Cash Management

The Quest for a Perfect Credit Score

What does having a perfect credit score mean to you? Well, it might mean being able to show up at the dealership and buy your next car without worrying about how you will finance it.

Or, it might mean having peace of mind knowing that you can purchase your dream home because you've qualified for a relatively low-interest rate.

Either way, having a perfect credit score can open up many opportunities you may otherwise not have access to.

Now, you may be saying to yourself, "I have a good job, I pay my bills on time, what more do I need to do?"

Well, if you're planning to finance any big-ticket purchase in the next twelve months, or even apply for a new job, effectively managing your credit is essential to achieving these goaks.

That's because we're currently in an economic environment where loan approval rates are falling, and borrowing costs are rising. And so, it's crucial, now more than ever, to do the work to build up your credit profile even if you already have a solid credit score.

To be sure, according to the credit reporting agency Experian, only around one percent of Americans have been able to attain a perfect 850 credit score.

 And while the goal of a perfect score may seem elusive or simply put, not relevant, practicing good credit management habits towards that end can help give you optionality, access to better financial opportunities and potentially save you thousands of dollars in borrowing costs in this challenging credit environment.

So how do you go about maximizing your credit score in this uncertain economic environment?

What you should do is focus on the basics.

And while you may already be proficient in many of the credit management basics, taking a few moments to check your credit report to review your account profile, account summary, and payment history for potential errors can help you maximize your purchasing ability and avoid unnecessary costs in a rising rate environment.

How to Navigate Your Credit Report

Now, with a perfect credit score seemingly elusive to so many, the big question here is, what does having a solid credit score mean to you?

Well, for Craig, a talented tech professional, it meant being able to use his high earnings to secure his dream of buying a new home. You see, Craig's impressive skills earned him a handsome salary, and the world seemed to be his oyster.

Now, despite his financial success, Craig had always felt a nagging uneasiness about his credit and could never quite shake the feeling that he wasn't in complete control of his financial destiny because he didn't understand his credit report or how the items in it affected his credit score.

Then, one day, while browsing through his bank account, Craig stumbled upon an advertisement for a free credit report. Intrigued, he decided to pull the report and was shocked by the contents. That's because his credit score was far lower than he had imagined, and he realized he needed to take control of his financial journey.

But where should he start?

Well, determined to turn his credit score around, Craig began doing some homework and discovered the secrets of credit utilization, payment history, and credit age and how they affected his credit score. Now, as Craig dove deeper into the rabbit hole of all things credit, he soon realized that this was the knowledge he had been seeking all along. But could he apply this newfound wisdom to his own financial situation?

Well, soon enough, Craig embarked on his journey of credit transformation. He diligently paid off his outstanding debts with a focus on reducing his credit utilization. At this point, Craig was determined to prove his creditworthiness to the world, and nothing could stand in his way. And, as the months passed, his credit score began to rise, and he felt a growing sense of pride and accomplishment.

However, was this newfound knowledge enough to truly conquer his financial fears?

Craig soon faced his most significant challenge yet: purchasing a home. As he began the mortgage application process, he couldn't help but worry that his past credit mistakes would come back to haunt him. After all, despite his progress, could he truly overcome the shadows of his financial past?

But when the results of the mortgage application came back, Craig was overjoyed. His diligent efforts to understand and improve his credit score had paid off and he was approved for a mortgage with a favorable interest rate. In that moment, Craig truly understood the value of his journey.

And, as Craig settled into his new home, he couldn't help but reflect on his incredible transformation. No longer was he the high-earning tech professional who felt powerless over his financial destiny. He was now a financially savvy individual, unafraid to confront the challenges of the credit world.

Indeed, what Craig's story tells us is that while it may seem like our current routines are enabling us to do all the right things to manage our credit, what really counts is what's in your credit report. To be sure, the act of simply reviewing your credit report and understanding the factors driving your score is one of the most commonly overlooked factors when it comes to optimizing your credit score.

So, what do you need to do to level up your credit score and set yourself up for borrowing success?

Well, according to John Ulzheimer, the author of "The Smart Consumer's Guide to Good Credit," there are several steps you should take to get a better understanding of your credit score and, ultimately, what you should do to improve it.

Get Copies of All Your Credit Reports

The first step to better understanding your credit profile is to obtain a copy of your credit report from each of the three major credit bureaus. Now, a common mistake many individuals make is just pulling one copy of their credit report.

And why is this a mistake?

Well, Ulzheimer recommends obtaining reports from all three major credit reporting agencies, including Experian, Equifax, and TransUnion, instead of just one because the information contained in each report can vary. That's because lenders and creditors may report information to just one or two bureaus and not all three at the same time, which can result in differences in your credit report and credit score. 

Therefore, be sure to download a copy of your report from all three agencies, preferably in a consolidated format. Now, while each bureau will offer you a copy of your credit report from their website, you can get a free copy from all three bureaus once a year by visiting htttps://www.annualcreditreport.com.

Check for Errors

Alright, now that you have your credit reports in hand, what you’ll want to do is take a moment to review each copy for errors. You can start by looking for inaccuracies in your name, address, or Social Security number, and make sure that the accounts listed on your report belong to you and reflect accurate information.

And why do you need to look for errors? Well, according to various surveys out there, as many as 33% of the respondents have indicated that they've found at least one mistake in one of their three credit reports in the past year, and that could be costing them money! 

Indeed, errors in your personal information or accounts listed on your credit report can negatively impact your credit score and your ability to obtain credit on favorable terms. That's why it's essential to check for errors on your credit report at least annually to ensure that your credit score is not negatively affected by inaccurate information.

Review Negative Items

Now, after you've reviewed your credit reports for mistakes, take the time to work through any negative items that may have shown up on your credit report. These negative items include things like late payments, collections, charge-offs, bankruptcies, and other delinquencies. 

And, it's worth noting that these negative items can stay on your credit report for several years and lower your credit score, making it more difficult for you to obtain a loan on favorable terms. 

That’s why it’s essential to remember that the longer you wait to address negative items on your credit report, the longer it will take you to get to your ideal credit score. Ultimately, reviewing your credit report for negative items is an essential step in understanding your credit score and taking the necessary actions to improve it.

File a Dispute if Necessary

Now, if you find inaccurate or negative information in your credit reports, it's essential not to panic. That's because, more often than not, there's something you can do about it, and that's filing a dispute. Indeed, by filing a dispute, you can ensure that your reports reflect current and correct information which can improve your score in certain situations.

And, so, how do you go about filing a dispute?

Well, the first thing you should do is contact the credit bureau reporting the error or inaccuracy in writing and provide them with supporting documentation to prove your dispute. Now, each of the three major bureaus offer a way to complete this process through their website.

Then, after you've notified the credit bureaus of any errors, you should wait for a response. The bureau will investigate the dispute and typically respond within 30 days. If they find that the disputed information is inaccurate, they must correct the information on your credit report.

And what do you do if they don't correct the information?

Well, if the credit bureau doesn't resolve the dispute in your favor, you can try directly contacting the creditor that reported the inaccurate information and ask them to take a look. At that point, you can provide them with the same supporting documentation and request that they correct the information.

Now, if the creditor or lender doesn't correct the inaccuracies, you can request that the credit bureau conduct a reinvestigation of the disputed information. At that point, if the dispute remains unresolved, you can add a statement to your credit report explaining the inaccuracy and provide any supporting documentation to back it up.

Either way, taking steps to correct any errors on your credit report is essential to improving your credit score and your overall creditworthiness. So, if you notice any inaccuracies or errors on your credit report, don't hesitate to dispute them with the credit bureau and the lender involved.

Dealing with Negative Items

Now, if you do find adverse facts on your credit report and know that they're not items that you can dispute, then it's time to bite the bullet and do the work to address them. Indeed, one way to deal with old debts that show up as negative items on your credit report is by negotiating to settle your debt or by paying them off. Now, depending on your situation, this approach may involve dealing with an old debt, a court settlement for a judgment, or an old utility bill.

And how should you approach this task?

Well, according to John Ulzheimer, you should first reach out to the creditor or debt collector and work out a payment plan or settlement that you can afford. In this case, you can offer to pay off the debt in full or suggest a settlement amount that is lower than the total amount you owe. And, if the creditor agrees to your offer, be sure that there's a written agreement in place and that you’re keeping track of all the payments you make.

Now, once you've paid off or settled the debt, the creditor should report the updated information to the credit bureaus, which can help improve your credit score. And at this point, it's critical to remember that paying off old debts won't necessarily remove them from your credit report entirely. Even so, their impact on your credit score will lessen over time as the account ages and eventually falls off your report.

To be sure, negotiating to pay off old debts can be a helpful strategy for improving your credit score when you have a negative item on it that can't be removed. And remember to be proactive when you do find negative items, negotiate with your creditors for a lower payment when you can, and always keep records of all payments made towards the debt.

How to Optimize Your Credit Score

Alright, so now that you've reviewed your various credit reports for inaccuracies, what else can you do if you already have a solid credit profile or are looking for ways to optimize your credit score?

Well, according to credit experts, the factors that truly affect your score include 1) age of your accounts, 2) credit utilization, 3) types of accounts, 4) recent credit inquiries and 5) payment history.

Age of Accounts

Let's start by taking a look at the age of your credit accounts. Now, a common mistake many financially prudent individuals make after reviewing their credit reports is closing out those accounts they haven't used in a while.

Now, while this approach could make sense if you're trying to simplify your financial household, like we've discussed in previous posts, but closing out the wrong accounts could materially affect your credit score.

How so?

Well, that's because having a more extended credit history indicates that you have experience managing credit and are a responsible borrower, which makes you appear more trustworthy to lenders and creditors.

Indeed, your credit score considers the length of your credit history, which makes up around 15% of your overall credit score. Now, for many of us, this credit history is often based on that first credit card that you opened in college that may no longer seem relevant to your life situation. But whatever you do, don’t allow that account to be closed because it could negatively affect your credit score.

Indeed, in this challenging credit environment, it's crucial to review your credit report, identify the accounts with a long and positive credit history, and ensure that you avoid allowing them to be closed for inactivity.

Does this mean that you have to start relying on credit cards again? Well, not necessarily. In most cases, you can keep your credit accounts from going inactive by making a small $50 purchase and them immediately paying it off in the same month.

And what happens if your oldest account gets closed out? Well, closing out an aged account can lower the average age of your credit, which can negatively impact your credit score. So, from this perspective, keeping your oldest credit accounts open and active is generally recommended as long as it financially makes sense.

Manage Credit Utilization

Now, let's talk about credit utilization. And what is credit utilization? Well, credit utilization is the amount of money you owe on your credit cards compared to the total amount of credit that's available to you. For example, if you have a credit card with a $30,000 limit and you owe $15,000 on it, your credit utilization ratio is 50%.

Now, why does this matter? Well, your credit utilization ratio is a big factor in your credit score. You see when you use too much of your available credit, it can make you look like you're not great at managing your money. That's why keeping your credit utilization ratio around 30% is ideal for maintaining a solid credit profile.

Indeed, if you consistently use a high percentage of your available credit, it can make it seem like you're relying too much on debt to fund for your lifestyle, which can make lenders and creditors worried about giving you more money in the future.

So, then, as you review your credit report, be sure to review your credit utilization and remember to keep it low, ideally under 30%, to maintain a good credit score and show lenders and creditors that you're responsible with your money.

Hold a Variety of Accounts

Now, another factor to consider when you're trying to boost your credit score is to focus on the kinds of accounts you have open. That’s because lenders and creditors like to see a mix of credit types, such as credit cards, installment loans, and mortgages, to demonstrate that you're able to handle different types of credit responsibly.

And why does this matter?

Well, the types of credit you use often makes up around 10% of your overall credit score. So, if you only have a mortgage and credit card on your credit report, for example, then your overall score could be lower than someone who has an auto loan, mortgage, credit card, store card, and personal loan. That's why having a mix of credit types can improve your credit score and demonstrate to lenders that you're responsible with debt.

Even so, before you go out and start opening up multiple credit cards, it's worth noting that not all types of credit are created equal. For example, having a mortgage and a car loan can be viewed more favorably than having simply five credit cards from different banks.

And why's that?

Well, that's because installment loans, such as a mortgage or auto loan, require regular, consistent payments over time and can demonstrate to lenders that you can manage long-term debt. So then, as you look through your credit report, be sure to have a mix of various account types.

Either way, it's crucial to keep in mind that different types of credit are viewed differently by creditors, and having too much of any one type of debt can have a negative impact on your credit score.

Limit Credit Inquiries

Now, while it may be tempting to open a bunch of new accounts as a way to diversify your credit profile, there are a few things you should consider before doing so. Indeed, Lynnette Khalfani-Cox, author of the book, "Perfect Credit," notes that credit inquiries can impact your credit report, so it's essential to be mindful of how often you apply for a new loan or credit card.

That's because when you apply for credit, the lender will check your credit report, which is called a hard inquiry. And too many hard inquiries in a short period can negatively impact your credit score.

So then, what approach can you take to prudently apply for credit?

Well, when you apply for credit, it's vital  to be strategic and only apply for credit when you need it. Remember, each hard inquiry can lower your credit score by a few points, so it's best to space out your credit applications over time.

Additionally, if you're shopping around for a loan or mortgage, multiple inquiries from different lenders within a short period of time will only count as a single inquiry, as long as they're made within a certain timeframe.

Now, when it comes to credit inquiries, there's also something called a soft inquiry, which doesn't impact your credit score. And soft inquiries are typically made when you check your own credit score or when a lender checks your credit profile for promotional purposes, such as offering you a pre-approved line of credit.

Either way, it's vital to be mindful of how often you apply for credit and to only apply for credit as you need it. That's because multiple hard inquiries in a short period can negatively impact your credit score, so it's best to space out your credit applications over time. And remember, checking your own credit score or having a creditor check your credit for promotional purposes won't impact your credit score with a soft inquiry.

Maintain a Perfect Payment History

And last, but not least, the most essential component to building a solid credit score is to pay your bills on time. Now, while this may seem like a no-brainer, the fact is that your payment history can influence over a third of your overall credit score!

And even if you have solid credit today, one missed payment can lower your credit score by over 100 points! And to add insult to injury, it can take as long as seven years to have this one unfortunate credit event fall off your credit report.

So, what can you do to ensure that you have a solid payment history?

Well, if you want to ensure that you have a solid payment history and boost your credit score, Lynnette the Money Coach, has some great advice for you.

First and foremost, she suggests that it's essential to make all of your payments on time. As we pointed out earlier, late payments can significantly impact your score, so it's crucial to pay your bills on time every month.

And if you find that you're forgetting to make all of your payments on time, now is an excellent time to consider setting up automatic payments or prioritizing which bills you should immediately pay.

Now, from this perspective, you'll want to make sure that you pay the most important bills first, such as your rent or mortgage payment, then your car payment, credit cards and finally your utility bills.

And if you need help getting started with paying your bills, be sure to check out our report on financial procrastination to identify ways to move past analysis paralysis and payment indecision.

Now, if you're going to be late on a payment, it's essential to communicate with your creditor as soon as possible. That's because you may be able to negotiate a payment plan or a due date that works better for your financial situation.

And one thing that you definitely want to avoid is skipping payments altogether. That's because skipping payments can be one of the worst things you can do for your credit score. Even if you can only make a partial payment, it's better to do so than to skip the payment altogether.

And by following these tips from Lynnette, you can ensure that you're on the right track to achieving a solid payment history and on your way to an ideal credit score.

Why You Should Regularly Check in on Your Credit Journey

The last thing we'll discuss when it comes to your journey towards a perfect credit score is doing the work of actually monitoring your credit report.

Now, while it's essential to pull all three of your credit reports at least annually, tracking your progress should be a quarterly or even monthly endeavor.

And why's that?

Well, frequently staying on top of what's going on with your credit profile can help provide you with feedback on the progress that you're making and help you quickly get ahead of any issues that may periodically arise.

For example, if you're working on paying down your debt, checking your credit report can help you confirm that this information is being accurately reported and show you how lower debt utilization can positively affect your overall score.

What's more, experts recommend that it can be a good idea to review your credit report more frequently, especially if you're planning to apply for a loan or make a big purchase in the near future.

Indeed, the Money Coach suggests that it's a common best practice to check your credit report several months before applying for a loan and closing on your purchase. This approach will give you time to correct any errors or address any issues that could negatively impact your credit score.

What's more, checking your credit report frequently can also help you avoid identity theft by allowing you to spot any unauthorized accounts that could indicate fraudulent activity. That's because identity thieves often use stolen personal information to open new credit accounts or take out loans in someone else's name. And by regularly reviewing your credit report, you can identify any accounts you didn't open or any activity you don't recognize.

Consider Credit Monitoring Services

Now, if you're not in the habit of checking your credit report on the regular, consider subscribing to a credit monitoring service. Now, it's worth noting that your mileage may vary when it comes to these kinds of services but in the end it could save you time and money.

For example, when it comes to credit monitoring services, John Ulzheimer, has some mixed opinions.

On the one hand, Ulzheimer acknowledges that credit monitoring services can be useful in helping you detect potential fraud or identity theft. That's because these services typically monitor your credit report, notify you of any changes, such as new accounts or hard inquiries, and allow you to address suspicious activity sooner rather than later.

On the other hand, Ulzheimer cautions that credit monitoring services are only a partial solution when it comes to protecting your credit. That’s because while these services can alert you to potential issues, they don't necessarily prevent identity theft or fraud from occurring in the first place.

That's why Ulzheimer suggests taking a more comprehensive approach to protecting your credit instead of relying solely on credit monitoring services. This approach includes regularly checking your credit reports, monitoring your bank and credit card accounts for suspicious activity, and taking steps to protect your personal information, such as using strong passwords and avoiding phishing scams.

Dealing with Identify Theft

Now, these perspectives bring us to our final credit management topic and that’s dealing with identity theft. And whether this topic is relevant to you or not, you should know that, according to data from the AARP, there were 42 million people affected by identity theft in 2021, and the victims lost $52 billion.

What's more, when your identity is stolen, and credit accounts are opened in your name, it can ruin a credit profile you may have spent years diligently building and protecting.

So then, from this perspective, it goes without saying that protecting your identity is essential to optimizing your credit score. And so, how do you go about protecting your identity?

Well, one approach is to put a freeze on your credit report through each of the three credit reporting bureaus. That's because when you put in a freeze, it restricts access to your credit report by potential lenders, which makes it more difficult for identity thieves to open accounts in your name. Indeed, at the very least, be sure to check out services like Lifelock, or even proprietary services offered by credit reporting agencies like Experian, Equifax or Transunion to help you accomplish this task.

And what do you do if you’ve reviewed your credit report and find that your identity has actually been stolen?

Well, if you discover that you've become a victim of identity theft, first and foremost, it's essential to act quickly to minimize the damage. This means contacting the lender associated with unauthorized accounts or account activity and reporting the fraud. You should also consider filing a report with the Federal Trade Commission (FTC) and placing a fraud alert or credit freeze on your credit report.

What's more, you should also review all of your other bank and credit card statements for any suspicious activity. And if you do notice any transactions that you don't recognize, be sure to contact your bank or credit card company immediately and keep detailed records of all correspondence and phone calls related to the identity theft.

Now, there’s no guarantee that you’ll completely avoid having your information used in a malicious way. However, taking these steps can help you minimize your chances of financial loss and maximize your overall credit score.

The Quest for a Perfect Credit Score

Now, the quest for a perfect credit score can seem insurmountable and challenging to many. Indeed, even if you have a solid credit profile today, it still takes diligence and discipline to preserve and grow the score you've worked so hard to build over the years.

Even so, in today's challenging economic environment, where loan approvals are in decline and interest rates are on the rise, it's vital, now more than ever, to be a good steward of your credit even if your goal isn't to obtain a perfect 850 score.

This approach begins with making sure that you pull your credit report at least annually from all three major credit bureaus. Then, be sure to review your reports for inaccuracies and correct them as soon as you discover them.

And, as you go about managing your credit, stay focused on the essential items that can help or hinder your score. This includes avoiding closing out your oldest accounts, maintaining low credit utilization, having a mix of various credit types and paying your debts off on time. Remember, even one late payment on your report can affect your score by over 100 points!

And finally, make a habit out of reviewing your credit more than once per year. Doing so will allow you to track your progress toward your ideal credit score while allowing you to stay ahead of any potential irregularities. And if you do find errors or suspect identity theft or fraud, be sure to act quickly. The longer you wait, the longer it can take to get your credit back on the right track, which could mean the difference between closing on your next big-ticket purchase.

Either way, taking these steps today will not only help you on your quest for an ideal credit score, it can move you one step closer to becoming the master of your financial independence journey.

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by Peter Donisanu

Is Credit Your Superpower or Kryptonite?

Is credit a good thing or bad thing?

Well, it all depends on your perspective.

When used correctly, credit can supercharge your life and help you level up financially in a shorter time than you would have if you relied on savings alone. That's why Dale Carnegie, in his book, "The Gospel of Wealth," wrote that debt could be a powerful force for good if used productively.

Now, the trouble with debt is that, just like any other financial tool out there, it has been misused by lenders and borrowers alike, leading its use to be largely villainized by society. Make no mistake, in the wrong applications, debt can be a form of bondage. That's why in some cultures, its use is forbidden and why some individuals have mortgage payoff parties instead of retirement savings celebrations.

Make no mistake, however, when used prudently, credit can boost your earnings ability, enable you to acquire appreciable or income-producing assets, and help keep you from going broke when life throws you a curveball bigger than your savings account.

Even so, a Scottish historian and author, Niall Ferguson, wrote, "credit is like a looking glass. Once cracked, it can never be the same again, and the more we use it, the more fragile it becomes…"

Indeed, these perspectives from Carnegie and Ferguson show how on the one hand, the wise use of credit can dramatically enhance your current financial situation. On the other hand, debt can leave your finances in a precarious position when not managed properly.

Certainly, much has been written about the trouble with credit and how too much debt can be a trap. Before we discuss the drawbacks of credit, let's take a look at why you would want to use debt to lever up your current financial situation.

Why Credit Can Be a Force for Good

Credit as a Force Multiplier

When used the right way, credit can be a force multiplier. It can help you accomplish things in your life that you otherwise may not have been able to do on your own financially.

Now, the term force multiplier is often used in the military to describe a factor, such as better positioning or equipment, that can increase a unit's combat potential, allowing it to fight on a par with a more significant fighting force.

For instance, in World War II the development and use of radar technology arguably changed the course of the war in favor of the Allies. As you'll recall, radar is a detection system that uses radio waves to determine the location, speed, and direction of objects.

Now, radar served as a force multiplier for the Allies by providing them with a significant advantage in air and naval combat. With radar, the Allies could detect incoming enemy aircraft and ships at a much greater distance than the enemy could detect them. This tool allowed the Allies to prepare their defenses and launch counterattacks more efficiently and accurately.

For example, radar played a critical role in the Battle of Britain, in which the Royal Air Force (RAF) used radar to detect incoming German aircraft and direct their own fighters to intercept them. Using radar allowed the RAF to defend against the German bombing campaign more effectively and played a crucial role in their eventual victory.

So, from this perspective, credit can act as a force multiplier by taking the financial resources you have today and amplifying them to achieve a broader victory in your life.

How so?

Well, the first way it can benefit you is by enhancing your future earnings ability by allowing you to borrow money in the present so that you can improve your skills and get credentials that can help you break into a new field or raise you to a higher earnings level in your current role. And while the topic of college education, and more specifically college debt, is hotly debated today, the statistics still argue in favor of a college degree.

Now, according to data from the Bureau of Labor Statistics' most recent Occupational Outlook Handbook, the data show that those jobs with the fastest industry growth rates and median pay of at least $100,000 all require a college degree. Indeed, according to the same government data, there is a growing earnings gap between individuals holding a college degree and those without.

For example, government data show that the average 25-year-old full-time worker with a bachelor's degree made a median annual wage of around $55,000, compared with $30,000 for full-time workers of the same age group with just a high school diploma. And when we look at the earnings gap over a lifetime, it continues to increase. Here again a study from the Department of Education shows that an individual with a high school diploma is likely to earn a median income of around $1.9 million over their lifetime.

However, an individual with a bachelor's degree could earn $3.4 million over their lifetime, while a top-earning professional degree could bring in nearly $6.5 million. So, then, even if we assume that it costs an individual $160,000 to obtain and pay off their debt over ten years, the costs associated with the college debt would still net an extra $1.3 million or a multiplier of eight times of what a non-college graduate could earn over their lifetime.

So, then, from this perspective, we can say that credit can act as a force multiplier to enhance an individual's inherent knowledge and increase their earnings power.

A Lever for Wealth Building

Another way that credit can dramatically change your financial situation is by giving you leverage to use a little bit of money to create a lot of wealth. Now, for many individuals, purchasing a home is one way to create wealth. Certainly, arguments have been and continue to be made for and against the wealth-building attributes of home ownership. Even so, the long-term benefits become evident once you look past the short-term costs of home ownership versus renting.

Now, one way homeownership builds wealth is through the appreciation of the value of your home over time. Historically, home values have tended to appreciate over the long term, sometimes resulting in significant wealth gains to homeowners. And while you may be only putting down five- ten-, or twenty-percent towards the purchase of a home, you gain access to the full value of the appreciated equity in your home over time when you borrow against or sell it.

What's more, homeownership can help you build wealth through the process of forced savings. That's because the longer you make mortgage payments, the more principal you pay down, which is essentially putting money into a savings account each month, assuming home values remain stable. And this approach can help you build wealth over time, even if the cost of homeownership is slightly higher in the short term than that of renting.

Another way that credit can help turn a little bit of money into a lot of money is by starting a business. Now, the internet is filled with stories of individuals who borrowed money to achieve wildly successful outcomes. And one rags-to-riches entrepreneur who used debt to start their business is John Paul DeJoria, the co-founder of John Paul Mitchell Systems, the haircare company.

Now, DeJoria was raised in a low-income family and faced financial difficulties throughout his life. In fact, in 1980, when he decided to start John Paul Mitchell Systems with his partner, Paul Mitchell, DeJoria was homeless and living out of his car. Even so, he borrowed $700 to launch the company and personally went door-to-door selling their first hair care products. And through perseverance and hard work, DeJoria managed to grow the business into a multi-billion dollar empire, making him one of the most successful entrepreneurs in the world.

Help You Stay Solvent

A final way that credit can be a valuable tool in your financial toolbox is that it can help you stay solvent even when you're short on cash. This point is especially salient should you have an unexpected home or auto emergency, an unforeseen medical expense, or suddenly find yourself without a job.

Now, make no mistake, when it comes down to it, an emergency fund or a solid cash management strategy is a prudent way to help mitigate these financial risks.

Even so, a time likely will come when using credit can help you stay solvent enough to keep your priorities straight and stay on track to your journey to financial independence. That's because if you're facing an unexpected one-time big-ticket expense, such as a large medical bill or a significant home repair, instead of drawing down on your savings or liquidating your investments, you can use credit to cover the expense to preserve your financial security.

Indeed, by using credit responsibly, you can, over time, spread out the cost of a large one-time expense. And why not just use cash savings to pay down the debt? Well, if you draw down your cash reserves too much, you risk putting yourself in a position where you'd be unable to handle uneven cash flow situations or potentially limit your optionality when other unforeseen expenses come your way as they inevitably do.

What's more, using credit to cover unexpected expenses can also help you achieve financial freedom in the long term. Now, while this may sound counterintuitive, this works because by avoiding the need to liquidate your investments or tap into your savings, you can preserve your wealth and allow your money to compound over time.

So, when it comes down to it, credit can be a force for good when it's used the right way. Indeed, credit can act as a force multiplier when it comes to your earnings ability, and it can serve as a lever to help acquire assets that might build long-term wealth and a means to help buy time and stay solvent so you can keep fighting in the game.

Give Your Credit a Good Purpose

Now, when it comes to the prudent use of credit, what trips up a lot of individuals is not necessarily gaining access to credit but needing a clearly defined purpose for how they'll use the credit itself. At that point, credit becomes a problem because, without a clearly defined purpose for your money, you may end up relying on credit to live someone else's money script., or, as Will Rogers puts it, spending money you haven't earned, to buy things you don't need, to impress people you don't like.

Indeed, this topic is essential and one we spent time on in a broader discussion about giving your money purpose in past articles. And as you'll likely recall, giving your money purpose means knowing…

• why you work in a chosen profession
• where you are spending and what you are spending my money on
• why you are saving money for the future
• how you will feel when you can use your money to make critical life change
• that your kids won't have debt burdens when they go to school
• that you are leaving something behind for future generations to enjoy
• that you can spend money without feeling guilty
• that no matter what happens in the economy or markets that, your financial situation is secure
• that you can help out a friend or family member when the financial need arises
• that you have the resources you need to pursue your hobbies and passions
• that you have the time to do what you want when you want
• that you have options to make life changes
• that no job or relationship will ever control your ability to live a fulfilling life
• that you can give your family life experiences that they can treasure

So, what purpose does your money have?

Take a moment to consider the values and purpose that you defined for your life. Then, think about the near- and long-term life priorities that you've defined for your life journey.

Now, ask yourself, "how can I use my credit as a force multiplier, leverage to acquire productive assets, or to ensure that I have an adequate last-resort backstop?"

Put differently, if you plan to use credit to amplify your future earnings potential, ask yourself if your chosen profession on vocation and the credential you're planning to borrow for is genuinely something that aligns with your values and the purpose that you've defined for your life. If not, then carefully consider whether borrowing for this education goal is something you might regret if it's not moving you closer to your intended life.

Tim Kasser, a psychologist who has written extensively on the psychological consequences of materialism and the pursuit of wealth, emphasizes the importance of aligning one's chosen vocation with their values and life purpose. And Kasser argues that people who pursue careers solely for the sake of money and status are more likely to experience adverse psychological outcomes, such as anxiety, depression, and a lack of fulfillment.

That's why Kasser suggests that individuals who choose a career that aligns with their values and life purpose are more likely to experience a sense of meaning and purpose in their work. This, in turn, can lead to greater intrinsic motivation, satisfaction, and overall well-being, but more importantly, a genuinely prudent use of credit.

As it relates to borrowing to acquire an asset like a home or car, here again, the question you want to ask yourself is whether the purchase you make will move you further down your path to financial independence or whether it's simply serving as a means to satisfy someone else's money script.

To be sure, Horstein Veblen, a prominent economist and social theorist, believed that people often engage in conspicuous consumption, or the spending of money on items solely to display wealth and social status, in order to signal their social status and impress others. In his book "The Theory of the Leisure Class," Veblen argued that people engage in this behavior as a way of demonstrating their superiority over others in their social circles.

So before you go out and borrow to buy a new house or car, ask yourself if your motivation is based on moving you closer to your intended life purpose or simply to live someone else's money script.

And when it comes to relying on credit as a stop-gap for emergencies, remember that cash should be your primary means for addressing one-time big-ticket spending needs.

An emergency savings fund can serve as your financial safety net, ensuring that you stay on track with your financial goals and avoid setbacks when unforeseen expenses arise. When you have this reserve in place, you're able to cope with unexpected events, such as medical emergencies, car repairs, or job loss, without dipping into your long-term savings or incurring debt.

Either way, giving your money purpose is the first step in getting off the hedonic treadmill of mindlessly borrowing more money simply to chase after outcomes or spend it to impress others. Alternatively, it can give you the push you need to begin spending more intentionally if you're a natural saver and worry too much about overspending.

How Much is Too Much of a Good Thing?

Now that we've talked about how credit can fast-track your path to financial independence and how aligning its use with your money's purpose can help you make wise borrowing decisions, let's take a moment to discuss why too much credit can be too much of a good thing.

Now, it's common sense that we all need to borrow money within reason. Most, if not all, financial professionals out there argue against accessing credit, and the truth is, you likely know individuals in your own life who have had their financial plans derailed because of unmitigated borrowing and spending choices.

In fact, Suze Orman, the well-known personal finance expert, struggled with debt early in her life, which impeded her ability to achieve her financial goals. That's because Suze grew up in a middle-class family in Chicago, and while she was always interested in finance, she didn't have the best financial habits.

As a young adult, Suze worked as a waitress and later as a financial advisor, but she was living beyond her means and accumulating debt. At one point, she had over $20,000 in credit card debt and owed money to the IRS. Despite making a decent income, Suze struggled to make ends meet and could not save for her future.

It wasn't until Suze hit rock bottom that she realized she needed to take control of her finances. That's when she made a plan to pay off her debt, cut back on her spending, and start saving for her future. She even took a job as a financial advisor in California to learn more about managing money and building wealth.

Over time, Suze's financial situation improved, and she was eventually able to achieve her financial goals. Despite her early struggles with debt, however, Suze's experiences taught her valuable lessons about the importance of managing money wisely and avoiding the pitfalls of debt. She has since become an advocate for financial education and empowerment, helping others take control of their finances and achieve their financial goals.

Now, as you think about the possibilities that borrowed money can open up in your life, it's easy to forget that your debt will need to be serviced. That's why when you're not paying attention to how much you're borrowing or who you're borrowing from, you could find yourself in a position where you're earning an income simply to pay off your creditors. And when you do, it becomes a form of bondage.

This is because you could find yourself in a position where a large portion of your income is going towards paying off your debts, leaving you with little money to spend on the things you want or need. You may also find yourself needing help to make ends meet, unable to save for the future, or even struggling to pay for unexpected expenses.

Additionally, having excess debt can also limit your options and control over your life. For example, you may be unable to change jobs or start a business because you need a steady income to service your high debt load. You may also have to put off major life milestones, like buying a house or starting a f amily, because you simply cannot afford it.

The stress and anxiety that come with being in debt can also take a toll on your mental and emotional well-being. You may feel trapped and hopeless, constantly worrying about how you will make ends meet or how you will ever pay off your debts.

And, when taken together, servicing too much debt can be a form of bondage because it limits your options, control, and ability to live the life you want. It can be a constant source of stress and anxiety, leaving you feeling trapped and unable to break free.

Setting the Right Levels

So, what is an ideal amount of debt to carry? Let's take a look at some ideal borrowing limits for key consumer debt categories, starting with your home.

Mortgage

Now, when it comes to borrowing to purchase a home, Clark Howard, author of the book," Living Large in Lean Times," believes that limiting your monthly mortgage payments to no more than 28% of your gross monthly income is important because it can help you avoid taking on more debt than you can comfortably afford to repay. That's because when you take on too much mortgage debt, you risk becoming "house poor" and not having enough money to meet other financial obligations or save for the future.

In his book, Clark further explains that your mortgage payment should consider the principal and interest on your loan as well as the property taxes, insurance, and any homeowners association fees. That's why he recommends that you calculate the total cost of owning a home before making a purchase, taking into account all of these expenses as well as any maintenance or repair costs that may arise.

For example, Howard suggests that if you earn $5,000 per month before taxes, your total monthly mortgage payment should not exceed $1,400 (28% of $5,000). If your mortgage payment is higher than this amount, he recommends that you consider finding a less expensive home or waiting until you have saved up a larger down payment to reduce your monthly payment.

Auto Loans

And when it comes to buying a new car, what's a reasonable amount to borrow? Well, in "Your Money: The Missing Manual," J.D. Roth recommends that you should keep your auto loan debt to a minimum and aim to pay cash for your vehicles whenever possible. However, if you need to take out an auto loan, he suggests limiting your monthly car payments to no more than 10% of your take-home pay.

Roth believes that taking on too much auto loan debt can be a financial burden and limit your ability to achieve other financial goals, such as saving for retirement or emergencies. He suggests that you should choose a used car instead of a new car, as they are often more affordable and can provide good value for your money.

Roth also recommends that you shop around for the best auto loan rates and terms before making a purchase and suggests that you should avoid dealer financing and consider getting pre-approved for an auto loan from a credit union or bank before shopping for a car.

Credit Cards

According to government data, many Americans carry a balance of at least $1,000 on their credit cards. That's why in her best-selling personal finance book "The Money Class: How to Stand in Your Truth and Create the Future You Deserve," Suze Orman recommends that you aim to keep your credit card debt to no more than 30% of your available credit limit.

What's more, Suze argues that you should aim to pay off your credit card balances in full each month to avoid high-interest charges and long-term debt. In her book, Orman goes on to explain that carrying a balance on your credit card can be costly, as interest charges can quickly add up over time.

Student Loans

And finally, when it comes to student loan debt, how much should you aim to borrow for yourself or for your children? Well, in "Making the Most of Your Money Now," Jane Bryant Quinn recommends that you should limit your total student loan debt to no more than your expected annual salary after graduation. This means that if you expect to earn $40,000 per year after graduation, you should aim to limit your total student loan debt to $40,000 or less.

Quinn emphasizes the importance of minimizing student loan debt as much as possible by exploring alternatives such as grants, scholarships, work-study programs, and part-time jobs. She also suggests that you should choose a less expensive college or university, attend community college before transferring to a four-year institution, and take advantage of programs that allow you to earn college credit while still in high school.

The Costs of Poor Debt Management

Now, as we mentioned earlier, being able to stick to a disciplined use of credit can help you avoid running afoul of common borrowing issues. That's because when your borrowing gets out of hand, it can lead to unfavorable situations that 1) limit your optionality and creates missed opportunities and 2) creates more emotional stress and anxiety in your life.

Make no mistake, when managed wisely, credit can help you fast-track your path to financial independence by acting as a force multiplier for your earnings ability, providing you with the leverage you need to acquire appreciable assets and keeping you solvent in times of emergency.

Too Much Debt: Missed Opportunities

Even so, taking on too much debt can limit your ability to jump on financial opportunities that may come your way.

How so? Well, let me tell you about Frank.

Frank is an entrepreneur who used his stellar credit to borrow money to start a business. However, one afternoon, Frank found himself sitting at the kitchen table, sifting through a pile of bills he had accumulated from his startup. Now, Frank had always been a responsible person, but a series of unexpected events with his startup had left him struggling to keep up with his financial obligations.

And, a few weeks ago, a close friend approached Frank with a promising business opportunity. They needed a partner to help expand their thriving local storefront into a chain of stores, and they believed Frank had the skills and experience to make it a success. The potential for lucrative returns was undeniable, but the required initial investment was substantial.

Frank spent countless nights analyzing the opportunity and dreaming of the financial freedom it could bring him and his family. This opportunity could be his ticket out of debt, a way to secure a comfortable future. But as he sat down to create a detailed plan, he realized that his current debt situation made it impossible to take on the additional financial risk.

His mortgage, car loans, and credit card balances had snowballed into a mountain of debt that was suffocating his finances. The monthly payments were barely manageable, and he knew that adding another significant obligation could easily push him into a downward spiral.

Frank hesitated for days, trying to figure out a way to make it work. He considered taking on a second job, selling some assets, or even asking for a loan from family members. But deep down, he knew that none of these options would be enough to keep his head above water if the venture didn't go as planned.

With a heavy heart, Frank picked up the phone to tell his friend that he couldn't join them in the business venture. He could hear the disappointment in their voice, but they understood his situation and wished him well.

Now, as he sat at the kitchen table, he knew that it was time to face his financial reality head-on. He would need to develop a plan to tackle his debt, cut back on expenses, and work towards a more secure financial future. The missed opportunity served as a reminder of the importance of managing his finances responsibly and staying on top of his obligations.

Though the thought of what could have been stung, Frank understood that he must focus on overcoming his current challenges before he could chase after new opportunities. He was determined to learn from this experience and ensure that the next time an incredible opportunity came knocking, he would be ready to answer the door.

Too Much Debt: Financially Fragile

Certainly, taking on too much debt may limit your choices when lucrative financial opportunities come your way. What's more, while credit can act as a lifeline for one-off, big-ticket purchases, borrowing too much money can leave you financially fragile and unable to bounce back if you get hit with another unexpected life event.

And that's what happened to Maria.

Now, Maria had always been prudent with her money, living frugally and saving for the future. However, she couldn't have anticipated the series of events that would unfold and leave her in a financially fragile position.

A few years ago, however, she decided to take the plunge and purchase her dream home, with a picturesque view and a spacious backyard for her growing family. She took out a sizable mortgage that was at the top end of her budget, but with her steady income and careful budgeting, she felt confident that she could manage the monthly payments.

Life carried on smoothly for a while, and Maria made consistent progress towards paying down her mortgage. However, unforeseen challenges began to arise. Her partner lost their job due to company downsizing, and although they actively searched for a new position, it took months for them to secure another job, leading them to burn through their emergency savings because her partner's unemployment benefits weren't enough to cover their share of the household expenses, leaving Maria to shoulder the burden alone.

To make matters worse, she was hit with an unexpected medical emergency that required surgery and a lengthy recovery. While her insurance covered most of the costs, she was still left with significant out-of-pocket expenses. This event also forced her to take extended leave from her job, which impacted her income further as her long-term disability only covered a portion of her regular income.

To stay afloat, Maria reluctantly turned to credit cards to cover the mounting expenses. Soon, however, the minimum payments on her credit card balances began to pile up, adding to her already strained budget.

Just when she thought things couldn't get any worse, a leak in her home's roof led to water damage and costly repairs. Desperate to address the issue before it worsened, she took out a home equity line of credit, hoping to pay it off once her financial situation improved.

Unfortunately, the combined weight of the mortgage, credit card debt, and the home equity line of credit left Maria struggling to keep her head above water. With each passing month, she found it harder to make ends meet, and the stress began to take a toll on her physical and mental well-being.

Maria never imagined that her pursuit of a dream home could lead to such a financially fragile position, but the combination of unforeseen challenges and mounting debt became an overwhelming burden. Nevertheless, this was her “rock bottom” moment, and now she's focused on finding a way to overcome this difficult situation and regain control of her financial future.

The takeaway here is that while credit can be helpful, too much of a good thing can act as kryptonite, holding you back from potential opportunities or leave you financially fragile if you overstretch your borrowing budget.

That's why it's crucial to understand that debt isn't always the enemy when you're working towards financial independence. Indeed, if used wisely, credit can be a superpower, amplifying your future earning potential, providing leverage for purchasing valuable assets, and offering a safety net during tough times.

However, it's vital to remain true to your core values and the purpose you've assigned to your money. Be introspective and ask yourself whether a debt-related purchase aligns with your financial goals or if it's merely catering to someone else's expectations. This mindfulness will help you avoid overconsumption and ensure your credit works for you, not against you.

And finally, think of managing your credit as an essential skill, much like spending and saving judiciously. Overwhelming debt can lead to lost opportunities and financial fragility in the face of life's unpredictable events. Nevertheless, by adopting a balanced approach, you're well on your way to crafting a stable, prosperous future—one in which you're moving one step closer to mastering your path to financial independence.

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by Peter Donisanu