Handling Credit
September 28th, 2011
A line of credit can be a valuable tool for a consumer, but only if it’s used responsibly. It can also be a trap that is very difficult to escape. Your new credit card may have a $5,000.00 limit, but should you go out right away and buy $5,000.00 worth of home theater equipment? If you couldn’t afford to buy all that gear before the card, chances are you’ll be stuck making just minimum monthly payment and carrying the balance for a very long time. By handling your line of credit irresponsibly, you’ve essentially trapped yourself.
So how do you avoid the trap? Under ideal circumstances, you should only carry a balance on your line of credit that can be paid in full every month. Two key things are accomplished when you get into this habit of credit use:
1) You establish discipline over your spending patterns.
2) You avoid revolving interest charges incurred by carrying an ongoing balance.
This approach, however, isn’t achievable for everyone’s financial situation. If you must use a line of credit to make a purchase, come up with a plan to pay off that balance in four to five months. You will incur some interest charges along the way, but you still get the all-important benefit of practicing discipline in your spending and reduce the amount of interest you pay. Remember, the goal here is responsible use.
A common pitfall is the idea that an available line of credit can serve as a buffer in times of financial hardship. If you’re carrying a balance of $3000.00 on a card with a $12,000.00 limit, you’re probably thinking, “Hey, I’ve got a $9,000.00 cushion I can use if something bad happens.” What most people don’t realize, however, is that banks and other credit lenders have the power to lower your credit limit if your risk level changes.
Let’s say the crisis hits. You lose your job, start paying bills a little later, and before you know it your credit score starts to drop. The bank’s risk evaluation department now determines that you are a higher credit risk and decides to drop your limit all the way back down to $3000.00 until you pay off the balance. Poof! The buffer you were depending on to get you through this financial drought is gone in the snap of a finger. The lesson here is that, in the end, saving money is the only way to create a reliable financial buffer to get you through life’s stormy seasons.
Use credit lines wisely. Don’t trap yourself with undisciplined spending and no savings. Make a payment plan and stick to it. Handling credit well is one of the most important keys to your overall financial freedom.
