Element 4.4: Manage Credit Wisely

“There are but two ways of paying debt — increase of industry in raising income, increase of thrift in laying out.”

In William Shakespeare’s play Hamlet, Polonius advises his son, Laertes who is going off to college, “Neither a borrower nor a lender be, for loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.” Not only good advice in that specific context, responsible planned borrowing and lending (also called investment) are essential aspects of a modern economy. The problem arises when emotions overcome rational, forward-looking decisions.

Imprudent use of credit cards and debt can be a huge obstacle to financial success. Although many people use credit carefully, others behave as if an unused balance on a credit card is like money in the bank. This is blatantly false and dangerous thinking. An unused balance on your credit card merely means that you have some additional borrowing power; it neither enhances your wealth or provides you with more money. It is best to think of your credit card as a means of using what you have in your checking account. If you have funds in your checking account, you can use your credit card to access those funds, provided you pay off the bill every month. If you don’t have sufficient funds in your account, don’t make the purchase.

Exhibit 27 demonstrates that the percentage of credit card ownership varies across regions. In the Euro area, it reaches up to 50 percent, while in North America, it stands at 68 percent. Comparatively lower rates are observed in East Asia and Latin America. It is important to note, however, that credit card ownership is increasing worldwide. Over the decade between 2011 to 2021, credit card ownership among individuals aged 15 and over rose globally from about 15 percent to 25 percent.

Source: databank.worldbank.org.

While credit cards and their electronic counterparts (Digital Wallets, such as PayPal and Mobile Payment Apps, such as Apple Pay) are convenient to use, they are also both seductive and costly methods of borrowing. Your outstanding credit-card balance is a loan—a debt that must be repaid. Because credit cards make it easy to run up debt, they are potentially dangerous. Some people seem unable to control the impulse to spend when there is an unused balance on their cards.⁽¹³²⁾ If you have this problem, you need to take immediate action! Stop using credit for spending you cannot afford. Get a pair of scissors and cut up all your credit cards. If you do not, they will lead you to financial misfortune.

Making purchases using your credit card gives the illusion that you are buying more with your money. Invariably, when the bill comes due it presents another temptation: the option to send a small payment to cover the interest plus a tiny fraction of the balance, and keep the bulk of your money to spend on more things. If you choose this option and continue to increase your balance, however, you will quickly confront a major problem—the high interest rate  charges on the unpaid balance. Interest charges of 15 to 18% or more on credit-card debt are common in the United States and Euro area.⁽¹³³⁾ In less established markets, rates are often much higher. At the time of our writing reputable banks in Kazakhstan were offering consumer credit cards with annual interest rates of 39.9% while in Azerbaijan the interest was only 25%. These rates are far higher than most people, even successful investors, can earn on their savings and investments. As we shall see in later elements, you can become wealthy earning 7 percent per year on your investments. Unfortunately, high interest rates on outstanding debt will have the opposite impact. Paying 15 to 18 percent on your credit-card debt can drive even a person with a good income into financial distress.

Consider the example of Ivan, a young professional who decides to take several days to relax on Santorini. The trip costs €1,500, which Ivan puts on his credit card. But instead of paying the full amount at the end of the month, Ivan pays only the minimum, and he keeps doing so for the next ten years, when he has finally paid off the bill. How much did Ivan pay for his trip, assuming an 18 percent interest rate on his credit card? He pays €27 per month for 120 months, or a total of €3,243. So, Ivan ends up paying his credit-card company more than twice what he paid for travel, hotel, food, and entertainment.

Ivan could have taken the trip for a great deal less by planning ahead and starting to make payments to himself before the trip, instead of making payments to the credit-card company after the trip. By saving €75 a month at 5 percent per year in compound interest (we will discuss compound interest in Element 4.7) for 20 months, Ivan could have had €1,560.89 for the trip, rather than paying €3,243 including interest for the same trip (but taken earlier) on the credit card. In other words, by saving and planning to make his trip, instead of running up credit-card debt to pay for it, Ivan could take two trips for less than he ended up paying for one on credit.

Suppose you already have a sizable credit-card bill? If you are serious about achieving financial success, the very first thing you should do, if possible, is pay off the debt from savings, and if you don’t have enough savings, reduce expenses. Although it would have been better if you had avoided that debt, paying it off does provide an opportunity for you to get a very high return. Let’s suppose the interest rate on the debt is 18 percent. Every euro you save now to pay down the credit-card debt effectively earns an interest rate of 18 percent. Look at it this way: if you put one euro into an investment paying 18 percent, then one year from now it has added €1.18 to your net worth. Likewise, if you save a euro to pay off your credit-card debt, then one year from now it will also add €1.18 to your net worth. Your debt will be that much lower—first, from the euro you saved that reduced your debt initially and, second, from the 18 cents you would have otherwise owed in interest.

Does it ever make sense for an individual or family to purchase a good on credit? The answer is “yes,” but only if the good is a long-lasting asset and if the borrowed funds are repaid before the asset is worn out. This way you pay for the asset as you use it.

Very few purchases meet these criteria. Three categories of major consumption expenditures come to mind: housing, automobiles, and education. If maintained properly, a new house may provide useful life for forty or fifty years into the future. Under these circumstances, the use of the longest mortgage you can get to finance the expenditure is perfectly sensible. Similarly, if an automobile can be expected to be driven for five or six years, there is nothing wrong with financing it over a four-year period.

Notice that we have been speaking about consumption purchases, not the investments that may be necessary to start a business where you expect to be able to repay the loan from the profits of your enterprise. When long-lasting assets are still generating additional income or providing a valuable service after the loans used to finance their purchase are repaid, some of the loan payments are actually a form of savings and investment, which will enhance the net worth of a household. Like housing, investments in education generally provide net benefits over a lengthy period. Young people investing in education through debt financing may reap dividends in the form of higher earnings. The educational investment will be a good one if, over the next twenty or thirty years, the higher earnings are sufficient to pay off the borrowed funds. But there are risks here: if the additional education does not increase future earnings, at least not by much, it may be exceedingly difficult to repay the borrowed funds. (Note: This issue will be considered in more detail in Element 4.11.)

Financing an item over a period longer than the useful life of the asset forces you to pay in the future for something that will no longer be of value to you. As a result, you will be forced to reduce your future consumption. Further, this strategy increases your indebtedness, and you will become poorer in the future.

For most households, the implications of this guideline are straightforward: do not borrow funds to finance anything other than housing, automobiles, and education, or to invest in a business. Furthermore, make sure that funds borrowed for the purchase of these items will be repaid well before the expiration of the asset’s useful life. Application of this simple guideline will go a long way toward keeping you out of financial trouble.

How can you tell if you are managing your credit and debt wisely? Here are two general guidelines. First, no single monthly debt payment should be greater than 28 percent of your monthly gross income. Second, all combined debt payments should be no greater than 36 percent of your monthly gross income. Even if you follow these two, your credit score is the primary indicator. Numerous corporations calculate and provide credit scores based on various models. These models may differ in scoring ranges, algorithms, and factors considered, but they all aim to assess individuals' creditworthiness. In the United States FICO score, created by the Fair Isaac Corporation, is the most widely used metric. With a range of 300 to 850, it is used by banks and other financial institutions to assess risk and determine the interest rate you will pay on loans. Another global information services provider of credit information and analytics is Experian. Its credit scoring model is tailored to the European market. The Experian Credit Score evaluates individuals' creditworthiness based on multiple factors, including payment history, credit utilization, and credit mix. Maintaining a consistently high score will enhance your wealth-building potential.

Notice that in this section we have almost exclusively discussed borrowing from formal, legal institutions such as banks (or for investment microcredit institutions that may finance investment loans). There are, of course, other sources of credit. Families often lend to one another, particularly when a young person is going to university, starting a family, or beginning a business. Such solidarity is both admirable and somewhat dangerous. It is important that all involved understand the implicit expectations about repayment and other conditions so as to avoid later stresses. Short-term, informal loans between friends and neighbors are often a part of community life in developing countries.

What is essential is to avoid if at all possible relying on shady characters such a “loan sharks” who will lend at very high interest rates to desperate borrowers who may never be able to get out from under the accumulating debt burden. Even with careful planning emergencies do happen, but if you have shown yourself but unlucky (say after an auto accident), help from friends, family or the community is almost available.