Credit and Spending: Avoiding Common Mistakes and Borrowing Responsibly

The following are some tips for the responsible use of credit:

 

•Shop around for credit. If you cannot get credit at a reasonable rate, consider whether you should get it at all. If you have to pay over 30 percent for credit, something is wrong.

•Do not get credit without a clear plan as to how you are going to repay it. Obtaining another extension of credit is not such a plan. That is how people get into the “payday loan debt trap.”

•Do not ignore credit problems. Generally, credit problems get worse when left alone. It is in your best interest to directly address any such problems as quickly as possible. One of the most common responses to a financial crisis, such as a job loss, is to continue spending at the same level using credit cards. This is not a good idea. It typically takes a job seeker one month to replace $10,000 of lost income.

•If you have saved money for retirement, do not use it in a financial crisis, at least in a state that protects such assets from seizure by creditors. Taking cash out of a traditional individual retirement account (IRA) can lead to a 10 percent penalty and taxes of at least 25 percent if the person is younger than 59-1/2 years old. There are exceptions, such as if the withdrawal is made to pay for medical expenses. However, even apart from the exceptions, you are always going to need financial reserves, even if the crisis leads you to bankruptcy. We strongly suggest that consumers never pay creditors with assets that a creditor cannot reach by legal process.

•Get organized. Make payments on time. The easiest way to damage your credit score is to make late payments. Just one missed payment could drop your score significantly. Either enroll in automatic payment programs or develop a system that works for you and reminds you when bills are due. One easy system is to pay outstanding bills with approaching due dates on the immediately preceding payday.

•Stay in control. Develop a budget. Collect your bills. Write down your recurring monthly expenses in four categories: (1) essential fixed payments, such as housing, car payments, insurance, and minimum payments on credit cards; (2) essential nonfixed expenses, such as food, gas, utilities, and medical expenses; (3) discretionary expenses, such as clothing and entertainment and savings; and (4) expenses that you should try to eliminate (tobacco, alcohol).

     Then keep to the budget. Without discipline, impulse control, and diligent logging of your income and expenses, a budget does no good. All members of the household need to participate in this. Save receipts so you can tell if you are keeping to your budget.

     Determine the amount you can afford to save each month. Have it direct-deposited into a savings account or mutual fund. Over time, it will make a big difference. Being able to put money down on a car or home will result in substantially lower payments and interest costs.

•Do not max out credit cards or lines of credit. Excess “utilization” of available credit brings down your credit score. Try to keep your utilization rate (credit balances divided by your credit limits) between 1 and 20 percent. To lower your utilization rate, try making payments more than once a month, asking for a credit limit increase, or simply using your cards less.

•If you find that you are carrying balances on credit cards from month to month, identify the card with the highest interest rate and pay as much as you can each month, while paying the minimum balance on other cards, until it is paid off. Then, choose the next card and pay extra on it while you pay minimums on the others. If you pay only the minimums on all your cards, you’ll be paying a lot more in interest than you may realize.

•Avoid impulse purchases of substantial items. The fact that something is on sale is not a reason to purchase it if you don’t need it or cannot afford it.

•Use cash instead of credit or debit cards for discretionary spending. Take out enough cash to last one to two weeks at a time. Make up your mind that the cash you have is all you get for discretionary expenses, or things that you could live without, each week. It’s much easier to turn down a $100 pair of shoes when it will take the last of your week’s cash than it is when you just have to swipe a credit card.

•Avoid useless expenses like overdraft charges. Balance your checkbook regularly, and reconcile your checkbook with your bank statements. If your bank gives you free checking if you keep a certain sum of money in the account, keep the money there without using it. If you’re on a tight budget, a couple of small mistakes can lead to overdraft charges and insufficient funds in your account.

•Do not apply for excessive amounts of credit. Every time you apply for a new credit account, the lender will pull your credit report and add a hard inquiry. In addition, having excess credit may tempt you to use it.

•Not using any credit is also a mistake. Lenders actually like seeing consumers responsibly use credit. You can’t prove that you’re a responsible user of credit without using credit. Also, if you don’t use your credit cards, your lenders may close your accounts, which could further hurt your score. Instead, use your cards for modest purchases and pay off the balance the same month or the next month.

•Don’t be quick to cosign or guarantee debts of others. One of the most frequent inquiries we receive is from cosigners and is “How can I remove myself from X’s debt. X isn’t making payments, and it is harming my credit.” X is often a former significant other.

     In most cases, the answer is that you can’t. The entire reason creditors want cosigners is that they don’t trust the primary debtor to repay the debt, so they want someone more creditworthy—the cosigner—to be liable for it.

     This raises the following question. Creditors have credit scoring models and lots of experience in evaluating whether consumers will repay their debts. They request cosigners because they do not trust that the person applying for credit will repay it. If an experienced professional creditor with far more expertise in evaluating credit risks doesn’t trust the person applying for credit to repay it, doesn’t that tell you something?

     There may be times when you want to cosign anyway. Your child may need a first loan, or a close friend may need help. Before you do so, consider carefully how it might affect your financial well-being.

•Can you afford to pay the loan? If you’re asked to pay and can’t, you could be sued or your credit rating could be damaged.

•Even if you’re not asked to repay the debt, your liability for the loan must be disclosed on your credit applications and may keep you from getting other credit. Creditors will consider the cosigned loan as one of your obligations.

•Before you pledge property to secure the loan, make sure you understand the consequences. If the borrower defaults, you could lose these items.

•Obtain a copy of the Truth in Lending Act disclosures concerning the loan so that you know the amount you might owe.

•You may be able to negotiate specific terms of your obligation. For example, you may want to limit your liability to the principal on the loan and not include late charges, court costs, or attorney’s fees or limit your liability to a specific amount. This must be in the loan document and signed.

•Insist that the loan document (this must be in writing) provide that any creditor or subsequent holder must notify you if the borrower misses a payment or (very important) requests forbearance or an extension or other change in terms. Many form loan documents provide that the bank can change the terms or grant forbearances or extensions without affecting the cosigner’s liability. That sort of provision should be deleted and replaced with the one described. That will give you time to deal with the problem without affecting your credit, or to make back payments without having to repay the entire amount immediately. Such notice is mandated under the laws of some states, but not everywhere (e.g., 815 ILCS 505/2S). If provided for by contract, the creditor or holder will be required to comply before you can be held liable.

     In sum, cosigning a debt may well amount to a gift in the amount of the debt to the person you are cosigning for. If you are not comfortable with the idea of such a gift, don’t cosign.

     If you already have cosigned or guaranteed a debt, the law does afford a number of protections. First, under the “statutes of frauds” in force in most states, agreements to pay the debt of another generally must be in writing, signed by the party to be charged with liability. There is no such thing as an oral guaranty.

     Second, the guaranty may not be valid. There are special notice requirements imposed by Federal Trade Commission regulations (16 C.F.R. §444.3) and also by laws in many states. Noncompliance may invalidate the guaranty.

     Other states require a written notice to the cosigner or guarantor before collection action is taken so that the cosigner may take over payments and protect his or her credit (e.g., 815 ILCS 505/2S).

     Finally, there is an extensive body of law on whether extensions and forbearances by the creditor to the principal debtor release the cosigner. Most standard-form bank documents attempt to reserve the right on the part of the bank to grant such extensions without releasing the cosigner.

•Make sure it is in writing.

 

All agreements with banks and creditors need to be (1) in writing, (2) signed by the bank or creditor, and (3) made part of the basic note, guarantee, or other credit instrument.

Apart from the general principle that oral agreements are worth the paper they are written on (nothing) and the propensity of certain creditors (such as car dealers) to dispute or deny oral agreements, most states have statutes of frauds that make certain promises legally unenforceable unless in writing, signed by the party to be charged with a promise. This is a pre-1776 English law that was widely adopted in the United States.

 

WARNING

All agreements with banks and creditors need to be (1) in writing, (2) signed by the bank or creditor, and (3) made part of the basic note, guarantee, or other credit instrument. Agreements that do not meet all three requirements may not be enforceable.

 

Common statutes of frauds require signed writings for promises relating to the transfer of an interest in real estate (including a mortgage), promises that are not to be performed or are not by their terms capable of performance within one year (exactly what contracts are covered varies), and promises relating to the sale of goods for more than $500. If a writing is required and does not exist, the party seeking to enforce the promise loses.

In addition, at the insistence of the banking industry, many states have enacted special statutes of frauds that protect banks, credit unions, and other professional lenders by making some or all promises relating to the extension of credit unenforceable unless they are in writing, signed by a bank officer. Some of these laws are limited to commercial loans, whereas some extend to all loans (e.g., 815 ILCS 160/1 et seq.).

Finally, if a bank fails and is taken over by state or federal regulators, federal law provides that even written promises by a federally insured institution that are not part of the basic loan instrument are generally not binding (D’Oench, Duhme & Co. v. Federal Deposit Ins. Corp., 315 U.S. 447 (1942), codified and expanded upon at 12 U.S.C. §1823(e)). Even a signed “side agreement” purporting to alter the terms of what appears to be an unconditional note or loan agreement will not bind the regulator or someone who acquires the loan from the regulator. All agreements must be in the same document that creates the obligation.

The theory behind this rather harsh rule is that bank examiners need to be able to rely on what they find in the bank’s loan files in carrying out their duties, and allowing such hidden agreements, oral or written, would operate as a fraud on the system of bank regulation and insurance. A bank customer cannot agree with a friendly or corrupt bank officer outside of the loan document because what appears to be a valid note in the bank’s files and carried on the bank’s books at face value is really a worthless piece of paper that will not be enforced against the customer. Given the number of major banks that have failed (e.g., Washington Mutual, Indymac), this is a serious problem.