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Understanding what credit is, what it can do, how to responsibly use it, and how to optimize it is almost like a financial superpower. Unfortunately, many people don’t take the time to grow their depth of knowledge when it comes to credit and everything it touches in their lives. This Credit 101: Ultimate Guide to Credit will help lay down a strong foundation of core knowledge for your journey to financial independence and beyond.
Ready, Player One?
Table of Contents
- What is Credit
- Brief History of Credit in America
- The 4 Types of Credit
- Say NO to Store Cards
- How To Build Your Credit
- Credit Cards: Compounding Interest vs. Grace Period
- Your Credit Score: Why It’s Important
- Make Credit Cards Work For You
- Protecting Your Credit
- Take Advantage of Your Credit Card’s One-Time Credit Card Number Generator
- Utilize Two-Factor Authentication
- Utilize Your Free Credit Reports Offered by the Government
- Freezing Your Credit
- What to Do if You’ve Been a Victim of Identity Theft
- COVID-19 and Protecting Your Credit Health During the Pandemic
- Repairing Your Credit
- Advanced Credit Tools: M1 Borrow
- Mortgages: Credit to Purchase Real Estate
- Student Loans
- Final Thoughts
What is Credit
Credit is a financial tool that allows people to purchase goods and services without “hands-on” money. Banks, retail stores, car dealerships, and the like can extend credit, and you pay back this loaned money for these resources over time.
Credit extending institutions make their money by charging interest (a percentage of the balance borrowed) on top of the principal (original) balance of the item you received. If you use your credit wisely and make payments on time, credit can be extremely beneficial and, in some situations, necessary (e.g. car loans).
When you consistently pay on time, the higher your credit score will be (we will go into detail about credit scores later on). Essentially, credit is an extension of value to the consumer in exchange for the convenience of not having to pay a lump sum of money upfront.
Stressing the importance of credit is always an understatement. Credit is a tool that has been used, in one form or another, since humans began trading goods and services. Smart credit management, how credit impacts your life, and (here’s the good stuff!) how to hack your credit score and travel rewards are all necessary on your journey to FI.
Brief History of Credit in America
Credit truly and metaphorically makes the world’s economy “go round.” Without credit, consumers wouldn’t be able to purchase products and goods that they may not have the money for at the time (eg. houses, appliances, cars).
Created in the early 20th century, credit lending helped people like Henry Ford create his name-sake car manufacturing brand. During World War II, before the United States entered the war, the nation created the Lend-Lease Act, which allowed the Allied Powers (mainly the United Kingdom) to borrow money and war machines to fight. Further, because we sold them our goods, they not only had to pay for the product – but also interest upon payment. This propelled the United States from a country still suffering from the Great Depression of 1929 to becoming one of two world superpowers.
Credit highly influences the health of a country’s economic GDP (Gross Domestic Product) and the GNP (Gross National Product). If the US is “running” a deficit, it means that faith in the dollar is falling, therefore devaluing the dollar and trade decreases. Overall, if the US economy has an influx of printed money, depressions (1929’s great depression) and recessions (2008’s housing value bubble), heavily influence the borrowing power of credit and what percentages of return banks and other institutions charge.
The 4 Types of Credit
This financial product functions as an open credit line set at a certain amount (credit limit) or with no limit on the amount. This is a flexible type of credit that allows the borrower to pay over time for high-value products.
These are the most popular forms of credit. Credit cards are issued by financial institutions with a set limit of spending. Charge cards are lines of credit with a spending limit; however, the balance must be paid in full by the end of the month.
Installment credit is a line of credit extended to consumers that the borrower could not pay in full at the time of purchase. Mortgages and car loans are two common examples. Mortgages also require some form of collateral (money that the consumer has on hand) to secure the ROI (Return On Investment) for the financial institution.
This type of credit includes your utility bills and store cards (that can only be used at designated locations). Payment of service credit is calculated at the end of the month, or else your utilities (e.g. water, electricity) will be discontinued until the bill (and subsequent fees) are paid. Non-installment credit is typically reserved for store cards. Failure to pay these bills on time can result in repossession of the product, usually command a high APR (Annual Percentage Rate), and lower your credit score.
Say NO to Store Cards
Ah, the temptation of buying that dress or suit at a department store that you can’t exactly afford at the moment. But wait! They offer their own credit card and will give you a 10% off! And you don’t have to pay the balance off each month. No brainer, right?
Wrong. So very wrong.
Store cards are a slippery slope on the way to destroy your credit. Let’s explain.
Retail stores are notorious for pushing their own cards on consumers for a reason. First of all, interest is usually compounded daily, meaning that each day you don’t pay off the balance, the next day interest accumulates. This is the opposite of cards like Visa, MasterCard, Discover, Chase, or Capital One, which offer a grace period. A grace period is when interest is only charged on the last day of the billing cycle.
Then there are the astronomical interest rates. Rates vary widely over from store to store but expect to pay 25% to 31%. And remember, this interest is tacked on daily. So that dress or suit you purchased for $200 could balloon into $250+ before you know it.
Store Card Rewards: Not Exactly Rewarding
The plane continues its uncontrolled descent when you are sold on the rewards. Rewards are a key component to making your credit word for you; however, because of the pitfalls with store cards, accumulating rewards in this way could satisfy that desire to say to yourself, “…and I get store credit back.” Miss one payment, and not only do you get popped with a huge late payment fee, but you also lose your rewards. And since interest is compounded daily, those rewards essentially become a wash.
Finally, each time you apply for a store credit card, you receive a “hard-hit” (we’ll talk about ‘hard’ and ‘soft’ hits more below) on your credit report. Apply for three store credit cards in a month and watch your credit score drop 30-40 points.
And this is why you should say NO to store cards. Period.
How To Build Your Credit
So, you are new to the world of credit and want to establish yourself. Well, having ‘no credit’ isn’t necessarily as bad as many may think (and/or tell you). The best way to establish a sound footing when it comes to credit is to find a guarantor: a co-signer for a credit card, when you rent your first apartment, or when you buy your first car.
This co-signer is vouching for you. If you do not pay the debt, the burden of said debt falls to the co-signer. In this regard, make sure that the co-signer understands what they are signing up for and that they have a good to excellent credit score.
Pay on time and you both benefit – as payments are reported as paid-on-time for both you and your co-signer will increase both your scores. Also, be sure to pay all your utilities and installment credit lines on time. This includes your water, heat, electricity, and cell phone bills. It is a slow process, so don’t be discouraged. The more you prove you can pay on time, the higher your score, and the more credit you will receive.
Credit Cards: Compounding Interest vs. Grace Period
Credit card interest calculation comes in two different forms: compounding interest and a grace period. Compounding interest cards are the ones you want to stay far away from, as they compute and charge interest on a daily, rolling basis. This puts you at a disadvantage, especially when it comes to making the most of your credit when it comes to rewards. (more on that below). These cards often have a higher APR on average, so your wallet gets hit harder from both directions. Grace period cards, as the name states, give you a grace period (a full billing cycle) before interest is billed.
To better express the difference between the two here is an example:
You decide to purchase an item for $2000. Each card has an APR of 15%.
The payoff for the compounding interest card at the end of the billing cycle is: $2,025.31
The payoff for the grace period interest card at the end of the billing cycle is: $2,000.00
Your Credit Score: Why It’s Important
Your credit “worthiness” is determined by your FICO score. The Fair Isaac Corporation (FICO) determines your credit score by using a credit scoring model that looks for:
- A mix of your previous credit usage
- How much of your current or previous credit you used (did you always use the maximum amount of extended credit?)
- Whether you’ve been paying your bills on-time
- Occurrence of massive shocks to your credit (this category is chiefly about bankruptcy, outstanding debts (both current and abandoned), and a qualitative profile of the applicant for new credit.
Here is a rough snapshot of the weight of each characteristic:
- Payment history (30% to 35%)
- Current outstanding debt ((about 30%)
- Length of credit history (15%)
- New credit (10% to 15%)
- Credit mix (10%)
A couple definitions that are worth knowing:
Length of credit history: extends furthest back to your very first credit account and moves forward. (i.e. you opened a credit card account with a limit of $100 at age 18 and you are now 25, your credit history is 7 years old).
Credit mix: the various types of credit you have in your name. All credit cards are a “poor credit mix.” If you have some credit cards, a car loan, utilities, and a mortgage – that is considered a “great credit mix.”
Your FICO scoring range is: 300-850. The higher your score, the more likely you’ll receive additional credit. Pay your bills on-time, don’t carry too much debt, and don’t apply for too many extensions of credit. In some instances, your yearly salary and wealth holdings will configure into a credit decision; however, your FICO score is the gospel in most decisions to extend credit by financial institutions.
A High FICO Score Guarantees A Lower APR Overall
A score of 670 is considered a good credit score. When achieving FI, getting close to or reaching 800 should be your goal. Your credit score and APR are mutually inclusive. The higher your FICO score, the lower the interest rate you can command from credit card issuers. This is a simple cost v benefit analysis.
The financial institution understands that the higher your FICO, the more likely you’ll pay your bill. Therefore, they will want to entice you with a lower APR to do business with them.
Don’t be afraid to call your credit card issuer. Negotiate if you have a higher FICO score than when you opened your account. They will not offer this for you, so make them come to the negotiating table and see if you can receive a lower APR or additional rewards. They know they are in competition with many other issuers, so they will probably fight for your business. It’s as simple as a phone call.
Soft vs. Hard Hits On Your Credit Report
A “soft hit” or a “soft pull” on your credit does not affect your credit score, nor is it pulled to determine a credit extension decision (unless you consider passive pulls – those are used to send you “pre-qualified” credit cards).
Checking your own credit report and score are also regarded as soft pulls. Finally, some employers will soft pull your credit to determine if you are “qualified” for hire. For example: if you apply for a job at a financial institution, that institution may soft pull your credit to see if you are able to manage your own finances.
A “hard hit” or “hard pull” on your credit directly impacts your credit score. This is why we mentioned earlier that it is best practice to not apply for several lines of credit in a short time period. The more you apply, the more hard pulls, and the lower your score falls.
There is no algorithm or industry standard that can be explained to pin-point the amount of credit score points you’ll lose, but expect the range to be around 10-40. Obviously, hard pulls are damaging, so use them sparingly by not applying for many lines of credit. Hard pulls affect “big ticket” financial decisions: a mortgage, a car loan, credit cards, and even private student loans (outside of those issued by the Federal Government) are driven by your credit score.
Chase’s 5/24 Rule
Chase Bank offers one of the best lines of credit cards in terms of APR, balance transfers, and rewards. This makes opening a credit card with the bank competitive. So, within the financial industry there is a rule called the Chase 5/24 rule. This means that you cannot (in nearly all cases) open a Chase credit card if you have opened 5 other cards within a 24-month period.
It is necessary for those shopping for cards, especially the reward-rich Chase cards, to know and understand. Chase mitigates their potential loss by making this limitation. They see opening too many cards in a relatively short period of time as a higher-than-average risk.
Since Chase cards are in high demand, they can short their supply of cards to protect their interests and still command a high number of card holders. This is important to you because each card application lowers your FICO score. If you have opened 5 cards within the last 2 years, applying for a Chase card is an exercise in futility. So, save those precious hits to your FICO if you fall into the 5/24 category.
In today’s economy, we all understand that getting a job is increasingly difficult. Ever since the economic crash of 2008, businesses and corporations are enjoying an extended “buyers market” regarding employment. This is further exacerbated by the arrival of the COVID-19 pandemic. So, each part of your employment viability is under a microscope. This is why employers (usually financial institutions) may soft pull your credit to see how well you manage your money.
From retail to specialized markets, other businesses may also soft pull your credit to gauge your character on paper. There are some employers who believe that a quantitative representation of your finances shows how you are responsible overall. This may sound counterintuitive; if you lose your job and are out of work, you may not be able to pay bills – therefore hurting your credit score. With this lowering of your score, you may not qualify for certain jobs. Yes, it is a nightmarish merry-go-round.
How To Rebuild Your Credit
Since payment history affects your credit score the most, ensure that you budget your money to make minimum payments on all your bills at the very least. The goal is to pay off all your debt, but sometimes you need to take baby steps before you can run a marathon.
Don’t get discouraged if you look at your score and think, “I’ll never get out of this.” Financial planning is key. Also, applying for a secured credit card is a good move to consider. Secured credit cards are cards that require collateral up-front to receive a line of credit.
At first, this line of credit is how much money (collateral) you deposit into a new credit line. The upside to this is two-fold: First, you are limited by this amount to spend, forcing you into not overspending.
Secondly, and most importantly, each time you make a payment on this card, it is reported as a credit payment on time. Most consumers erroneously look at secured cards as pre-paid debit or gift cards. This is certainly a misnomer.
Finally, use as little of your extended credit as you possibly can. Again, this comes down to financial planning. For example: if you combine all your lines of credit and determine you have $50,000 available, DO NOT consider this as a windfall. Keep your balances low, and your credit score (and you) will thank you later.
Make Credit Cards Work For You
We here at ChooseFI embrace the art of making your credit cards work for you. If you have a high credit score, financial institutions will offer perks that range from points redeemable for products to a high volume of travel rewards or miles. The process may seem daunting at first, but once you get the hang of it, you’ll understand why we dedicated an entire section of our website to credit card travel rewards. Check out our FREE ChooseFI Travel Rewards 101 course here, grab the interactive PDF here, and see our top recommended credit card offers from our partners here.
Dive deeper: 3 Different Types Of Travel Rewards Credit Cards
If you are ready to unlock a world of free travel, start with the Chase Sapphire Preferred. Welcome bonus is worth $1,250 of travel, more if you transfer them to partners like Southwest Airlines or Hyatt hotels. Details: $95 annual fee | $4k min spend in 3 months to earn 100k Chase UR Points.
Things to Consider Before You Start
- Do not overextend your credit limits – this negates the risk v reward factor.
- Be careful and read the fine print. Some reward cards have blackout dates for miles, while others may charge an annual fee.
- Reward points may expire, so make a note of expiry dates on your smartphone’s calendar.
- Most importantly: set goals. If you want an “x” number of miles or “y” number of points, make sure you stick to those goals. Ensure those big purchases you make can be paid off during the grace period to run up the point score.
How to Start Making Credit Cards Work for You
Learning to make your credit cards work for you is a marathon at first, unless you have reached FI and can open reward credit cards without taking a blow to your FICO score.
Start with examining the plastic in your wallet. Do any of these cards offer rewards? Many consumers aren’t aware that they are accumulating points on their existing accounts.
If your cards don’t, start slow by doing your homework. Take a look at reward cards and find one that offers miles or points that fit your goals. Start putting a large portion of your purchases onto that card. This will help you accumulate rewards quickly. Further, sometimes card issuers offer double points for the first 6 months or a bonus of 10,000 miles when you sign up. Be sure to capitalize on this period.
Another upside to travel rewards is that they are (almost always) non-taxable. This means you accumulate more value by avoiding taxes on cashing-in your rewards miles. If you purchased those same miles, you would have already paid taxes on the money you’ll spend.
Transferring balances from one card to another to receive points is another way to start making your credit cards work for you. You must, however, be aware if there is a transfer fee (one-time or a percentage that ranges from 1-3%). We are looking for the best “bang for your buck,” and this negates a proper return. If your credit score is high enough, you usually can transfer balances onto another card without penalty and receive points/miles simultaneously.
Balance transfers don’t have to be purely about rewards. Keep in mind, if you are carrying any type of balance on your cards – many cards offer a 0% interest fee for balance transfers for the first 12-24 months. So, moving your existing debt onto these cards will automatically payoff.
Juggling Reward Card Balances
Juggling credit card rewards takes patience and research; however, not only is the pay-off worth it, the process can be fun – especially the more comfortable you become with making your credit cards work for you.
Preface: the grace period is what makes this technique lucrative. Underline and highlight this in your brain. Why? You need to pay-off your balance before grace ends or interest kicks in and destroys your hard work.
First, make sure you apply for no-annual fee cards. Annual fees wash out a lot of your expected positive return. A good rule of thumb: find a card that matches your needs. Then call the financial institution and see if they’ll waive this fee. If you have a solid credit score, the odds are in your favor. Remember: virtually everything is negotiable.
Next, set the importance of the rewards that you want and use the “best” cards for most of your purchases. If you travel, get a card with the best mileage per dollar spent. If you like cash-back, make sure you get the best cash-back per dollar spent. Sound easy? Read the fine-print. Mileage cards can have black-out dates and lower reward miles for certain purchases. This is even more true with cash-back cards: many tout a high percentage of cash-back, but only within finite categories.
Finally, as stated above, pay the balances off each month. The only exception to this is if you want to hack balance transfers. If you are carrying a balance on anything that can be moved to a introductory 0% APR card, do so.
In this use instance, the benefit of balance transfers is the ability to pay an effective APR of 1-3% on the amount you transfer to the balance transfer card. This is assuming 0% APR and a one-time balance transfer fee. The upside to these cards is two-fold:
1) This one-time fee is immediately added to your balance. So no compounding interest.
2) Time. Make the minimum payments and pay off the card at the end of the 0% term period (typically 12-24 months). Use the money you would have used to pay the balance in full and invest it in M1 Finance or your favorite investing platform.
This may seem complex, but as long as you’ve done your research and know the due dates of payment and the rules set forth by the financial institutions, you can really make “debt” work for you.
To reiterate, you must be aware of the reward rules and payment due dates. Don’t get lost in too many cards if you feel uncomfortable in making the correct movement of funds and their payment due dates.
Protecting Your Credit
Your credit has never been more important in 2021. With currency circulation at an all-time low and the pervasive nature of plastic, nearly every consumer carries at least 2 credit cards on their person at one time. This has made id theft more and more lucrative.
Technology is a double-edged sword. Embedded security chips and credit monitoring tools help combat theft; whereas identity thieves and scammers have created more advanced tools (such as Trojan viruses) that infect your smartphones and computers so they can mine your financial data. Security chips aren’t 100% safe, as RFID (Radio Frequency Identification) tools can “grab” your financial data by just being in the proximity of your cards.
Remember: protect your personal information! This will go a long way in preventing you of becoming a victim on identity theft.
Here are a few tips to help you protect your credit and what to do if you think you’ve been a victim of identity theft or fraud:
Take Advantage of Your Credit Card’s One-Time Credit Card Number Generator
More than likely you use an app or a website dedicated to giving you a dashboard snapshot of your credit card usage and transactions. Among many dashboard options may include “Generate SafeShop Card Number.” Clicking this will automatically generate a new credit card number, expiry date, and CVV code.
You can set your own credit limit and the number of times this unique number can be used. This handy tool helps protect you from credit card theft as it blocks off your real card number by using the generated card number as a firewall gateway. If you aren’t familiar with a website and would like to make a purchase, this feature will protect you from scammers draining your account.
Utilize Two-Factor Authentication
If you use multiple devices to log-in to your financial institution’s website to check your balances or to make click-through purchases for rewards, two-factor authentication will make your life much easier.
Two-factor requires not only a password to log-in but will send you a text message that someone is attempting to get into your account. If it is you, you can enter the given text code to complete the authentication.
If you didn’t attempt to log-in, you know someone has stolen your password and take steps to secure your account further. You also need to contact your credit card issuer that an access attempt has been made. This could alert the bank that they may have a data breach/leak. Although it does take a few extra seconds to log-in using two-factor authentication, this ounce of prevention is definitely worth it in the long run.
Utilize Your Free Credit Reports Offered by the Government
The Federal Trade Commission (FTC) offers each US citizen a free credit report from each of the three credit reporting agencies (Equifax, Experian, and Transunion) within a 12-month period. You can pull all 3 at one time or you can stagger them across the year.
Equifax has also offered all U.S. residents 6 free credit reports per year through the year 2026. That is in addition to the 1 free Equifax report you can get via AnnualCreditReport.com through April of 2021.
We highly suggest you pull them every 3 to 4 months. Credit reports are incredibly important as it tracks any line of credit attached to your name and Social Security Number. If you do not recognize an account or notice straight-out fraud, you can contact the credit reporting agencies that your credit has been compromised.
Freezing Your Credit
Implementing a credit freeze adds a thick layer of protection against identity theft. A credit freeze “freezes” or “locks down” your credit in place. You cannot open additional accounts. Freezing your credit can be beneficial in many different scenarios. If you suspect credit or identity theft, implementing a freeze prevents further damage and buys time to determine how your credit was compromised.
If you have reached FI and have no reason to open new accounts in the near future, freezing your credit is a proactive step in protecting your hard-earned credit position. To freeze your credit, you must contact all 3 credit reporting bureaus and request a freeze.
There is no fee to implement this protection mechanism. It’s important to understand that a freeze does not affect your current credit cards. So, you’ll be able to use your open lines of credit as usual; a freeze prevents the opening of additional lines of credit. To “thaw” your credit, simply contact the credit reporting bureaus and make a request.
What to Do if You’ve Been a Victim of Identity Theft
If you think you’ve been a victim of identity theft or fraud, there are a few things you should do immediately.
- Contact the fraud department of the companies where you suspect the fraud has occurred.
- Place a free, one-year fraud alert with one of the three credit bureaus: Experian, TransUnion, or Equifax.
- Make sure to get copies of your credit report from all three reporting agencies.
- File a report with the FTC by submitting the online form found here.
Once you’ve completed those first crucial 4 steps you can start repairing any damage that might have been done.
- Start by getting fraudulent charges removed from your accounts.
- Close any new accounts that may have been opened.
- Get in touch with all 3 credit bureaus and have them correct your credit report.
- Review and monitor your credit report often and consider adding an extended
When it comes to credit or identity theft, timing is crucial. If you discover it soon enough and act immediately, it will limit the thief’s potential damage to your credit report and lessen the headache it causes overall.
COVID-19 and Protecting Your Credit Health During the Pandemic
We can all agree that the COVID-19 pandemic has changed the way we live everyday life. Society has transitioned from going out to work, enjoying in-person shopping, eating in restaurants, getting together with friends to attend a concert, and the ilk to staying indoors and only going out when absolutely necessary.
Unemployment and lay-offs have dramatically increased – limiting the flexibility of your income. Because of this, credit card use has skyrocketed since March 2020. Food and other goods are delivered directly to our door, and touchless transactions have become an everyday phrase.
So, when credit card usage increases and your income decreases, your credit health is automatically at risk. In order to protect your credit, contact your credit card issuer and create a repayment program if you cannot afford your payments. If you do come to a repayment agreement, ensure that you receive a written agreement/contract to protect yourself.
Also, keep on top of your credit report. Criminals and scammers often take advantage of a crisis. Make sure that your credit hasn’t been compromised. And, due to the pandemic, the government is providing a free credit report from each of the 3 credit reporting agencies once a week until April 2021.
Repairing Your Credit
If you have taken a few hits to your credit due to late payments or applying for too many lines of credit, you’ll need to take steps to improve your credit. It is a slow process, but if you are patient and take the necessary steps, you can recover.
The first step is to NOT close your unused lines of credit. This may sound counterintuitive as it makes sense to close credit lines you no longer use; however, FICO scores consider your maximum available credit v your available credit ratio. This appears to credit bureaus that you are budgeting your credit well by not maxing out your available credit.
The next step is to triage the importance of each debt line and pay accordingly. Your mortgage and car payments take the top spot. Then make sure your utilities are paid. After that, pay down your revolving credit (credit cards) in order of highest-to-lowest APR.
Remember not to sacrifice paying additional funds towards higher APR cards and not make the minimum payments on the lower APR cards. Finally, do not open new lines of credit. Not only will you more than likely not qualify – that hard pull will just hurt your credit worse than it already is.
Advanced Credit Tools: M1 Borrow
M1 is a financial insulation that simplifies money management and offers great flexibility in investment, borrowing, and spending. They support brokerage accounts, retirement accounts (traditional, Roth, SEP), and trust accounts.
Once you make your initial deposit, you are asked by M1 to determine how conservative or aggressive you want to be with your investment, and M1 does the work on the “back-end” for you. There are no physical locations to visit; simply fill out a short form and submit it. Just like that, you hit the ground running. M1 truly defies that “one size fits all” rule of investing.
We here at ChooseFI are big fans of M1 Borrow – a function of M1 that allows those with at least a $10,000 brokerage vested portfolio (*IRA accounts do not qualify) to borrow funds at a very low interest rate (3.5% at the time this guide was published). You are allowed to borrow 35% of your portfolio value at any one time. Although borrowing rates can change if the Fed increases the borrowing window rate or if your portfolio loses value, the risk vs. reward speaks for itself.
Paying back your M1 Borrow account is as easy as logging in to your personalized Dashboard. M1 also does not have a minimum monthly payment. That means you can continue to take advantage of their incredibly low borrow rates so long as you do not exceed 35% of your portfolio value. As you can see, the possibilities of investment and fund utilization are nearly endless with this flexible/low-interest rate.
Still looking for more? M1 Borrow offers another tier called M1 Plus. For a $125 membership fee per year, you can take advantage of a 1% APR return on your checking account and 1% cash back on spending. Most importantly, the 3.5% borrow rate falls to 2% if you are an M1 Plus member. You simply won’t find another financial institution that offers a lower borrow rate.
Overall, M1 Finance is a vital tool you’ll want to take advantage of on your path to FI. And if you’re already FI, M1 gives you that much more return-on-investment.
Find out how M1 Plus from M1 Finance can boost your FI journey by helping you save, earn, and invest more. We cover 3 use cases in this free course: The Cash Stasher, The Uber Optimizer, and The Loan Consolidator. Note: The tips and tactics covered in this free course are intended for a US audience only.
Mortgages: Credit to Purchase Real Estate
More than likely, the largest purchase of your life will be purchasing a home. The stakes are high, but so is the potential to create value if you do some market research and follow the expert advice available from our ChooseFI blog and podcast. On the surface, borrowing funds for real estate may seem incredibly daunting, especially when you look at the paperwork alone. But we have some tips and tricks to help you get the most value for your money.
The most important rule of thumb when considering buying a home is to take everything step by step.
Don’t get “married” to a home that you absolutely love. Make sure you give yourself some flexibility both financially and emotionally when making such a huge decision. Look at purchasing a home as a long-run investment.
Research tax values and comparable homes that have recently sold in the neighborhood. Shop around for the best interest rates and which mortgage options you can afford.
If you are a first-time homebuyer, look at what FHA (Federal Housing Administration) advantages you can use. And remember, when you pay on the mortgage principal, you are creating equity that can be used later for refinancing or home improvements.
Traditional vs. ARM Mortgages
ARM (Adjustable Rate Mortgages, also referred to as Variable Rate Mortgages). These have a fixed rate for “x” amount of years and then a variable rate for “y” amount of years. ARMs are usually expressed as [fixed rate year term / number of times the rate varies after the fixed-rate expires].
For example, an ARM regarded as 5/1 means that for the first 5 years the interest rate is fixed. After that 5-year period, for the remainder of the loan period, the interest rate is adjustable according to the base rate the Fed sets forth – plus a few additional factors. The financial terminology for the adjustable rate is the “fully indexed-rate.”
The goal is to determine when to take a fixed interest rate (standard time frames: 15 or 30 years) or an ARM. Here is what you should consider when making this decision:
Pros of ARMs:
- Lower interest rate (than the market fixed rate) during the initial mortgage term until the mortgage becomes variable.
- Opportunity to pay a greater portion of the principal within the initial term – allowing you to build equity faster. Especially effective if you plan on selling before the variable rate begins.
- In a “bear economy” the adjustable rate can be comparatively lower all-in vs. a fixed-rate mortgage.
Cons of ARMs:
- Monthly changes to the variable interest rate can rapidly increase your payment.
- If you are on a fixed income (e.g. Social Security), the variable rate can price you out of your home.
- Rates historically rise, not fall, over time.
Learning From History
During the 2008 Housing Crisis, 200,000 Americans became homeless because they could no longer afford their mortgages. Some of this was due to financial institutions playing “fast and loose” with credit default swaps (betting against themselves – hoping mortgages would fail). However, in large part, this result was due to homeowners with ARMs that could not afford their payments when the variable interest rate kicked in.
The takeaway here is that fixed-rate mortgages are more predictable and stable than ARMs. Although the economy is down right now (along with the Fed rate), ARMs seem attractive – however, when you’re on the path to FI, always play the long-run game. It is impossible to know how the economy will change in the next 5, 10, or even 30 years. Do your research first, but make sure to keep all these factors in mind.
Tax Value vs. Asking Price
The tax value of real estate is the value assessment of specific property in the county you live in or want to live in. This is done to determine how property tax is calculated. The real estate market also uses tax value to estimate what a seller should start their asking price at for a particular home.
This is important to understand for a few key reasons.
- The tax value is often how much financial institutions allow you to borrow to purchase the home. In high-demand areas, the asking price can far exceed the tax value. This is due to the implied value of the property (what it will be worth in the short-to-long run) entices the seller to sell at a higher price. So, getting a mortgage with a much higher asking price than the tax value is incredibly difficult, if not impossible.
- The tax value determines the down-payment required by the buyer (usually 10-20%). If the asking price is higher than tax value, you will pay a much lower effective cost for the property. This can negate much of the equity put forth.
- Even if you had the liquidity to purchase the property with the two initial factors in mind, a bidding war might price you far outside your comfort zone. We mention bidding wars because they are almost always psychological and overlooked by other financial credit guides.
As stated earlier, do not become “married” to a specific property. You need to have the will to walk away. You may get caught up in the fever-pitch of a bidding war. The result: paying thousands of dollars more for a property just because psychologically you want to win. This is a fool’s errand.
HELOC’s (Home Equity Line of Credit) or home equity loans is a form of credit where you borrow against the equity that you have invested in your home. Some of our regular readers will know the terminology of “Line 1”, which is just another way of saying it is the first line of credit taken against a mortgage. HELOC’s can be a crucial financial tool to some and an extreme foreclosure risk to others, as it requires you to pay back the money (and interest) borrowed in order to keep your home.
HELOC’s are relatively easy to open. With the pervasive nature of online banking, you can shop around for the best fit for you. When you open a HELOC, two time periods are defined: the draw period (usually about 10 years) and the repayment period (usually around 10-20 years). The draw period is when you can utilize the borrowed equity however you’d like.
One of the upsides to borrowing against your home equity is that the payments are tax-deductible. Because of this, if you qualify for a low interest rate, you can pay off higher interest rates of debt at a low rate and have a tax write-off. A nice two birds/one stone situation.
Once the draw period ends, you enter the repayment phase. You have until the defined time-period (declared at opening) to repay the HELOC. You must pay back the principal and the interest rate during this time.
Getting the Best HELOC Rate
Interest rates for HELOC’s vary widely between 2.5%-23%. To get the lowest interest possible, you need to have the following:
- A healthy financial history and good overall credit.
- A good credit mix, a high FICO score, a low income-to-debt ratio (ie: if you make $200,000 a year, but your outstanding debt is $500,000 – you’ll probably not qualify or if you do, the interest rate will be through the rafters)
- A large amount of equity capital in your home.
New users get a free trial of M1 Plus for a year, which includes perks like: • 1% APY on checking,• Smart Transfer to optimize and automate your saving and investing, • a low 2% rate for emergencies or to consolidate loans. New users will also earn $30 if they fund their accounts with $1000 or more in the same month.
Pros and Cons
Like any financial tool, there are pros and cons to opening a HELOC:
- A long draw (or pull) fund time-period compared to the repayment period.
- An exceptionally low APR
- Tax-deductible payments
- Most financial institutions charge little to no closing costs (dependent on your eligibility and equity)
- No interest charged on funds you have access to, but do not borrow
- Flexibility in borrowing and repayment
- Your home can be foreclosed if you fail to pay the HELOC in full
- Missing payments, even though you are borrowing against yourself, still damage your credit
- HELOCs can be fee-heavy — again, do your homework!
- Interest rates are a double-edged sword
A key component of HELOC’s is this: you can open a HELOC if you suspect you may need an emergency fund (e.g. medical emergencies, home repairs, other necessary large purchases). You can choose to use the line of credit or not – with no penalty. So keep that in mind if you need a lifeline.
Something else to keep in mind is that if you plan on selling your home within the draw period, you MUST pay off the HELOC before your home can be sold. So if you are planning on selling your house within a certain amount of time and aren’t sure you can repay in full, you should probably pass.
A HELOC is not for every homeowner. You need to be sure that you can pay back the loan in full. If you are carrying a lot of unsecured debt (credit cards), a HELOC could be an excellent option for repayment or a horrible one. HELOC’s are one of the few credit tools that are far from a one size fits all. You need to do your homework and see if they are right for you.
On the Subject of Buying vs. Renting
Renting instead of buying offers two key upsides: flexibility (if you move around frequently) and an option if you aren’t in a financial position to purchase a home. Outside of these two factors, your goal should be to buy a home (especially if you are on the path to FI). Making payments on a home creates equity; renting, on the other hand, gives you a roof over your head with no return on investment.
Some may argue that when renting you don’t have to pay for repairs if the sink explodes or the roof caves in. This isn’t exactly true. While the landlord will make the arrangements to make repairs, that’s as far as your positive value extends. Rent payments include expected repairs.
They also include a high premium for the landlord to make money. For instance, you can look at the value of a house and determine that a 30-year mortgage with an average interest rate and the payments will more than likely be about 30-40% lower than a rent payment. All in all: invest in real estate as soon as possible.
Final Thoughts on Mortgages
Equity is the name of the game when it comes to mortgages.
Remember that on your journey to FI, you will come across peers who will act counterintuitively to you because they are spending and borrowing with their hearts – not their heads. To successfully achieve FI, you need to be disciplined when it comes to the largest purchase in your life. Of course, you should purchase a home you love, but don’t get tunnel-vision. Nor take a bidding war personally. Business is never personal. Buying a house is business. Yes, it is your sanctuary and safe place, but don’t let your heart outride your head here.
In today’s talent market, a college education isn’t quite the necessity as it once was to land a dream job. With so many alternatives to learning and specific technical training that is unorthodox to the traditional 4-year education, student loans are on the precipice of a falling demand shock. However, with $1.5T debt on the Fed’s balance sheet from the Department of Education, they are far from going away. So, let’s discuss your credit options should you decide to attend university.
Borrowing for College Through the Department of Education
The Department of Education offers 3 different types of loans to pay for school.
The amount you can borrow per semester is determined by the information given when you fill out a FAFSA (Free Application For Student Aid) and are married with the institution you attend.
- Direct Subsidized Loans – offered to undergraduate students only. Subsidized loans are both deferred (meaning you do not have to start repayment while in school), and interest is paid for by the government until the grace period (six months post-graduation) elapses. You must demonstrate financial need to receive Direct Subsidized Loans.
- Direct Unsubsidized Loans – offered to undergraduate and graduate students. Unsubsidized loans are deferred while in school, but interest begins to accumulate immediately and the borrower is responsible. You do not need to demonstrate financial need to receive Direct Unsubsidized Loans…HOWEVER, you have the option to pay the interest while in school. If you decline this option, interest accumulates and is capitalized to the principal after grace.
- Direct PLUS Loans – are unsubsidized loans used when other financial loan options (see two above) are exhausted and additional funds are needed. These loans are credit-dependent – meaning that you, or your parents as a co-signer, must have a credit score healthy enough to borrow these funds. Interest accumulates at the origin of the loan and is capitalized at the end of the loan period.
Pay Attention to the Fine Print
There are many guides online that tell you the limits of these loans and the repayment options. We here at ChooseFI want you to be aware of some of the proverbial “fine print” instead of rehashing information that can be found everywhere.
- Capitalized interest can be devastating.
- Student loans CANNOT be discharged if you declare bankruptcy – this is virtually the only line of credit untouchable in bankruptcy filings.
- Failure to pay back your student loans will not only destroy your credit, but the government can also garnish your wages, among other tactics, to get the money you borrowed back.
- The Public-Service Forgiveness program (where you devote your professional time and skills to public service) is incredibly limited in size and scope.
- The rules frequently change. Limits on borrowing, subsidizing, and forgiveness have all changed quite often over the past two decades. Be sure to keep this in mind, as when the rules change, they are never in your favor.
- Nearly 90% of student loan recipients take the entirety of what they can borrow, not what is necessary to borrow. You are allowed to borrow up to a certain amount. If you plan on getting a student loan, borrow only what you need.
- Similar to rule changes (see above), the political climate also has a vital role in how student loans are addressed. This is another wild card that you need to consider.
Student loans are unique in that they are very easy to obtain yet nearly impossible to discharge. In almost all cases, they must be paid back in full (with interest). Consider this before deciding to go back to school or send your kids off to college.
Dive deeper into student loans:
Every consumer’s fear – declaring bankruptcy. Not only is it financially devastating, but it also causes an emotional and psychological toll. There are no real upsides in declaring, outside the protection of the most vital of your assets. It’s a defensive mechanism that should only be utilized if absolutely necessary. A few insider knowledge tips to consider:
- Hire a lawyer. Yes, it sounds counterintuitive as you’ll have to pay $1,000 – $3,000 (including court fees); however, a lawyer will ensure you’ll be protected to the fullest extent of the law.
- Keep records. This is something those seeking FI should do automatically. Having proper receipts and documentation will help the process go as smoothly as possible.
- Know the laws in your state. Bankruptcy laws vary from state to state. Some states have exceptions you can take advantage of, such as keeping your primary vehicle valued at a certain amount. Other states have what’s called “wild card exemptions” – which means that you have an allotted capital cap that you can use for any asset you own. Like we always say: do your homework.
- Use only as a last resort. Bankruptcy will destroy your credit, plain and simple. Your employment and potential employment will be severely handcuffed. It will also stay on your credit report forever. The good news is that the “look back period” for creditors is 7-10 years. This period effectively times out the damage that bankruptcy causes.
Again, most of the recommendations in this blog are proactive ways to improve and hack your credit – an aggressive strategy. Being on the defensive is uncomfortable. But, if you have depleted all other options, this hail-mary pass is the only mechanism that will protect the assets you need most.
Chapters of Bankruptcy Explained
Let’s look at the 3 most common chapters (or rules of declaration) of bankruptcy. These 3 will fit 99% of consumers that do not own massive corporations.
Liquidation Bankruptcy: Chapter 7
Liquidation Bankruptcy, or Chapter 7, is the most commonly used for consumers outside of an organization. All non-essential assets are seized by the government and sold at auction. The consumer keeps “exemption assets.” These exemptions vary from state to state, so make sure you do your research and hire a lawyer to ensure you are protected.
Note: Most consumers who file this type of bankruptcy usually have substantial unsecured debt (e.g. credit cards) and not many assets, so filing discharges the unsecured debt, and very little, if any, assets are seized.
Reorganization Bankruptcy: Chapter 11
Reorganization Bankruptcy, or Chapter 11, is a type of bankruptcy is for organizations, partnerships, and LLC’s. The rules of are much more complicated than some other chapters of bankruptcy, and certainly require the assistance of legal counsel.
Essentially, it allows small businesses and partnerships to carry on their business while working with creditors to pay off the debts they can and triage the rest to negotiate installment payments while keeping a relative “business as usual.” Negotiation needs to be stressed here. And because of said negotiation, a lawyer will need to speak on behalf of the organization or individual counsel can be obtained for each partner.
Repayment Plan Bankruptcy: Chapter 13
Chapter 13, or Repayment Plan Bankruptcy, can only be filed by individuals. To be eligible to file, an individual needs to owe no more than (estimated) $400,000 in unsecured debt and (estimated) $1.2M in secured debt. Filers also must have a regular income, so you are out of luck if you are unemployed.
The advantage of filing for Chapter 13 instead of Chapter 7 is that you do not need to liquidate your assets to stay afloat. Agreements are worked out between the courts, the creditors, and the debtor to make installment payments to keep their assets and reduce the stress of high monthly payments. Think of it as slowly freezing outgoing payments. Those who file usually have numerous high-valued assets (such as real estate) and want to keep them with the protection of the bankruptcy shield.
It cannot be stressed, highlighted, underlined, or italicized enough: bankruptcy should only be used as a last resort due to the damage it causes to your credit.
Filing any Chapter will trigger a massive black mark on your credit report and your score will fall, perhaps hundreds of points, and will stay that way for years to come. Seek the help of a financial advisor, but most certainly acquire the assistance of a lawyer who specializes in bankruptcy law. The small investment up front could save assets and make an incredibly rocky and stressful process more manageable.
Dive deeper into bankruptcy: How Hitting Rock Bottom Put Me On The Path To Financial Independence
We’ve covered a lot of ground regarding credit management and how to best take advantage of lines of credit and the rewards that follow. Remember that credit is NEVER a windfall. Just because you have an available balance on your credit card, you don’t have to max-out and make astronomical payments due to APR. Your expected value should always trend upwards as you approach FI. Carrying balances and opening multiple lines of credit is inverse to this goal.
If you take away anything from this guide, we hope you can better understand how credit works and respect credit like it needs to be. It is a powerful tool that, if used correctly, can pay off in many different ways. Use the methodology we have put forth, and you are well on your way to reaping the benefits of card rewards and managing your money (and debt) efficiently and capably