Becoming a smart borrower
Learning the necessary skills to manage your debt is a first step on the path to financial freedom.

With historically low interest rates and a large number of lenders competing in the marketplace, now it’s easier than ever to borrow money. The process of applying and qualifying for credit is also fairer and more accessible than it was in the past.

This is a good thing, because it makes it financially possible for more people to pay for a home, a car or a college education. But it also means that for some there’s a temptation to borrow more than they can afford.

That’s why it’s important to become a smart borrower — and the first step is to learn the difference between good and bad debt:

• Good debt is borrowing to purchase an asset that is likely to go up in value. It comes with a favorable interest rate and may even be tax-deductible. A mortgage that you can comfortably afford is a good example. Borrowing to buy a business, or to upgrade your education or job skills can also be good debt, since you’re using the money to build future wealth.
• Bad debt, on the other hand, is expensive and used to buy things that quickly lose their value. If you buy a big-screen TV and take six months to pay it off on your credit card at 18 percent interest, that’s bad debt. So is taking out a seven-year-loan to pay for a car you’ll only drive for five years.

Sometimes a debt is bad not because of what you buy, but because of the type of financing you choose. For example, if you take out an interest-only mortgage to buy a house you would otherwise be unable to afford, you could find yourself in a budget crunch when the interest-only period ends and you have to start making higher payments.

Becoming a smart borrower means using good debt to build wealth and avoiding bad debt that erodes it. Here’s how to start:

Keep on top of your credit score. Whenever you borrow money or apply for credit, the lender checks your credit score. This number reflects your past history of borrowing. The higher the number, the lower risk you are to the lender and the better interest rate you’ll receive. By paying your bills on time and maintaining a good credit score, you’ll be able to get loans at the best rate going.

Request your free credit report and score from LendingTree.

Make sure you’re getting the best rate. Check if you can refinance your mortgage to one with a lower rate, or one that pays down your principal faster. You might even be able to get your credit card company to lower the rate it charges you by simply asking. With so many lenders competing in the market, you can easily shop around for a better interest rate if you request a loan through LendingTree.

Review your credit accounts and consolidate. Paying off your high-interest credit cards with a low interest debt consolidation loan or home equity loan or line of credit may save you a considerable amount in interest rate charges. Just remember, it’s crucial that you avoid running up your credit card balances again. Otherwise you’ll find yourself in an endless cycle of debt.

How to set up an emergency fund
You never know when you’ll need extra cash for an unexpected emergency. Be sure to set aside enough.

U.S. families rank saving for emergencies as the second most important reason to save, according to The Federal Reserve Board’s most recent Survey of Consumer Finances. Yet its estimate of the rate of saving by U.S. households indicates a significant drop in recent years, both in levels and as a percentage of disposable income.

Few Americans set aside enough to weather even a mild financial storm. According to a 2004 poll by the American Payroll Association, 68 percent of Americans think they would fall behind on their mortgage, rent or other bills if even a single paycheck were to be delayed.

Don’t be caught off guard. Use the following tips to prepare for occasional financial setbacks by setting up a rainy day fund.

How much to save

A standard rule of thumb for emergency funds is to set aside three to six months’ salary. If your income is irregular, it’s wise to save a little more. Estimate the number of months you could be out of work and multiply it by your standard monthly expenses. These should include things such as rent or mortgage payments, utilities, car or transportation expenses, grocery bills and insurance costs. It should also be enough to cover any deductibles on your car or health insurance.

How to get there

One of the easiest ways to save is to have your bank set up an automatic withdrawal plan whereby a fixed percentage of your paycheck is transferred regularly to an investment account. A good amount to try to save each month is about a twelfth of your income (a little more than eight percent). This will enable you to save at least one month’s income every year. You can also increase your savings with any unexpected income you receive such as gift money, employment bonuses or inheritance funds.

Keep it accessible

Be sure to invest your emergency fund in a way that enables you to have access to it should the need arise. Your best bets are either a savings account with a bank or credit union or a money-market mutual fund. Savings accounts are insured by the Federal Deposit Insurance Corporation for up to $100,000, but typically pay only a low rate of interest. Money-market mutual funds aren’t insured but they provide a higher return. And they seldom drop in value as they invest only in short-term debt such as commercial loans, CDs and Government Securities. Be sure to talk with a financial planner about your situation before you invest.

Remember to review

Once you’ve established a rainy day fund, remember to review it periodically. Such things as the purchase of a new home, or the birth of a child, may cause your income need to increase. Be sure to keep yourself protected by adding money accordingly. With careful planning, you shouldn’t have to worry about paying for emergency expenses.

If a situation arises where your rainy day fund doesn’t provide you with enough money, however, a home equity loan or line of credit is a good alternative. Some lenders will advance you as much as 125 percent of the appraised value of your home, less existing mortgages. Make sure to shop around for the best rate.

Good debt: What do lenders look for?
Taking out loans and repaying your debts can appeal to potential creditors.

It can be smart to take out a bank loan or charge credit card debt. Here’s why: U.S. lenders rely on a credit report to decide whether to loan you money, to determine the interest rate they will charge you and, even, to establish your automobile or home insurance premium. If you have no track record demonstrating that you repay your debts, you may not qualify for a loan.

Credit reports are developed by one or more of three credit bureaus: Equifax, Experian and TransUnion. Each bureau sums up your credit history into a single three-digit number, known as your credit score. Most people’s scores range from 300 to 850. Generally, scores below 620 are viewed as risky, while those over 750 are excellent.

The following information is used to calculate your credit score:

• Your past payment history. Whether it’s credit cards, bank loans or your telephone bill, your creditors are happiest when you make regular payments — even if they are minimum payments — on all your debts. A single missed payment can lower your score. Bankruptcies, collections, judgments, defaults, liens, foreclosures, or repossessions, will lower your credit score.

• Current debts. The less money you owe, the better. Your debt ratio — the percentage of your paycheck that you spend repaying debt — should be no more than 40 percent of your take-home income. If you and your partner take home $5,000 per month, for example, potential creditors prefer that your debt repayments, including your mortgage payments, be no higher than $2,000 per month.

• Length of your credit history. Creditors prefer you to have a long and consistent track record of repaying loans.

• The number of new credit accounts you’ve opened or applied for. Every application for credit shows up on your credit report, telling lenders that you may be taking on new debt.

• The types of credit you have. Creditors look more favorably on some types of credit than others. They’d prefer you to have a mortgage secured by your home, for example, than longstanding credit card debt.

Loans that appeal to creditors:

• A mortgage can look good to potential creditors, as long as you’ve kept up your payments. As an added bonus, the interest on mortgage payments may be tax-deductible up to the first million dollars (though you should consult a tax advisor about your particular situation). And, hopefully, real estate is an asset that will appreciate in value.

• Automobile loans will not harm your credit rating provided you shop around for a reasonable interest rate. But it pays to keep in mind that a car is an asset that tends to depreciate in value the minute you drive it off the lot.

• Bank loans won’t hurt your credit rating as long as you repay them regularly and on time. If you borrow to pay for your education, it’s assumed you’ll get the money back in the form of a better salary.

• Credit cards can be a good thing in the eyes of creditors, as long as you make regular payments and don’t apply for many new cards within a short period of time. But creditors don’t like to see you carrying a credit card balance of more than 80 percent of your available limit. In other words, if your total credit card limit is $10,000, your total credit card debt should be well below $8,000.

• A debt consolidation loan could be a good signal to creditors — as long as it’s a one-time event, demonstrating that you’re serious about getting yourself out of debt. You may be able to get a debt consolidation loan at a lower interest rate than your current lenders are charging, which would also lower your monthly debt payments.