An Introduction to Credit and Finance

Greetings!

Over the last several months people have been asking me about credit cards, and I've decided to compile things together into a coherent document. Along the way I thought I'd include other sage gems of wisdom about finances in general. So here's my prescription for building a sound financial future...

One of the first things that you need to do to establish a good credit history is, well, acquire credit of some sort. There are many worthwhile ways of getting credit. All roads lead to Rome, so to speak, some just get there faster than others! I'll discuss two choices, credit cards and loans, in some detail.

A credit card is debt instrument with a credit limit (or credit line) and terms of repayment; it is essentially a pre-approved (and typically unsecured) loan you can use at any time. Credit cards usually treat purchases and cash advances differently, having different interest rates, fees, and grace periods for the two. Repayment is in the form of a minimum payment to be made each month, commonly a fraction of your outstanding monthly balance, plus any appropriate charges and / or interest. So you can charge $1,000 today and pay it off in $50 increments over the next 20+ months (along with the interest!)

A few credit cards have a fixed interest rate, but most will be variable rate indexed on the Prime Rate. (See here for more info.) This interest, while most often calculated in a daily fashion, will usually be expressed as an Annual Percentage Rate (APR). The grace period on a transaction is how long you have to pay off that charge before it accumulates interest. Note that grace periods only apply when you enter a month with a zero outstanding balance; new purchases accrue interest from the day of purchase when you have an outstanding balance. The interest you pay on your account each month is called the finance charge; sometimes there is a minimum.

Purchases usually have a lower APR, a 25 day grace period, and no fee. Cash advances have a higher APR (except on select cards), no grace period (that's right, you accrue interest the moment you take the money from the ATM), and you get charged a fee. This fee is a percentage of the cash you withdrew; there is usually a minimum cash advance fee, i.e. every cash advance, no matter how small, gets charged at least the minimum. If you are lucky there will also be a maximum, so that large cash advances are "free" past a certain amount. Cash advances are the enemy, and should be avoided whenever possible.

Your monthly balance will be calculated in some arcane fashion, like summing up the outstanding total charges at the end of every business day and then dividing by the total number of days in the last pay cycle. The main thing to keep track of is whether to pay your balance off in full every month. Every month you'll get a statement saying how much you owe total, and how much your minimum payment is for that month. If you pay your whole balance off in full, then you go into next month without interest, i.e. the next month's balance will be just the purchases you made this month. Paying your entire balance in full each month is the only safe way to avoid finance charges.

Lastly, credit cards will often have several types of fees which you should never run across. An over-the-limit fee is when you charge more than your available credit. Many credit cards will honor such transactions (as opposed to denying credit at the point of sale) and then slap the consumer with a fee. Others rarely invoke the over the limit charge, and do so only when a customer consistently is charging more than his credit line. A late payment fee, as the name suggests, is when you miss a scheduled minimum monthly payment. This fee will get charged, as will the returned check fees, etc. Needless to say, the best fee is the one you never pay.

What's Out There

Credit cards are critically different from charge cards or debit cards. Charge cards, like American Express and some store cards, expect payment in full every month. That means if you charge $1,000 today, then AMEX expects a $1,000 at the end of the month. Debit cards charge your purchase at the point of sale instantly to a separate account, say your checking account. That means you can't spend more than you already have! (Overdraft protection aside.) Both types of cards are conveniences, to avoid carrying around large sums or money or writing checks all the time. Neither charge cards nor debit cards build up an appreciable credit history.

[As an aside, credit cards and charge cards also charge the vendor a percentage of every purchase that you with a card. AMEX, charging no interest to the consumer, has to make its money through an annual fee and a large point-of-sale percentage of purchases. Credit cards, making money by charging the consumer interest, often have no annual fee and a smaller point-of-sale interest. That's why more places carry VISA and MasterCard than AMEX; it costs them less. It's also the reason why you get stiffed with fees on cash advances. Since there is no vendor involved in a cash advance, the credit card will usually charge the consumer!]

Of course, if you are just starting your great credit endeavor, you probably don't know what type of deals are out there. Here's a small chart to give you a feel for a good deal in 1997:

Category	Good	Typical	Bad
Interest Rate	PR + 2.9%, say 11%	PR + 6.9%, say 15%	PR + 8.9%, say 17%+
Cash Advance Fee	$2 < 1.5% < $10	$2 < 2% < $20	$2 < 2%
Late Payment Fee	$15	$20	> $20
Over The Limit Fee	None	$15	> $15

Getting Started

When you first try to acquire credit, you will face a heinous catch-22. Few organizations will offer you credit without a good history, and you can't establish a good history without credit! There are several options available, few of which I would endorse. One alternative is co-signing, i.e. having someone with established credit, say your parents, vouch for your ability to pay with their own. In theory this is an excellent idea; in practice it is a nightmare. Typically one signer is shafted by the other, through miscommunication, arguments, and pure fiscal irresponsibility. Furthermore, co-signing doesn't demonstrate clear financial maturity; the bank doesn't keep track of who made the payments. Never co-sign unless you are willing to pay the entire amount yourself; that goes for all the signers!

A slightly better option is to acquire a secure debt instrument, namely a debt backed by collateral. For example, a you might get a secure credit card. That means you pay the secure credit card company your credit limit up front (or a portion thereof) and then pay them interest for the privilege of using your own money. This is potentially useful if you've recently trashed your credit, but otherwise there is little practical benefit over a debit card. A better alternative is something like a vehicle loan, say buying a car. Banks are lenient with car loans, especially with regard to younger signers. In the worst case, you can usually finance through the dealer, though at exorbitant interest rates.

The best option is a special offer. This ranges from special applications for college students, to banks offering their own credit cards, to your company giving business cards to its employees, to professional organizations getting credit deals en masse. Anything! This is a good starting route since the criteria for approval is often simple and easily met (i.e. are you a college student without prior bad credit?). But beware! Those "special pre-approved offers" you receive in the mail are often nothing more than a marketing ploy to get you to apply for a particular brand of credit card; they are not guarantees, and usually no preference is given to the application at all. They aren't worth following up unless a) you think you could have gotten the card by applying normally and b) you wanted the card to begin with.

Lastly, get started young! Late teens / early twenties is the optimal time. I have a good friend Mark, about 29 years old, who is feeling the handicap of starting too late. He has had steady jobs since being a teenager, always keeps his promises and promptly pays his debts, and is an all around responsible person. But he also lived at home and then with friends (no record of rent payments), didn't have or need a car until his current job (no car loans / payments), and always pays for things in cash (no credit cards). He's recently tried getting credit cards, and no one will touch him, citing "a notable lack of credit activity". The point is that if Mark were ten years younger with the same profile, some companies would have taken a chance on him.

Let's consider three different types of cards. First, you definitely want a big ticket credit card like VISA, MasterCard, Discover, Optima, etc. This is the most important of the three! The second type is a store credit card (not a charge card!) that you will find useful. If you are intending to get appliances, consider a Sears card; if you are going to buy clothes, maybe get a Macy's card, etc. The last type is a chump change card, like a gas card or some other minor convenience.

Eventually you will want to phase out the latter types cards and replace them with big name cards. Why get them at all then? Because they are much easier to get, and they are a decent way to start off. The goal is three cards, say a Citibank VISA, AT&T Universal MasterCard, and Discover card. If you can get those right off the bat, go for it! (If you are a college student, you have a fair shot at getting three special offers approved. In that case, that is the way to go!) Optimally, each card should have no annual fee, and end up with about a $10K credit limit and a PR+2.9% interest rate.

Why those cards in particular? Well, Citibank has great customer service (second only to American Express in my opinion) and they make balance transfer offers about once a year. The AT&T card allows you to choose a custom calling card number and have the phone charges billed directly to your account. Discover is one of the few credit cards which offer cash back for your purchases. That means that you can use it for common monthly purchases, pay off the balance each month, and make money in the process! Those are the three cards I have in my pocket right now (in addition to an Optima True Grace, mainly because I have a soft spot for AMEX. :-) The target is about three cards and, of course, any three cards will do.

A loan is a debt instrument, which can be secured or unsecured, with a principal balance and terms of repayment. Repayment information includes at least the interest rate and compounding method, payment interval and payment value, a term and a balloon, and early principal payment and default rules. A mortgage is the name for an important class of loan, namely a loan secured by real estate, usually with interest compounded daily, monthly payments, a 30yr term with no balloon, and no early payment penalties. Whew! Let's discuss each of these concepts in more detail.

A secured instrument is one with backed by collateral. That means that when the bank gives you the money you give them ownership of something tangible, say a house or some property. If you default on your loans, i.e. meet the criteria in the loan contract, then the bank enforces their ownership and typically sells the item(s). If you pay the loan, then after the last payment you (re)gain ownership of the security. An unsecured instrument is one backed by a person's promise to pay. Of course, if you default there are still legal recourses for an agency to reclaim its lost money, such as liens against your property or salary. Securities are a big financial topic in and of themselves, as any member of the Securities Exchange Commission could tell you. :-)

Interest rates come in several flavors. There are two major classes, fixed and variable. As the names imply, a fixed rate doesn't change and a variable rate can; the latter is typically tied to the Prime Rate. The PR is set periodically by the Federal Reserve and in essence represents the interest rate at which banks are allowed to loan each other money. (Consequently, you will rarely find a better rate than prime; short-term special deals are about it.) The compounding method is how often your interest is calculated on your outstanding balance; the shorter the duration the more interest you pay. For a private individual this really isn't a concern, daily or twice daily, it doesn't make much difference. But when dealing with large sums of money that small difference becomes significant. Make sure your mortgage is compounded monthly.

The payment interval and value are how often and how much you pay. Most private loans use monthly payments; sometimes commercial loans are paid quarterly (or yearly). A single payment consists of both principal and interest. The principal is the outstanding amount of money you owe at any given time, initially equal to the starting balance (i.e. how much money you borrowed). The amortization schedule is a list of when to make your payments, how much principal is paid off each month, and what the remaining principal is after each payment. If you glance at a schedule, you see that the early payments are almost all interest and the later payments are almost all principal. This is key! I'll harp on this much more later.

The term is how long all parties expect it to take to pay off the loan, and the balloon is how much money is due at that time. Most loans that people take out have no balloon, i.e. the last monthly payment pays off the loan in full. However, commercial loans and sometimes mortgages can have a balloon, which is the remaining principal at the end of the term. If this seems funky don't worry about it; it has to do with the time value of money and you can learn more about balloons if you ever come across one.

Early principal payment means that you make more than the required payment and want the excess to be paid directly toward reducing the principal. This not only shortens the term but also reduces the overall interest that you pay. Banks used to charge fees for this, but that has become a rarity; on all loans insist on free early principal payment. A sample default might be to stop making payments for so many months, or get behind payments for so long. Despite what you might think, modern banks prefer people not to default. There is time, money, and uncertainty involved with repossessing cars and foreclosing mortgages. Most banks would far rather have a happy, responsible customer who will pay them regularly and furthermore take out loans with them in the future.

Refinancing is when you seek another loan on your remaining principal, usually to get a more favorable interest rate or a smaller monthly payment. Though you might refinance through the same bank, technically the old loan is being paid off in full and a new loan is being created. This is more easily seen in debt consolidation, a common form of refinancing. To consolidate debts one loan is used to pay off several other debts (loans, credit cards, whatever) and then you only have to make the payment on the loan, since the other debts have been cleared.

Refinancing is crucial! Especially when it comes to large debts or long debts, like mortgages. Let me show you an example of just how important this is. Consider a standard $100K mortgage, fixed rate 10% compounded monthly drawn for 30 years. The monthly payment for this is $877.58 per month, which times the 360 months comes out to a grand total of $315,909.34. That means that after thirty years you've paid $215,909.34 worth of interest! (Okay, we are ignoring the time value of money here, but it turns out it isn't important for the illustration I'm about to make.)

Suppose that at the start you had the opportunity to get the mortgage at 9.75%. You do your calculations and discover that the monthly payment would be $859.15 times 360 months for $309,303.68 over the life of the loan. Pah! A mere 6K worth of savings over thirty years! What's the point of breaking your back to get an extra quarter point? Wait! Suppose that you got the lower rate of 9.75% but paid it off as if it were 10%, i.e. paid $877.58 per month, so that an extra $18.43 per month was going toward principal.

Then what happens? First, the term of the loan shrinks to 322 months, shaving more than three years off the lifetime of the mortgage. This in turn means that you pay $282,133.72 overall, which is a 33K savings! I cannot stress this enough. That means that, on average, you are paying $18.43 per month to save yourself $104.89. Paying a small consistent amount toward principal saves you big money in the long run. This same idea applies with debt consolidation; if consolidate your debts under a lower interest rate and then pay more than the minimum amount, you will save beaucoup bucks.

Unfortunately, this is exactly what people don't do. Typically they don't avail themselves of refinancing opportunities when they are in good financial health, thinking, "All that trouble for a measly quarter point and all it saves me is $20 a month. It's not worth hassle of filling out the application!" Or they consolidate debts because they are hurting to make monthly payments, and thus are unable to pay more each month. The true utility comes when you refinance in good times, and then continue paying the old terms. It makes a big difference. I will continue harping on this later...

There is a lot of things that people don't know about loans and mortgages that they probably should. I became a Certified Mortgage Investor in 1995, and discovered that a) the mortgage industry is the biggest non-commercial cash flow in the world, and b) the average loan holder gets ripped. They pay far more money than they have to, because they don't comprehend that small amounts of money today are worth huge sums in the future. And the worse part is that the financial institutions aren't to blame; people let themselves get raked over the coals, either by ignorance, irresponsibility, or apathy. A person conscientious about their finances can use the same organizations to provide comfort, security, and affluence.

Anyway, I'm going to stop here before I go on a rant. Most of what I'm going to say about credit cards applies equally to loans as well, so I'm going to focus on credit cards for the bulk of this document.

Okay, you've just gotten your Chase VISA, Sears card, and Mobil Gas Card. What now? How do you build up good credit? Before doing anything, you have to understand what good credit is, and that requires swallowing a bitter pill. What is good credit? It is:

"Maintaining a reasonable debt and paying it off in a timely fashion."

What does that mean? Well, for credit cards it means selectively making purchases, leaving the charges on your monthly balance, and then shelling out thousands of dollars of interest over the next five years. That was interest that you didn't have to pay, mind you, and that you deliberately created with the express intent of fattening the already over-large purses of your credit card companies. Here's a typical conversation after I tell people this.

Person: "What! Are you insane? You should pay your current balance every month to avoid a finance charge! Barring that, you should pay off your balance as soon as possible to minimize the interest."

Kim: "Actually, credit card companies are in the business of making money from interest. If you were a credit card company, who would you prefer? Someone who paid their balance every month and from whom you got nothing, or someone who paid you interest every month?"

Person: "Well, clearly the schmuck who was paying me interest. But why should I pay them money that I don't have to?"

Kim: "There are three compelling reasons. One, these are the people who give you credit, and they give credit to people who give them money. Two, because good credit is a powerful convenience which is in your best interest to acquire. Three, because when used properly it will save you money in the long run. Let me tell you some stories..."

My family has never been in good financial health. On my first birthday my father filed for bankruptcy. When I was growing up dollars and cents mattered, and my father told us repeatedly: "Never go into debt." He hammered it into the children until it was a phobia. I worked my butt off when I began college to avoid taking college loans, maintaining both a full time course of studies and a part time job.

My second undergraduate year I decided I should start building up my good credit. I choose the American Express Card because it was a charge card, and it suited my mentality of avoiding debt. Around that same time an electronics store opened up nearby, The Good Guys, and students were going there in droves to buy things. I told my fellow students that if they had something they were going to pay for in cash, to let me buy it with my AMEX and they could pay me the money. After all, I got an extra year warranty on everything for free, and it was no sweat off their noses.

What happened? Well, first of all both American Express and the Good Guys loved me. In the course of two years I funneled about $15,000 worth of purchases through the card, and paid every bill on time. AMEX upgraded me to a gold card the second year I had it; my credit was A-okay with them. (BTW, as an aside, I have always been impressed with AMEX. There have been two times when I needed to get someone somewhere, fast!, and they've always come through with aplomb.)

Three years later I'm looking to buy a used car. I find one I like, and start going to banks looking for a used card loan. They asked me what credit qualifications I had, and I mention the AMEX card I've had for three years, and kept spotless. Their response: "That is a charge card, sir. It does not demonstrate good credit." I was shocked, to say the least. I talked to seven banks, three loan agencies, and two friends of mine who are financial consultants. Every one told me a variant on the same theme: good credit is "maintaining a reasonable debt and paying it off in a timely fashion." I didn't get the loan

It was hard for me to accept that I needed to carry debt in order to build credit, especially given my upbringing. But I thought about it for awhile, and it made sense. So I changed my battle plan. I got a few credit cards through student offers. I maintained a reasonable debt on them. I forked over the interest every month, never missing a payment. I periodically asked for credit line increases. After three years I had stellar credit.

Today I get applications through the mail for credit cards, consolidation loans, home equity opportunities, and retirement fund prospectuses, all pre-approved. I carry about $30-40K of credit in my pocket, and I routinely cancel cards with $5-10K credit limits. And yes, I am trying to impress you here. I'm trying to impress on you that when I needed the loan, I couldn't get it because I didn't have a good credit history. Now that I've built my credit, I can get a loan when it really counts. And I'm confident that as long as I maintain my fiscal reliability that will continue to be true. Agencies want people who will pay them interest.

There are many more benefits to a large, well-maintained credit base. I think a lot of people think that "financial responsibility" is synonymous with "scrimping and saving". It isn't. The people who've planned for their fiscal future are the ones who buy things when they want, and have the capability to splurge when they please. The people who haven't are the ones who live from paycheck to paycheck, and have to look after every dime. Let me give you some examples.

This last year I started up a bi-weekly dinner club. My friend Andy and I went to all the dinners, and we invited other people to go with us. We started going to some pretty ritzy restaurants, and people asked me to find less expensive establishments. Eventually Andy asked me, "How the hell can you afford to go to these places?" (Both of us are students whose main source of income are small monthly stipends from the school.) I responded, "I can't. I go about $100 in debt every month."

Needless to say, he was flabbergasted. But I told him that I expected to go about $1K - $1.5K in debt per year while in school, and to make it up afterward. Since I had a huge credit limit on my cards, it wasn't a problem. "But what about the interest you pay?" he asked. Well, I was deliberately running up my debt for the express purpose of paying interest. And since my interest floats around 7-8%, I'm paying at most an extra $100 per year. Ah, but look at what I get for that $100... I get an even better credit rating. I get freedom to go out and enjoy myself when I want. And most importantly, I get to stop worrying about the difference between a $10 dinner and a $25 one.

Essentially what I was doing was leveraging future buying power; using anticipated income in a judicious manner to buy goods and services today. This, of course, is the two-edged sword of credit. When used properly, it cuts through a lot of hassle, making life convenient and enjoyable. When used improperly, well, you slice off an arm and a leg. The trick is to decide what you can afford beforehand, and then stick to it. Let me give you another example.

For some time I had wanted to get LASIK done on my eyes, a laser corrective eye surgery. The surgery costs about $3K and while I could easily "afford" it credit-wise, it would exceed the $10K debt limit which I've set for myself. So I planned on knocking down my debt (that's right, scrimping and saving) so that I could give myself a Christmas present that year. But then I got a summer job at MIT Lincoln Labs, one which paid quite well. After figuring out the finances, I discovered that I could afford not only the eye surgery but also a number of other things. So before the summer, I got the surgery done (and incidentally bought a new wardrobe, something else I wanted).

Wait! You haven't heard the upshot. I bought the surgery on my AT&T card, which gives the standard 25 day grace period on purchases. Then I balance transferred it onto my Optima True Grace card, which gives a real grace period on things (even if you are carrying a balance). And by the time I would have been charged interest, I had paid off the surgery with my first two paychecks. My large credit base enabled me to get the surgery done 6 months earlier than I had planned, and it didn't cost me one red penny in interest.

Don't underestimate the power of good credit, when carefully and intelligently applied. It smoothes things out; you buy things when you need them, not when you get your paycheck. It buffers against emergencies. My parents, due to their own mistake, got whacked with $18,000 in taxes one year. I had to bail them out with a check drawn on a credit card. Credit draws from your future so you can enjoy today. And don't underestimate the psychological impact; it can free you from needless stress over short-term finances.

Have you swallowed the bitter pill yet? Let me coat it with some sugar for you. One way to justify spending money on interest is to believe that you are buying a good credit rating with it. Supply and demand: you want the convenience of good credit, you have to pay for it. As far as it goes, that is exactly what you are doing. But you are also investing in your future; you will save money with a good credit rating. If used properly, you can recoup many times your initial investment.

Let's work some numbers. Suppose that, like me, you decided that $10K worth of debt is reasonable. Suppose the best interest rate you can find is 12%; that means that you'll be paying a $100 per month to build up your good credit. Suppose you do this for five years, bringing the total to about 6K paid in interest. (In reality you'll find better rates and it will take less than five years, but hey, let's take a worse case scenario.)

Now you go out and buy a house, our mythical $100K 30 year mortgage. The bank guy tells you that he can give you 10%; say at the time that's a fair rate. But wait! You are forgetting that you are a commodity. If you really have kept 10K of debt for five years, and made all the payments on time, then you are exactly the type of person they want as a customer. You tell the bank that you were really looking for 9.75%; he says it's not possible. "Oh well," you say as you get ready to leave, "I'll see whether your competitors across the street can help me out." Do you know what will happen? You'll get the quarter point off your mortgage approved by his manager on the spot. When you have good credit, you don't "shop around", you "advertise yourself".

We've already worked out the straight savings for the 9.75% loan vs. the 10%; it comes to about 6K. In essence, you've just regained your investment. Furthermore, as I've already shown you can parlay this minor savings into a huge amount with very little effort; no more effort than it would have taken to pay off the 10% loan in the first place. If you want good credit, accept that you will have to pay for it up front. Swallow the pill. Digest it. But don't think you are wasting money. If you use your credit wisely, you will make back all the money you paid and save even more.

How do places find out about the interest you've joyfully shelled out for the last few years? Most financial institutions, especially credit organizations, used your credit report as a litmus of your fiscal health. There are many credit bureaus out there, dealing with everything from checks to credit cards to loans, and each one keeps a report on you; so you have as many different credit reports as there are bureaus who maintain them. Fortunately, there are three big league credit bureaus out there which most credit agencies use. They are Experian (formerly TRW), Trans Union, and Equifax.

Credit reports from the three major bureaus contain essentially the same information. We'll divide this into three rough categories for convenience: personal identification, request history, and per account information. The first category contains things like your full name, SSN, birth date, your most recent addresses, etc. Basically anything which can be used to positively identify you. The bureaus also track your employment history, and Trans Union even has your current salary listed!

The second category is a list of any agency which has requested your credit report. A little known fact is that any company with your personal information can request your credit report, but every request is logged and shows up on your report. Common reasons your report is requested are: employment qualification (by potential employers), rental investigation (by landlords), lending approval (by banks and such), credit approval (by credit agencies), and promotional searches (by basically anyone). The latter accounts for all that mail people automatically receive, ranging from nifty deals for those with good credit to credit consulting services for those with bad credit.

The third category is the meat of the report, and is the most complicated. Every account has information like: the account number, the creditor, any current disputes, when you opened it, how long you've had it, when you last used it, if it is active or closed. Loans typically have your current principal balance, monthly payment, loan term, and other loan particulars. Credit cards accounts have: your credit limit, your current balance, the highest monthly balance you've had in the past. But don't get overwhelmed! There are two critical pieces of information that everyone looks for.

First is the account type. Accounts can be joint or individual (i.e. co-signed or not), revolving or open (i.e. a credit card or charge card). The best type of account to have from everyone's perspective is an individual revolving credit account. That shows that you alone have been responsible for the account, for better or worse. The second key datum is the account status. This is basically whether you've made all your payments on time. Late payments are usually tracked by how many months it is late, i.e. 30, 60, 90, or 120 days late, and every late payment is immediately visible on your report.

... you have a right to see all your credit reports, often for free? Credit bureaus are severely limited by legislation, both the federal Fair Credit Reporting Act and all applicable state laws, and must always allow a person to see their own credit report. They will try to charge a fee for this (which is also limited), but in many cases they must honor a free request. Any time that you have been denied employment or credit because of the information in your credit report, you can request a free report from that agency up to 60 days later. In many states, especially the east coast, you can also make one free request per year per credit bureau.

... you are responsible for the accuracy of the information in your credit reports, and not the credit bureau maintaining it? The government believes (and rightly so) that individual people are responsible for their own finances. Thus, you must make sure your credit reports are correct! Legislators have written laws allowing you to freely access a report, dispute items on it, and even write short explanatory comments which must be printed with it. Clearly there is no reason for a report to be incorrect, except individual apathy. So check your credit reports periodically, say once a year, and make sure they are accurate.

... that you can have too much unsecured credit? Many agencies, especially credit card companies, will calculate a total credit limit based on your credit report. This is basically what they feel you should have for combined credit among all your cards, and they will refuse credit to anybody, even people with stellar credit histories, if they are already above this limit. They are also leery of people with too many credit cards, and will deny credit because of that as well. So optimally you want to have a few cards with ample credit among them, say about half of your yearly income.

... that you can be denied credit for building it up too fast? Recall that a history of requests is kept and displayed to creditors (except for promotional offers, which are only shown to the consumer). Most companies consider more than two transactions per month on the report to be "suspicious credit activity" and may steer clear of you for that reason. The requests you have under your control are: applying for new credit (cards or loans), asking for credit line increases, changing employment, and moving. I suggest that you take your time and do only one of these per month. So take three months to get those first three credit cards, and space out your credit limit increase requests.

... that credit reports can help as much as harm? Most people think of credit reports as the enemy, haunting them for years because of a fiscal mistake. Some even try to have them "fixed" by companies, which is a fruitless endeavor given their extensive regulation. Credit reports are a record of your fiscal history; if you want to improve your report, become more financially responsible. If you do, your credit report will become a useful ally. Good credit "haunts" people just as much as bad. It attracts special deals and extra consideration from financial institutions, and automatically opens doors previously closed. People with good credit are a commodity in high demand, and credit agencies are willing to bend over backward for your good business.

Now that we understand that building good credit means paying interest and lots of it, how do you go about doing this? Here are some easy maxims which people find hard to do.

Without doubt the number one way that people thrash their credit histories is they fail to make payments on time. They get behind on payments, they pay too little, they default on loans, and all around they fail to honor their financial contracts. Well, if you were a bank, who would you want to lend money to? Someone who promptly and fully meets their fiscal obligations, or someone who is spotty in their payment history? Reverse the situation. How would you feel if on payday your employer said, "Oh yeah, the paychecks. Sorry, I forgot about them. I'll get them in the mail next week."? What if they did that every fourth paycheck, or got behind in your salary?

Maintain a debt and pay off the monthly bills on time, and soon you will have great credit. Miss payments, and it will dog you on your credit report for the next seven years. It's really that easy. Given the simplicity, why do people have so much trouble paying their bills? I've been able to identify at least three distinct reasons: apathy, over-extension, and irresponsibility. Apathy is when a person doesn't really think their finances are that important, and doesn't take the time to manage them. Over-extension is basically mis-estimating your financial capabilities, acquiring more debt or payments than you can meet. Irresponsibility is the most insidious, being basically the attitude that "the bank can damn well wait for me to pay them."

All three conditions are fully rectifiable, but they require you to change your attitude and your habits. It is not only your responsibility to make the payments, it is directly in your best interests. It's your credit history. If you ignore your financial obligations, go ahead. But when you miss that payment because the statement got lost in the mail, it goes on your credit report regardless. If you scrupulously try to pay your debts on time, it shows. It shows in five years of no missed payments, and it shows in other ways. Did you know most credit card companies write down customer interactions on your account? Imagine how "Customer called to make monthly payment; statement lost due mail error" looks when they review your account for a credit line increase...

Okay, it's harp time again. Whenever you make payments, you should always pay more than the minimum amount. For credit cards, I suggest doubling the minimum payment; for mortgages, adding your interest does nicely (i.e. pay 110% of the payment on a 10% mortgage). There are numerous reasons why you want to do this. First, it demonstrates to everyone involved that you are in a comfortable financial position; hey, you can afford to pay more than you have to. Second, it gives you a monthly buffer in case of emergencies; if something comes up, you can drop down to the minimum payments until things blow over. Third, it saves you massive amounts of money.

Let's go back to our hypothetical $100K mortgage at 10%, with a monthly payment of $877.58. Let's make a chart of the savings we make for paying a little extra each month.

Extra	New Term	Time Saved	Total Paid	Saved Per Month
$0	360 mos.	0.0 yrs.	$315.929.20	$0.00
$10	337 mos.	1.9 yrs.	$298,929.52	$50.44
$20	318 mos.	3.5 yrs.	$285,209.08	$96.60
$30	302 mos.	4.8 yrs.	$273,778.24	$139.57
$40	288 mos.	6.0 yrs.	$264,035.33	$180.18
$50	276 mos.	7.0 yrs.	$255,587.48	$218.63
$60	265 mos.	7.9 yrs.	$248,161.19	$255.73
$70	255 mos.	8.7 yrs.	$241,559.73	$291.64
$80	247 mos.	9.4 yrs.	$235,638.24	$325.06
$90	239 mos.	10.1 yrs.	$230,284.41	$358.35
$100	231 mos.	10.7 yrs.	$225,413.59	$391.84

So if you followed my guideline, you'd kick out an extra $87 / month, reducing the time to ~20 years instead of 30, and saving ~$80K in the process. Not bad for a measly $87 bucks per month, eh? This same principle applies to credit cards, loans, basically any debt instrument which charges interest. The more you pay up front, the more you save in the long run. Of course, that extra money you are paying has enjoyment value now. I'm not saying you become miserly and scrimp every penny investing in your future; I'm suggesting you limit your debts to begin with. If your debts are reasonable, then you will have enough money not only to pay more on them but also to go out and enjoy life!

So I've been advising to maintain a reasonable debt this entire time, but I haven't described what I mean by "reasonable debt". What's reasonable? Unfortunately, people's situations vary so widely that it's difficult to describe any hard and fast rules. As far as numbers, I would say that reasonable is the lesser of ½ your total credit limit or ¼ your yearly income; but hey, that's just my opinion. The key thing is to decide beforehand how much you'll spend, and then don't spend more than that. And just as important as how much to spend is what to spend it on.

The second way that people get burned by credit is they overextend themselves. They make impulse buys with the newfound financial freedom credit brings them, and then they spend the next decade trying to pay it off. Or they don't track their buying habits and find they've dug themselves into a huge hole of debt. How do you avoid doing this? I think the easiest way is this: don't buy anything you wouldn't have bought before you had credit.

What does that mean? It means that if right now you buy $200 worth of groceries per month, use your credit card to do that instead. What about that $50 of gas? The $100 of toys? If you could afford it before you got credit cards, you should be able to afford it now. Use credit mainly to smooth things out, to allow yourself to spend an extra $40 on your kid's birthday party, without worrying about the immediate cost.

As for the types of purchases, I must forewarn you that my opinion is highly biased. I always try to limit my spending to two main things: utility and memories. My main criteria for the types of things to buy are: will this be useful? Will it create a happy memory? So on the one hand I make long term investments in tools, appliances, and equipment; on the other, I prodigally blow my money on dinners, music, movies, etc. I guess the trick is find something that is important to you and then employ credit to enable you to use / enjoy it.

Of course, the astute reader will wonder, "If we are buying things we could pay for before, and we are not paying it off immediately, what about the money we were using to pay for this stuff originally?" Of course, part of the cash flow you were using to buy groceries, etc. goes into paying off the credit cards. But why not use the money which you are allowing to slowly go into debt? Why not use it to invest in, say, knocking down the principal of your mortgage, or clearing away other higher interest debts? Why not put it into a interest earning savings account, earmarked for that trip to Florida next year?

I know a lot of people who plan their finances on whether they can make the required monthly payment(s). This is not good. It is even worse when you do it with credit cards. There are numerous reasons to avoid this; let me emphasize just a few. Stretching yourself to your monthly fiscal limit will hinder you from getting loans when you need them. One of the things a bank does on a loan application is calculate your monthly payments. And yes, they give money to people who can already afford it, and that means people with the spare funds to make another monthly payment.

Riding the monthly payment curve also limits you in emergencies. "But that's what credit is for!" you might say. Agreed. But if you are already spending all your money on minimum monthly payments, then another $50 per month can break your back. What if the emergency requires you to fly out to Montana for a week, comforting your distraught parents after the fire? How are you going to make that month's payments when you just lost a week's paycheck?

There is another good argument on the other end of the spectrum. Forget emergencies, what about enjoyment? Personally, I allocate a budget for "impulse buys", the tickets to that great play I just heard about, or the sale on that computer memory I've been itching for. When you stretch yourself to your monthly payments, you curtail your ability to use credit on the spur of the moment. And one of the benefits of well-maintained credit is the ability to occasionally pamper yourself.

Lastly, and most importantly, acquiring debt to fill up your monthly payments robs you of the tremendous advantage of paying off debts early. In a sense, budgeting to your monthly payments is maximizing the overall long-term interest you must pay. We saw just a moment ago how incredibly valuable $50 a month can be, when consistently applied. You want to keep your monthly payments well under your ability to pay. That way you can use the "excess" money to selectively wear away long term / high interest debt, where it does the most good.

Okay. Let's get down to some brass tacks. Here's my suggestions on how to buff up your credit capabilities.

• Apply for three credit cards, one per month. Decide on a total amount of debt that you can a) afford to pay interest on and b) are comfortable with. Also decide on how much total credit you want.
• Focus on one card, and start spending with it. Try to keep your monthly balance about 50% of the total credit limit, say fluctuating in the 30-70% range.
• Ask for credit line increases on all your cards once every six months per card. Remember to stagger these to one request per month! (to avoid excessive credit report activity). A reasonable increase sequence is {$500, $1,000, $2,500, $5,000, $7,500, $10,000}. Don't ask more often than once every six months; they will automatically decline.
• Make the payments on time, dammit! And, of course, pay more than the minimum required every month.
• Start with another card after a year. Lather, rinse, repeat. Keep going until you've reached both your target debt and credit limit.
• Cancel cards if you have to, especially if you can get a better deal with another one. Make it clear during the call that you are switching your business to their competitors, for the specific reason that X (say, a lower interest rate) is better with the other card. Often they will change your account to match!

There is one other key element to a credit card battle plan, namely balance transfers. The credit market has become quite competitive lately, and companies will offer special low interest deals if you'll transfer your debt from other cards to theirs. The lower rates typically last 6 or 12 months, depending on the company. This is most often done as part of an introductory offer, when you first apply for a card, but is also offered periodically to established cardholders.

Well, even though your intention is to fork over interest to credit card companies, there is no reason you have to do it at an 18% rate. Use balance transfers judiciously and you should be able to shield your debt at much lower interest rates (the best I've had so far is 5.9%; 7.9-8.9% seems to be the norm). Furthermore, with three cards the likelihood is that you'll be able to keep the same debt circulating among the accounts without ever being charged the normal interest rate. Once you've established your good credit, all it takes is a five minute phone call every six months.

Of course, while good credit is important, it is only one aspect of your overall finances. Like everything else in life, your finances reflect how much time, consideration, and effort you invest in them. If you take some time now to develop a financial plan, it will pay real dividends in the future. I seriously suggest that either a) you become fiscally savvy yourself or b) you hire a financial planner.

Many people associate a stigma with acquiring a financial planner. "What, you don't think I can handle my own finances?", or "The stuff they tell me to do is unreasonable", or "It's not worth the fees they charge". I view the situation very much as the service of any specialist. Sure, you could become adept at managing your finances, the same way you could learn to build your own furniture. But it is often easier and better to hire someone else who knows what they are doing.

Suppose your health was flagging and you went to a doctor. If the doctor told you, here, swallow this bitter pill four times a day for the rest of your life, would you think it unreasonable? When you get the medical bill, was the fee worth it if it made your life better? If you already exercise your fiscal health every day, then a checkup can't hurt; but all too often people's finances are sick and need stiff medicine to cure. Every person I know who became wealthy has followed the sound advice of their financial planner, and none shy away from a little inconvenience or effort.

Probably the first step in implementing a financial plan is to track your finances in some fashion. I would suggest leveraging the computer technology and using a financial program. I use Quicken myself. At the beginning it was a hassle entering every little thing into the computer, but it was very nifty when I could balance my checkbook at the end of the month with a few clicks. It was even better when I began catching errors by my banks and credit card companies. And at the end of the first year, when it basically filed my taxes for me, I actually began saving time.

Managing your finances is much like managing your time. At some point, you reach a comfortable level where you are able to do everything you want to do, and more management has diminishing returns. However, you should always avail yourself of conveniences. For example, use direct deposit. Time is money; why waste it shuttling back and forth to the bank? Furthermore, banks offer incentives to people who use direct deposit, like checking accounts free from fees.

An integral part of managing your finances is to periodically redirect your cash flow where it will do the most good. Formulate clear investment and spending goals, and every so often (say once every few months) reflect on whether you are meeting those goals effectively. Once you know what you want, and how much you want it relative to other things, it becomes much easier to channel your finances into achieving those goals.

Investment can take many forms besides the savings accounts people are familiar with. For example, paying interest in order to build up credit is a type of investment, and a mostly counter-intuitive one. However, you already have ready made long-term investments: your debts! Consider that paying off the principal of a large debt is equivalent to earning the loan interest on that extra money. A good CD earns six percent; what is the interest on your mortage? Your credit cards? You should always pay off higher interest debt before lower interest debt; in some sense it is a higher return investment!

With luck, at some point you will have eliminated all your debt except for that which you have consciously decided to keep. What then? That's when you start creating an investment portfolio with your standard investments, stocks, bonds, mutual funds, etc. And when you start investing in some non-standard things as well: high liquidity insurance annuities, privately held mortages, commercial options, etc. The subject of investments is huge; let's wait until we are on a sound financial footing before we tackle this topic.

Think Long Term

If you've read this entire document, then you've probably already noticed the consistent theme throughout. Think long term. Make small investments today which reap large returns tomorrow. Spend your money on what counts, your future security and your present enjoyment. However, there is one long term investment which needs attention: your retirement.

"The time to start planning for your retirement is now." It's a cliche. It's also true. A minimal investment at age 25 is equivalent to a moderate investment at age 40, both of which become large sums at age 65. Every year you can compound your interest means that much larger an eventual return, and that much less worry.

Furthermore, the government offers a powerful incentive to invest in your retirement: tax deferment. Tax deferment means that any money you invest in specially approved retirement funds is not taxed in that year, but is rather taxed when you withdraw the funds after retirement. Any money you put into a 401(k) or an IRA, say, falls under this category. Let me make a bold statement:

Tax deferred savings is the best investment you can make.

Now let me back up that grandiose claim with some facts. First, tax deferred investments are essentially a tax deduction, reducing your overall income and thus lowering your yearly taxes. Second, companies will often match a fraction of your retirement contribution, so in essence you are raising your salary. Third, retirement shelters are often attached to mutual funds or some other money-making investment, which have a good statistical earning power in the long term.

But wait! The most compelling reason is that your tax deferred savings are a guaranteed high-yield investment. Every time you put money in, those funds avoid the death touch of taxes; you basically earn an incremental interest rate equal to your tax rate. What is your tax rate? 25%? 35%? How many guaranteed instant 30% yield investments do you know of? Of course, the actual rate of return is the difference between your current tax rate and the tax rate when you withdraw the money. But in reality, if you have a large nest egg built up in tax deferred savings there are ways of slowly and indirectly withdrawing the funds that will avoid most taxation.

The second biggest excuse people give to avoid saving for retirement (right after "Oh it's too soon to plan for that") is that you can't touch the invested funds without severe penalty. This is technically true, but in reality can easily be circumvented. Recall, you are an interest- paying citizen with good credit and a large retirement fund. If you need to access the money, say for a business loan, go to a bank and draw a loan against your savings as collateral. Remember, collateral isn't touched unless you default on the loan! There are numerous other ways to use the supposedly untouchable money.

I therefore recommend to everyone, in the strongest possible terms, invest in your retirement to the limit allowed by law (which is currently 10% into a 401(k) program). The money is automatically deducted from your paycheck every pay cycle; you won't miss what you never had. Lessee, that 3K I invested in my retirement account three years ago has already doubled... I wonder what it will be in 40 years?