take some action to begin improving your report and your credit score:

• Begin paying your bills consistently on time. A late payment in recent months can hurt your score more than a late payment several years back.

• Reduce your outstanding balance. The amount of money you currently owe in relation to the credit available to you weighs heavily on your credit score.

• Pay off your debt rather than shift it onto other cards. This seems quirky, but if you have $2,000 spread across five cards currently, realigning that balance onto just two cards and then closing the other three could actually lower your credit score. Here’s why: Say the combined credit limit of those five cards is $10,000. Your balance represents 20% of your available credit. But if you cancel three, and this means your combined credit falls to $5,000, your balance now represents

40% of your available credit. This relatively high number can hurt your credit score.

• Never apply for store-branded credit cards just to get the immediate discount. Increasing the amount of available credit lowers your score since it shows lenders that you have the ability to go out and in a fit of binge shopping pile on a ton of debt, which might leave you unable to pay this new debt you’re looking to take on.

• Don’t apply for new credit cards if you don’t need them. The new cards lower the average age of your account, making it appear in FICO calculations that you haven’t had credit as long as you really have. That, too, lowers your score.

• Don’t cancel your oldest card. This ties in to the comment above. Your first credit card, even if it is now charging you a 40% interest rate, establishes the longest history of credit worthiness in your name. If you cancel the card, you could reduce your credit track record and, as a result, lower your credit score unintentionally. Instead, keep the card someplace safe or even cut it up so that you never use it—but don’t call the card company to cancel it.