Bankruptcy hurts. It can seem like the end of the world to some. Picture everything you once owned gone in the blink of an eye. And starting over doesn’t just seem difficult, it truly is difficult. You’re a credit liability. And creditors will see it that way…for a while.

But bankruptcy isn’t the end of the world. You can come back and start to rebuild that trust with creditors. It isn’t always easy, and it takes some time, but if you’re able to learn from your previous mistakes, it can be done. Here’s how:

How bankruptcy affects your credit score

Bankruptcy is the single most damaging thing that can appear on your credit reports. For a while, getting any kind of loan or line of credit will be near to, if not completely, impossible. And once it’s there, it’s going to be there for a while. Over time, however, the damage bankruptcy does to your credit score will start to diminish, but only if you’ve kept the rest of your records clean for that time.

How much it impacts your score also depends on the type of bankruptcy was filed. Because with Chapter 13 bankruptcy you still have an opportunity to pay off a portion of outstanding debts and keep some assets, the effect isn’t quite as harmful as Chapter 7 (complete liquidation). Also, Chapter 13 can be removed from your credit reports in as little as 7 years after the debts are paid, while Chapter 7 it will remain for the standard of 10 years.

Before you begin: Educate yourself & learn from past mistakes

The first and most important step to recovering from bankruptcy is learning from the mistakes that got you into the mess in the first place. Get acquainted with your credit reports, they’re free once a year. Look over your past history paying close attention to the growing amounts of debt over time and the increasing late payments that followed. It’s not hard to see how quickly things get out of hand. Next, learn how to manage your reports: monitor potential negative marks, getting errors removed, etc.

This is also a good time to reflect on your relationship with money and the possessions you want to buy with it. It’s a time for hard truths and, in most cases, a total change of attitude towards spending. If you aren’t brutally honest with yourself or willing to make sacrifices to your lifestyle, you’ll be back in bankruptcy court before you know it.  It’s a great time to start being frugal.

Phase 1: Budget and save

Because immediately after bankruptcy getting a line of credit won’t be much of an option, the only thing you can do [at first] is focus on your income, spending, and develop a personal budget. First and foremost, make sure you are able to pay your remaining current bills (e.g. rent, utilities, student loans, etc.) on time. The very last thing you want during this stage is any more negative marks on your credit reports. Next, create and maintain a budget including these bills and all your other regular spending.

Keep. Track. Of. EVERYTHING.

In the first couple of years you need to also focus on building savings.  Mostly, because you won’t have the option of using credit for any larger purchases you’d like to make. But even more importantly, however, is that if you aren’t able to budget and save money, you aren’t ready to start using credit.  If you can’t save, it means you’re spending all the money you are making, and adding credit to that will only put you over the top. Another reason savings will be important is because when you are ready to take out a loan, creditors will want a significant down payment due to your poor credit standing (especially if you want a lower interest rate). So during the first couple of years after bankruptcy, focus on spending less money than you make and set the rest aside for larger as well as future purchases.

…Then you’ll be ready for phase 2:

Phase 2: A fresh start to your credit history

Once you’ve figured out a personal budget and have started to build up some savings, it’s time to start building a positive credit history again. This isn’t something you should jump into lightly, however. The key, here, is to start out slow and get used to utilizing credit without changing anything about your budget.

Something you need to be careful of, in this stage, is requesting too much credit. Applying for credit cards and loans can hurt your credit score, even if you are rejected. And that’s clearly not something you’ll want to do when the goal is to increase your rating. Instead, look at some other [beginner] options, like secured credit cards. These cards set your “credit limit” to the amount of an initial deposit. They’re a great way to build up a trust with credit reporting agencies as well as a great way to get used to making regular payments on a credit card. Only use it for things you have the cash to pay for and ***get used to paying the entire balance each month***.  If you can’t do this, stop using it immediately until you can, it’s that important.

Phase 3: Graduating to more serious credit usage

After a couple of years of using limited credit following a bankruptcy, you can’t expect your credit score to improve a whole lot. But after showing responsible use of a secured credit card, you might be ready to graduate to more beneficial credit-history-building revolving debt (i.e. typical credit card). Even though interest rate offers will be high, if you continue to pay the balance in full each month, you can avoid paying interest altogether. Stick to the plan: use the card more-and-more for everyday purchases, and don’t change anything about your budget. Even for big purchases, for example: save up for a TV you want and when you have enough cash, use the credit card for the purchase and pay it off right away (with the savings).

Something to be weary of before you can graduate to more serious loans is interest rates.  One of the major drawbacks for a poor credit rating is the higher interest rates. So before you consider taking a loan, mortgage, or even keeping a balance on a credit card, be sure you’ve built up your credit enough that you don’t pay the highest (poor credit) rates. Yes, this could take years, but the longer you can hold off, the better off you’ll be. Just continue to save, and that will help you out with the next step:

One way to reduce interest rates on loans is by making a larger down payment.  This is why savings is so important early on.  With secured loans, like mortgages, the more principal you can pay, the safer the loan will be for the bank. If you can afford 20% down, you usually get the preferred rate [sometimes] even if you don’t have the best credit score. High interest rates will cost you money in the long-run. More dangerously, it can become the driving force for repeat problems. If you can’t get a preferred interest rate consider waiting to make the purchase (and continue to save) until you can.

Phase 4: Full recovery

10 years after filing bankruptcy you can have a near perfect credit rating with no negative marks. Not only will the bankruptcy be off your reports, but most of your old closed accounts (with blemishes) should also be gone. Also, if you’ve been responsible since, making payments on time, 10 years is a relatively long time to build a good amount of positive credit history.

It certainly feels like this sometimes...

Bad news for students borrowing for college this past week:

The Senate failed Tuesday to advance a bill to keep federally subsidized college student loan rates lower for another year, prolonging debate on an issue that has emerged as an election-year flashpoint

Student loan interest rates for federally subsidized Stafford loans may as much as double, to 6.8%, this summer. The rate has been lowered since 2007 as a way to ease the burden of student loans. The failure of an extension of this part of the program is

While the rate probably seems high, the reality is, it may not be quite as bad as it sounds. The average additional cost per student (over a 10 year payment plan) would be about $2,600 or approximately $28 per month. But, of course, students need all the help they can get these days. So regardless of how objectively bad the reality is, it’s a step in the wrong direction for today’s students.

What the political debate is about

The debate isn’t about whether or not to extend the lower interest rate…both sides agree that it’s a good idea. The debate is how the extension is to be pay for it. According to the Washington Times article:

A House Republican plan approved in late April would pay for the lower rates by cutting almost $6 billion from a preventative health-care fund established in the Democrats’ health care reform bill.

Democrats pushed a plan to pay for the extension by ending a tax break that allows operators of some businesses with three or fewer shareholders to avoid paying payroll taxes by labeling some of their income as business profits rather than wages.

And now, the issue is being used as a part of the political posturing/blame game, with students caught in the middle.

Why student loan interest rates are so high

Because prospective students have little to no credit history, interest rates aren’t a reflection of the individual student’s responsibility with debt (credit score, etc.). Also, unlike other kinds of loans, interest rates don’t vary based on how much an individual borrows. Instead, student loan interest rates a reflection of the pooled risk among all student loan borrowing.

Two major factors are involved:

1. How much overall student loan debt (yearly demand)
2. The average estimated time of payback

The second factor is certainly affected by the first, but is additionally influenced by the overall job market for students who borrowed.

The main reasons student loan interest is currently so high is because overall student debt is at historic levels, driven by rapidly rising costs of education; and the job market is extremely weak, driven by poor economic recovery. Not just high unemployment, but also low salaries.

So while extending the low interest rates is probably the right thing to do for students, the discussion of how to pay for it should include a focus on ways to reduce the rates naturally. This means a focus on job creation for new graduates as well as ways to keep the costs of education under control. Not just to make paying loans back easier, but ways to reduce the demand for student debt in the first place.

What this all means for students

If the government doesn’t find a way to extend the low interest rates, next year’s students will be the ones that take the hit. Interest rates for past loans won’t change, but any new loans will be set at a higher rate. So what does this mean for students, exactly? Here’s the rub:

The maximum Stafford loan amount (for a 5 year degree) is $24,500. If it took the maximum 25 years to pay off, the higher interest rate could cost a student as much as $14,600 or about $50/month in additional interest payments. This is the worst case scenario.

If the high costs of education wasn’t enough of a wake-up call to students, the prospect of paying high interest rates should be. It’s an indication that college graduates are having an increasingly difficult time paying off their debt, so prospective students need to start taking it more seriously.  Here’s some advice for potential and current students:

• Know what you’re getting into: keep track of the amount and interest rates for all loans and understand what you will will owe overall when you graduate.
• Reduce dependence on borrowing by:
  • Choosing less expensive programs/schools (state school, community college, etc.)
  • Save for school, work summers & throughout school and pay more tuition up-front
  • Pay off loans quicker after graduation
• Take job prospecting & school more seriously
  • Get hands-on work experience BEFORE you graduate
  • Work with career centers & academic advisers/mentors
  • Consider career options before entering college (especially if you are borrowing)

An unemployed banker and father who is having trouble finding work has lost his home and finds himself in a heap of credit card debt just so he can feed his family. He applies for a job that he’s perfectly qualified for, but gets rejected because the employer did a credit check and his low credit score disqualified him from the position.

Across town, a recent graduate with tremendous qualifications enters the workforce with an above average amount of student debt. Also, to be responsible, she never so much as tried to open a line of credit to pay for her expenses while in school. Unfortunately, despite having actual work experience and tremendous grades, she can’t even get an interview as an accountant purely on the basis of her poor credit score.

When I hear or read about stories like this it makes me sick to my stomach. It’s hard to improve your credit score without income, and it’s harder to get a job with a low credit score. The system seems rigged. But you know what the honest truth is? Credit reports aren’t a perfect measurement of responsibility. So the question is: should employers even be able to use it?

It’s more common than you’d like to think.

According to a study in 2010: about 60% of companies polled did credit background checks for prospective employees. Another study from about a year earlier found that 1 in 10 employers said they’ve disqualified candidates based purely on credit scores.

It’s much more prevalent for some positions than others, however. For example, jobs that fiduciary or financial responsibility, credit checks were conducted 91% of the time. For health care positions where a person had access to drugs, on the other hand, it was used only 3% of the time. [Source]

It’s also a quickly growing trend. Perhaps more concerning, is that the poor state of the economy, particularly the job market, is partially a driving force behind the trend. As if the recession didn’t make it hard enough to get a job…

Petitions to restrict or ban the practice

A number of attempts to outlaw the practice of employment credit checks have been attempted to a varying degree of success. In 2009, the equal employment for all act (H.R. 3149) was introduced to congress looking to restrict the practice nationally except in rare circumstances (like accounting or banking institutions). The bill failed and was later killed (sent to committee). In Oregon, a bill that was modeled after H.R. 3149 passed and has been in effect just short of 2 years now. Oregon isn’t alone, however. At least 25 states have debated similar resolutions.

There are also current efforts to gain support for renewing discussions on such restrictions on a national level. To date, the petition has over 135,000 signatures and just passed 100,000 only two days ago. It asks potential signers to join them and:

“25 national civil rights organizations in calling on TransUnion to stop its sale of credit reports to employers.”

A suggestion for employers:

As an employer myself, I understand the temptation to use something like a person’s credit history to determine their responsibility – especially if that person will be handling company finances in any way.  But you have to be careful not to rely too heavily on these things without the proper context.

Using credit scores to create a minimum requirement (as opposed to deeper analysis of credit reports) leads to such a lack of context. There are a number of acceptable reasons why a persons score doesn’t accurately reflect their responsibility with money: lack of history, recent loss of income, identity theft (to name a few).

If employers are going to do a credit check on candidates, they need to be able to properly analyze the complete reports to get a better idea of what may have caused a poor score. If you understand what you are looking at, you should be able to pick out those whose credit scores are low through no fault of their own. And who knows, if employers used credit reports more responsibly, and not punish those who’s poor credit is no fault of their own, people wouldn’t be calling for a ban of the practice.

Advice for job seekers:

While it can sometimes seem like an unfair requirement, it’s not as though there’s nothing that can be done about it. Be proactive about your credit history:

• Check your own credit reports first for errors or blemishes
• Pay down credit cards and other revolving debt as much as possible
• Establish a positive credit history – no time like the present!
• Get current on bills and make payments on time

Is it ethical?

I’m torn.

While it’s hard to defend those who misuse credit scores and reports for employment decisions, that doesn’t mean I believe it can’t be used responsibly.  There are circumstances where credit reports can provide a telling sign that a person is not responsible enough with money to be trusted to handle it.  But what we can’t allow, is for a system that makes those with debt (of any kind) at a general disadvantage for getting out of debt.

That is a huge problem.

I was having coffee with a friend of mine the other day and she was telling me how she saved over $200/month by taking the train into work.

“How frugal of you.” I complimented.

But she did not look like a person who had just received a compliment. Not at all. Instead there was a confused anger to her face as if I’d just insulted her in a horrible way. “I’m not- FRUGAL, you know!” She finally spat at me.

She obviously misinterpreted what I meant. But more confusingly: since when did people get offended by being called frugal? It’s supposed to a good thing!

Frugal doesn’t mean cheap

After we cleared up our little miscommunication, it became clear she thought I accused her of being cheap. “On the contrary,” I suggested. “I mean it as a compliment. It’s wasteful for you to drive to work every day. What you’re saving could pay for your car! That’s not cheap, that’s smart. It’s frugal.”

It got me thinking, too, about the difference between frugality and cheapness:

• A cheap person doesn’t see value in spending money. A frugal person can.
• A cheap person would buy the least expensive car that can get him from point A to point B.
• A frugal person would buy the car that’s going to get him from point A to point B for the least overall cost, taking into consideration longevity, maintenance fees, gas mileage, etc.
• Frugality is thoughtful, cheapness is stingy.

Frugal means stretching all your resources to their fullest

Being frugal is less about how much money you spend and more about how far you can stretch each dollar. It means getting the most out of all purchases, possessions and resources.

Just like my friend is doing. Not only is she saving a ton of money on gas and parking each day, but by not using her car for her daily commute it’s going to last longer and retain its resale value better, too.

Believe it or not, her commute is actually quicker too (usually). So she can even sleep later and gets home earlier each day. That’s frugality at its best, because guess what: time is a precious resource.

Frugality isn’t just about the savings

Savings isn’t the only thing that’s important to a frugal minded person. Putting your resources, money, and time to work for you is also a part of it. It could be renting out an extra room or apartment. It could be paying down debt or investing with extra cash. Or it could be getting a second job or starting a small business with your extra time.

Frugality isn’t limited to your costs, it’s also about your income. It may be less expensive to make your own candles at home, but if you could spend the same time making some extra cash (more money than you saved by making candles), you’re better off buying store bought candles and using that time more wisely.

Frugal is efficient

Frugality is also about improving efficiency. That often includes initial investments for future returns.  Investments that can and will pay for themselves through a greater efficiency.  Not only from a resources standpoint, but also financial efficiency.  For example:

When I bought my house, it had an ancient oil furnace, and an aging electric water heater. The first thing I did was switch to a natural gas furnace. Not only was natural gas less expensive, but the new burner was tremendously efficient. Next, I switched to a tank-less hot water heater (also gas) that only heats the water as I need it. Not only does this mean endless hot showers (if we need it), but it means efficiency of not having to keep a tank of water heated 24-7 (which is particularly expensive in the winter). I spent a total of $6000 between the two. But I average between $100 of savings per month (closer to $100 today with the price of oil). That was 3 years ago…by now I’ve saved over $2000. Both will have paid for themselves within another 5 years.

Frugal is responsible

Being frugal is not exclusively a short-term mindset, either. It’s about considering all the implications of your financial decisions, both short and long term. A frugal person considers retirement, saving for future purchases, paying down principal debt for interest savings, future value of assets, and diminishing value of disposable purchases. Through considering the factors of each finds the best way to allocate their funds for maximum possible benefit.

Frugal responsibility also means being diligent about goals and financial responsibilities. It means paying bills on time, being organized, and (most importantly) well informed. There’s few things more wasteful than irresponsibility, particularly when it comes to finances.

Waste is the antithesis of frugality.

With the current housing market there are not a lot of people buying, but things are starting to look up. If you are looking to buy a house then now is a good time because prices are down low and you could get a great deal on a nice house. There are many people that just don’t think they can afford to get into a house because of many of the upfront costs on top of putting money as a down payment. There are ways around this though if you really want to own a home and one of the best things you can look into are FHA home loans. With these types of home loans there are many different options available to help you out, sometimes you can even get into a new home with no down payment and still get a nice interest rate. These 15 blog posts discuss FHA home loans and some of the benefits from them. There is also some info in here that discusses FHA home loan modifications if you already own a home but are having trouble keeping up with your mortgage payments.

• FHA Loan Resources – A State by State Listing – Here is a nice resource with State by State listings regarding FHA home loans and how you can get started obtaining one. This site has a lot of other good info on the topic as well and is easy to navigate.
• FHA Home Loan Information – Here is another great breakdown of FHA home loans and many of the different options you can find as well as how these all work.
• More Information on FHA Loans – FHA Home Loans are a great option for borrowers who have less than perfect credit, are seeking a small or no down payment loan.
• FHA Home Loan Resources and News Blog – Another FHA resource blog with lots of great info regarding FHA loans, this page links to State guides and the rest of the site has great info and news.
• Federal Housing Administration (FHA) Resource Center – Here is a comprehensive guide to up to date news and resources all about the Federal housing Administration and FHA loans.
• Understanding FHA Loans – FHA loans are just like any other types of loans when it comes to the confusion they can create, here is an article and a website that can help you better understand how these types of loans work when buying a house.
• FHA Home Loans Information and Mortgage Resources – This is a nice Squidoo lens related to FHA loans and has a nice collection of helpful and educational articles on the subject to help you better understand the process.
• FHA Loans: Acceptable Sources For Down Payments – When getting an FHA loan, it is common for one of the biggest questions to be about the (currently) required 3.5% down payment.  Many people have questions about what is or what isn’t allowed when it comes to rounding up the 3.5% down payment that is required.
• FHA Home Loans on the rise – The Federal Housing Administration is continuing to step up in an ongoing effort to help borrowers with less than perfect credit achieve the dream of purchasing a home.
• Avoiding Foreclosure – the Obama Administration has implemented a number of programs to assist homeowners who are at risk of foreclosure and otherwise struggling with their monthly mortgage payments. The majority of these programs are administered through the U.S. Treasury Department and HUD. This page provides a summary of these various programs.
• Loan Modification Resources – This blog is totally dedicated to saving your house if you are facing financial troubles and heading towards foreclosure.
• An FHA mortgage modification can help you – In July 2009, the Federal Housing Administration (FHA) launched the FHA Home Affordable Modification Program (FHA-HAMP) to provide assistance to borrowers with FHA-insured loans who are unable to meet their mortgages payments.
• Loan Modification FAQ – Here are some of the most commonly asked loan modification questions. The answers on this page will make understanding the mortgage modification process easier and more straightforward.
• Mortgage Refinancing vs Mortgage Loan Modification Programs – This article helps you figure out if you are better off with a home loan modification or refinance your house. Both ways have their pros and cons as with anything.
• Mortgage Resources – here is a great resource for all things related to your mortgage and answers to almost every question you may have can be found here.

Yesterday, Hidden Credit Repair Secrets posted the above credit score advice on our Facebook page. He suggested that closing old credit accounts could negatively affect your credit score so you shouldn’t do it. While there’s nothing necessarily incorrect about this advice, like most things, it’s not quite that simple. And sometimes it’s advice like this leads to a misunderstandings about credit scores and results in irresponsible practices for what amounts to minimal gain.

Understanding what credit scores are looking for and how they are calculated (like length of debt history) can help you understand why and how much closing an older account can hurt you. It will also empower you to make more well informed decisions about your credit and can even help minimize any negative effects of otherwise harmless credit account decisions.

FICO score calculation:

• 35% Debt History
• 30% Debt level*
• 15% Length of Debt History*
• 10% New Debt
• 10% Type of Debt

*Can be effected when you cancel a credit account.

Credit limit vs. utilization

Let’s take on the second part of the advice first, because it’s a bit simpler to understand and can have a more direct impact on your credit score:

“If you close a 10 year credit card account with a nice limit…your overall available credit will decrease, which will also drop your score.”

It’s not the available credit that’s important, it’s the ratio of outstanding debt in relation to your overall available credit that credit scores use. It’s recommended to keep your credit utilization under 30% of your available credit with an optimal rate under 10%. The lower the better.

In other words, a person who keeps no outstanding balance on their credit cards has nothing to worry about. For others, suddenly losing a chunk of available credit can increase the ratio and hurt your score. Here’s an example:

Dave has 2 active credit card accounts, each with a limit of $10,000 ($20,000 total); one card has no balance, the other has a balance of $5,000. That means the current utilization is 25%, which is not bad. But if suddenly Dave cancels the first card, his utilization jumps to 50%, which is bad. But even if Dave pays off the debt, he now has less leeway for utilizing credit without hurting his score (about $3000).

If consolidating cards is the intention, getting the one account to increase your available credit for closing out the other is ideal (banks will do this). Adding another new card to regain more available credit would only lower your ‘new debt’ part of the score as well. If you do decide to close out a credit account and don’t get the adjusted credit offer, keep a lower balance of debt or your credit score may suffer.

Still the effect is minimal for those with good to excellent credit. This is much more of a concern for those who are trying to repair a poor credit history.

Length of debt history

Now for the first part of the advice, which is usually why it’s suggested to keep older credit accounts active: length of your debt history (15% of your FICO score).

“If you close a 10 year credit card account with a nice limit…your overall length of credit will decrease, which will drop your credit score…”

When you close a credit account, it stays on your credit reports. For some agencies, it stays longer than others. According to Experian:

A closed account with no negative information in its history will be deleted 10 years from the date it is closed. A closed account with late payments in its history will be deleted seven years from the original delinquency date of the account.

In other words, even if you closed your oldest account, you still have 10 years before it’s removed from your credit report. 10 years is a long time to continue to build credit. In fact, because you can have a nearly perfect credit score with 10 years of credit history, getting rid of an old account probably won’t hurt you much if you continue to build a positive credit history in that time.

Credit scores are more interested in your most recent activity. Activity older than 10 years isn’t of much use to creditors, so even with the length of debt history part of the score, such accounts will offer minimal gain (if any at all). And if there are blemishes on the account, it’s usually better to get it off your credit reports.

It’s not just your longest running account that’s taken into account, however. Average age, and how recent the activity is also part of the calculation. In other words, even if you hold on to an old credit card, if it’s never used, it isn’t helping much. Also, the more old accounts you have on your report, the more stable your average age will be if you remove one.

Other things to consider:

Why are you canceling the account?
It’s probably not worth a second thought about the minimal potential damages to your credit score 10 years down the road if, for example, your credit card suddenly charges you a monthly fee or you’re otherwise looking for a better offer. And even if you’re just trying to simplify your life by consolidating credit cards to a single account, you might never feel any negative effects, so it may not be worth keeping account(s) open just for the sake of keeping an account open.

“Paid, Closed/Never Late” account status helps your credit standing
Having paid/closed accounts isn’t just good, it’s something that’s actually expected to show up for anyone who is responsible with debt and has been utilizing credit for some time. Sure, you need to have open accounts currently in use as well, but closing accounts doesn’t actually “hurt” your credit history for 10 years. Until then, it actually helps.

Old accounts can sometimes be a liability
Having multiple credit cards can be a pain to manage. Even if you don’t use the account, you need to be sure the terms don’t change or strange charges appear on your card. If you don’t manage these things and they happen, it can be a much larger problem for your credit rating than closing the account could ever be.

What’s your credit history like?
If you have little history or have a shaky credit past with a number of blemishes, it may (in fact) be wise to keep older accounts. Losing what little positive history you have can then be the difference between getting a loan and not. If you have a robust, diverse credit history with few negative marks, you have little to worry about and any negative effects on your credit score will likely be negligible.

It certainly feels like this sometimes...

Last weekend, when visiting family for Easter, I overheard my younger cousin Kyle talking about a problem with his student loans. He complained that he’d been paying $200 per month for about 5 years and has only paid off $2000 from the original loan amount. “That can’t be right!”, he insisted. Unfortunately, it was.

What Kyle didn’t realize, is that most of his monthly payments have been going towards interest. In order to keep his monthly payment lower, he chose a payback schedules based on a 30-year loan. As a result, only a small fraction of each payment has gone towards paying down the principal.  This is typical with longer payment plans.  And after going over some numbers with my cousin, he now understands that by paying only a little more each month, he can pay off his debt quicker and cheaper.

Understanding the difference between Interest and Principal

It’s an important lesson for Kyle and anyone who ever considers taking out a loan. To fully understand what’s going on when you pay back a loan, it’s best to first understand the difference between interest, and principal:

Interest – is a fee you pay to a financial institution for borrowing money. Based on (usually) annual percentage rates (APR) of the principal balance.

Principal balance – is the remaining amount owed on a loan, not including interest.

Interest payment – is the amount of interest to be paid with each payment.

Principal payment – is the amount of each payment that goes towards paying down the principal balance of a loan.

Put more simply, your principal balance is how much money is still owed from the original loan, and interest is calculated as a percentage of that balance.   Most payments plans have a component of both interest and principal with each installment.  The interest portion decreases over time as the principal balance is paid down.

Calculating your interest payments

Knowing how much of your payments are going towards interest is the best way to illustrate what is going on when paying down debt. All you need is your principal balance and current interest rate on the loan. Let’s calculate the monthly interest payments for a $20,000 loan at 5% APR:

[Principal Balance * (annual interest rate/100)] / 12 months = Monthly interest payments

[$20,000 * (.05)] / 12 = $83.33

Using the above example, the monthly interest payment would be $83.33. So if the borrower was paying the loan back at $100 per month, less than $17 (per payment) would go towards paying down the principal balance. At first…

Paying down the principal balance

With each payment, even if you’re paying mostly interest for the beginning portion of a loan schedule, the principal balance starts to shrink. Faster and faster, too, as the more it shrinks, the less is owed each month in interest. This also means the more you pay each month, the faster your principal shrinks, the less you will pay overall in interest, and the faster you pay off your loan.  It’s essentially reverse compounding interest.

Let’s start by continuing the example above with $100/month payments:

Payment: $100/month
Interest payment : $83.33/month
Principal payment: $16.67/mo. * 12 months = $200

After a year, about $19,800 of the principal is still left. So when you recalculate interest payments, they only shrink by about $.80:

[$19,800 * (.05)] / 12 = $82.50

Pay-off time: 36 years
Total interest paid: $23,091.39

However, if the person instead payed $150/month payments: after a year, about $800 of the principal balance will be paid off:

Payment: $150/month
Interest : $83.33/month
Principal: $66.67/mo. * 12 months = $800

And not only will this person be paying down the principal quicker in the first place, but interest payments shrink quicker as well:

[$19,200 * (.05)] / 12 = $80.00

Pay-off time: 16 years
Total interest paid: $9254.26

Over time, the savings compounds itself as more of each payment goes towards paying off the principal balance… quicker.  Also, these examples only calculate interest once a year. If interest is calculated more often, this effect is magnified.

This is why the borrower paying $100/month will take about 36 years to pay off the loan and pay an additional $23,091.39 in interest by the end. And the borrower who pays $150/month: 16 years and $9254.26 in interest.

Lump payments

It’s usually a wise investment to make lump payments to pay down your principal balance when you can. Because suddenly the principal balance is reduced, interest payments drop and even lower monthly payments can contribute a larger ratio of principal to interest.

Let’s say our example borrower, who can only afford $100/month loan payments is given $5,000 at graduation. What would their payment schedule look like if that money was used to pay down their $20,000 debt?

• 1^st year interest payments: [$15,000 * (.05)] / 12 = $62.50
• Pay off time goes from 36 to 20 years
• Total interest savings of $14,502.83

If you do this, just make sure your extra payment goes towards the principal balance or your lender may assume otherwise.

My advice for my cousin Kyle: find a way to pay more each month.  Every additional dollar he can spare each month beyond the minimum payment plan (that he currently pays) will go towards paying down the principal balance of his loan.  It will mean he’ll pay it off faster, and save money on interest in the long-run.

Some of the estimates on this page were made courtesy of: Asksasha.com’s loan calculator

Image credit: Flickr

Why is gas so expensive? Everyone wants someone to blame: Obama, the greedy oil companies, increased demand from India and China… Does it really matter? Gas is getting expensive and it’s likely to be more expensive tomorrow.  There’s little that can be done about it.  That’s really all you need to know. And if you want to escape the clutches of rising gas prices, the best way for you to do that is to learn how to use less.

Photo Credit – http://www.flickr.com/photos/ejcallow/3823944464/

Take the bus

Any mass transit will do. Even a park-and-ride closer to home will save you a bundle on gas. This doesn’t just go for your daily work/school commute, either. Gas prices have gotten to the point where taking the bus, train, or even flying can be much more cost effective than driving longer distances, especially if you’re traveling by yourself. Leave your car at home as much as you can. That’s the idea.  There’s a nice

Carpool

Don’t be ashamed to ask a co-worker and/or friend to share a ride. In fact, it’s nice to have company especially during those longer commutes. For every person you add, you each practically cut your commute costs in half. Just make sure you’re schedules are consistent…

Work from home

Not everyone can do this, but even one day a week will pay you back over time. Another option for some might even be the 4-day work week. (4 10-hour shifts) Don’t be afraid to ask your boss if it’s possible. What’s the worst thing that can happen? Either they say no or you cut your commute costs up to 25% and even potentially have a 3-day weekend.

Move closer to work

Location, location, location. If you’re looking for a place or simply find yourself with an unnecessarily long commute, it’s a good time to think about living closer to work. If you drive to work 10 miles, both ways, 5 days a week, you’ll commute over 5200 miles per year. That’s the equivalent of driving from NYC to LA and back and still have enough left to drive down to Washington D.C. If you moved just 2 miles closer to work, you’d shave off over 1000 miles and save about $200 per year on gas.

Ride a bike

What can be better than saving money while getting a little exercise? Sure, you have to live relatively close to your work, with bike-friendly roads, contingent on weather and it certainly isn’t for everybody. But having done this when I have the chance during the warmer months, it’s actually something I started looking forward to around this time of year. I highly recommend it.  Just be safe!

Shop locally

Support local shops and stores, also support locally grown/made foods and products. Not only is your drive usually shorter, but locally grown and made foods (and other products) tend to have more stable prices because transportation costs are minimal.

Improve Gas mileage

Finally, if you simply must drive, it doesn’t mean you can improve on traveling and commuting costs. You simply need to think of ways to improve and optimize your gas mileage. There are a ton of great ways to improve gas mileage. Here are just a few of my favorites:

• Get a more fuel efficient car…duh!
• Keep your tires properly inflated
• Proper maintenance
• Avoid traffic/rush hour

Gas rewards programs

I love these.  My local grocery store and a close gas station paired up to offer this and it’s a win-win.  I saved $.40/gallon the last time I filled my tank, just for buying groceries I would normally buy anyways.  In fact, the more I cook at home, the more I save on both food AND gas!

What other Gas saving tips do you have?

Credit cards, when used wisely, can be a beneficial way to pay for purchases and even a helpful way to manage your finances. But when they’re abused, they can become money pits. A hole of crippling debt of which escape becomes increasingly difficult the deeper you find yourself. But among some of the ways to properly use a credit card, there are a number of things that should be avoided. These are the 6 most dangerous habits of credit card users:

Paying the minimum balance

What makes this habit so dangerous (other than high interest charges) is how unfortunately common the practice is. Making purchases on your credit card you can’t afford (even in an emergency) leaves you with a balance you can’t pay off in one shot. So when the monthly bill comes, that “minimum payment” starts looking really tempting just so you can keep some cash on hand. But unfortunately, with interest rates sometimes as high as 40% or more, it becomes a trap.

What you should do instead: if you can’t pay off the balance in full each month (which is optimal), pay off as much as you can afford to. Don’t leave a balance on your credit card for too long or you’ll end up paying more in interest than the original purchase before long.

Late/Missing payments

Perhaps the only thing worse than paying the minimum balance is missing a payment or making the payment late. Charges of up to $50 for late payments aren’t unusual. Add that to the high interest rates of credit cards and you’re looking at an expensive mishap.

What you should do instead: Don’t be late. Pay the minimum balance if that’s truly all you can afford in order to be on time, but avoid paying late fees at all cost.

Balance transfers to pay your bill

Credit card companies try to steal your business from other banks by offering low or zero interest on balance transfers. Many times, it’s only a temporary “introductory rate” which increases after the grace period. Some novice credit card users think they can use these offers to “beat the system” and not pay interest through a chain of balance transfers. Not only will this fail to work out the way you think it does, but it can also do irreparable damage to your credit score.

What you should do instead: If you have a balance on your card and are looking for a way to reduce your interest rates temporarily, low rate balance transfer offers can be helpful, but do it sparingly. And also make sure the post-introductory rates are better (or similar) to your old card or you lose in the long-run.

Cash advances

Drawing cash from an ATM machine or during a credit card purchase from your credit account is another common credit card pitfall. Not only are there usually charges from ATM machines as well as your credit card company (commonly known as double-dipping), but the interest rates for cash advances are generally higher as well.

What you should do instead: Get cash elsewhere. Cash advances from credit card accounts should be an last resort for getting cash…next to a payday loan.

Maxing out your card(s)

Believe it or not, maintaining a balance of more than 10% of your available credit on your credit cards can lower your credit score. So maxing out your credit card (or cards, in some cases) can be incredibly damaging to your credit history. Use credit cards sparingly and if you can’t seem to stop your balance from increasing month to month, it’s time to stop using credit cards altogether.

What you should do instead: Try to keep a balance of no more than 10% of your available credit at any given time. If you can’t, perhaps you should cancel your cards until you have the financial responsibility to do so.

Keeping multiple credit card accounts

I know too many people who do this. They have one credit card for “regular purchases” and one for “emergency use only”. I don’t really understand the difference. It’s also common for shoppers to have store branded cards that they only use for stores. Avoid doing either of these if you can. Part of your credit score is calculated on how many active credit accounts you have. So even if you have open accounts for which you never have a balance it could hurt your credit standing. Worse yet, even though you don’t use a card, the terms can change, sometimes charging fees for non-use. Then, when you don’t pay that balance, you get hit with late fees, interest, and a stain on your credit report.

What you should do instead: Consolidate your credit cards to a single account. Keep the card that suits you best: lowest interest rate, highest available balance, best rewards, etc. If you must insist on having multiple cards, manage them diligently even if they aren’t being used regularly.

Poor budgeting

Using a credit card wisely means knowing what you can and can’t afford. So perhaps the biggest pitfall for credit card users is those who aren’t managing their purchases closely enough. Spending more money than they have. This is the easiest way to end up in a crippling debt situation where you start to consider some of the above poor habits like maxing out a card, paying minimum payments, or balance transfers.

What you should do instead: Watch your purchases closely. Understand the costs of interest and fees associated with maintaining a balance and avoid it all you can. Don’t use your credit card to purchase items you can’t afford and you’ll be just fine.

Money is tough to hold on to for many people, especially when you have extra cash and see something that you want but really do not need. Money tends to burn a hole in your pocket if you keep cash on you all of the time. One of the best ways to cut down on unnecessary spending is to put your extra money away in a savings account so you don’t spend it. This will leave you with less money in your pocket on a daily basis and can help a bit to end splurge spending. It is easier said than done, especially with so many cool gadgets and toys available all over the place. These 15 blog posts offer some great advice on saving your money rather than wasting it.

20 tips to keep from spending money – It’s hard to say no to yourself when the urge to spend strikes, especially when you have money in your pocket. Here are 20 tips to help stop spending.
Stop Spending Tips & tools to help you fight yourself – here are more great tips from different people including some money saving experts, there is a lot on this page to read and following through with the advice can make a huge difference in your spending habits.
Top Ten Money Saving Tips From Stop Wasting Money – Here are some more excellent tips to help you stop wasting money, these are all great ways to achieve the goal you are working towards and can help you also get some extra money put away towards savings.
Money tips and financial advice to help you stop wasting money – Money is tight for many people these days due to the struggling economy, here are tips to help you save and recession proof your money.
9 Big Time Money Wasters and How to Avoid Them – This post discusses 9 things that can waste a lot of money and gives advice on how to avoid these things so you can save more money.
Stop Wasting Your Money on These 25 Things – There are many ways that people overspend on a regular basis. They include costs that could easily be avoided, or reduced, by customers willing to do some market research, shop around, or plan ahead.
Ten Ways To Avoid Financially Irresponsible Buying – In this modern era, we are surrounded by almost infinite opportunities to spend money – and an almost infinite number of enticements to take up those opportunities. Advertisements trick us into thinking our lives will be better if we just buy this one item.
The Upside of Being Cheap – Some great ways to save money while also helping out with other things such as energy consumption and more.
Stop Wasting Money: Seven Ways to Cut the Fat from Your Budget – Even more wonderful tips that can help you cut back on spending money on things you do not need.
Time is Money – So Stop Wasting It with These Helpful Tips! – Do you sometimes wonder where all the time went? Or wonder where the money in your bank account went at the end of the month? It may not seem obvious, but time and money go hand in hand, and not just for fancy jobs that make a lot of money. Time is money for all of us.
Find Out Where Your Money Goes to Avoid Wasting More Of It – Most of us are not aware that the little amounts of cash we spend each day are actually huge when we total it each week or month. This makes us wonder where all our money goes, once we find that we’ve run out of cash even before the next payday arrives.
Stop Wasting Money Today – “Most people aren’t aware when they’re wasting money,” says Jeanna Bridges, Market President with BMO Harris Bank. “So the first step is becoming conscious of how much you’re spending and what you’re spending it on.”
25 Ways You Are Wasting Your Money – Getting out of debt is NOT hard. True, it does take time, patience, and discipline, but it’s not really that hard. Usually, all that is required is just changing your spending habits.
Stop Wasting Money – Another post with tips and tricks to help you stop wasting your hard earned money.
Stop Wasting Money Page on FB – This is a great Facebook page that is always updated with advice and tips on saving your money instead of wasting it, well worth a like if you are on FB.