Today that changed.

An article from CNNMoney.com (via Yahoo!) helped to clear up some of the confusion. The article actually breaks down how a credit score is calculated. Here’s a graph from the article:

It wasn’t clear to me if this graph covers ALL the factors in calculating a credit score, but it probably represents the most important factors. One clarification CNNMoney makes is that you should keep your debt utilization ratio under 10% if possible. It should never go higher than 20%.

I encourage you to read the whole article, but here is a summary of the most important factors in how your credit score is calculated and what you should do to keep your score healthy.

1. Don’t make late payments (specifically over 30 days late).
2. Keep your debt utilization ratio at ideally under 10% and certainly no more than 20%. This applies to any given credit account as well as looking at your debt for all accounts.
3. Try to occaisionally use older credit cards so they don’t close the account on you. Older credit carries a greater positive weight in calculating your score.
4. Opening new credit accounts tends to lower your score. Still no specifics on how much it lowers your score.
5. The type of credit account you open has an affect on your score. While the CNNMoney article didn’t mention specifics, we know from my previous post that you should try to avoid opening accounts for retail and gas credit cards.

The article also listed a couple of resources that I haven’t had a chance to thoroughly check out, but that look useful.
Card Ratings.com
CreditKarma.com

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The most interesting point for me was the fact that many credit card issuers are closing accounts that haven’t had any activity for a while. If these accounts get closed, the article points out, it could have a negative impact on your credit score. That’s because it would cause your utilization ratio, the amount of debt you have incurred compared to the open credit available to you, to go down which could cause your credit score to decrease. It would cause a similar affect to a credit card issuer decreasing your credit limit, which apparently happened to several million credit card holders fairly recently and which I wrote about just last week (see Credit Card Companies Adjust Limits: Credit Ratings May Be Affected. Frankly, I’ve tried to shut down some old credit card accounts before, yet they keep showing up on my credit reports. I’d be happy if they shut them down.

A couple of the points in this article didn’t explain at all how they affect your credit score. For example point #2 talks about paying off your lowest balance credit cards first. While this is a solid debt re-payment strategy, how does it affect your credit score? Point #3 says that sometimes it can be worth it to use a credit card with an annual fee. Ok, and how does that affect your credit score?

Here’s one of the seemingly conflicting pieces of advice. You want to have many open credit card accounts to increase the amount of unused credit available to you, yet opening up a retail or gas credit account actually counts against you when calculating a credit score. So I guess you don’t just want any credit lines.

If you don’t want to take the time to read the article, here are a few general take-aways:

1. Having available, unused credit has a generally positive impact on your credit score, unless the credit comes from retail or gas cards.
2. Using your credit cards occasionally will help keep your accounts from closing and maintain a high utilization ratio, which is a good thing for your credit score.
3. Consolidating multiple cards to one card can be risky if you come close to maxing out the card. Apparently that doesn’t look so good to the credit reporting agencies although the article doesn’t mention how close to the max is too close.
4. The length of time you’ve had a credit card account can help to increase your credit score. The longer the better. So I guess I shouldn’t want to close those old unused accounts after all.
5. Try not to max out your limits on one card. Instead, it’s better to charge a little on multiple cards. Apparently the credit bureaus calculate your utilization ratio on each individual card. This is a squishy one and there are no recommended limits to stay within.

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If you’re looking to borrow for a home or car, you may want to check your current score by checking the credit reports that you can get for free. A 20 point drop is enough that you may not qualify for the same rates as you could before.

Read more about this study at USA Today.
Download your free credit reports here.

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Becoming a black belt and having a “mind like water” in your personal finances is very similar. It means you can take whatever is thrown at you without knocking your finances out of control. You can respond to any situation with perfect balance. Unexpected events or changes in your finances, good or bad, can be handled with optimum efficiency, and little or no stress. It means you can direct the flow of money where you need it almost effortlessly.

In an effort to help people gauge where they are in their personal finance development, I’ve defined what people at the various “belts” might look like. Where are you?

White Belt

You’ve recognized there is a problem with your finances and have committed to taking control. Recognition that there’s problem may come as a nagging doubt that you’re not meeting all your financial goals or a harsh reality check as you face mounting debt. You have a lot of stress concerning finances (even if you’re living within your means). You tend to fight with your spouse every time you discuss financial matters. You recognize your spending isn’t in line with your true values. You have no idea where all the money goes from month to month. You may be living paycheck to paycheck. If you saved $5 on your phone bill, it would just disappear somewhere but you don’t know where. Your idea of an emergency fund is a credit card or Home Equity Line of Credit. You frequently pay late fees on your bills and unnecessary bank fees. Net worth? What’s that?

Despite your lack of financial control, you have a strong resolve to take action even though the thought of facing the “deep mess” of your finances seems overwhelming. You and your spouse have agreed to work together. In an effort to get your spending under control, you’ve started using cash for your “out-of-control” budget categories. You’ve stopped using credit cards somewhat reluctantly and possibly out of the sheer pain of your dire financial straights. Despite some complaining, your family has agreed to use cash as well. You’ve taken initial steps to figure out what your basic monthly income and expenses are and have tried budgeting for at least one month even though it doesn’t match reality yet.

Most importantly, you’re no longer willing to BE IN DEBT!

You’re no longer willing to constantly WORRY ABOUT MONEY!

You’re no longer willing to FIGHT ABOUT MONEY!

You’re no longer willing to PAY LATE FEES!

You’re committed to TAKING RESPONSIBILITY FOR YOUR FINANCES!

You’re committed to WORKING THROUGH FINANCIAL ISSUES TOGETHER WITH YOUR SPOUSE!

White belts come in many shapes and sizes. Of course, those steeped in debt and on the verge of bankruptcy can be white belts, but so can those who are living within their means (see below). Being a white belt means you don’t have total control over where your money goes. Your spending doesn’t reflect your true values and is not conscious. The white belt is about recognition and commitment. You’ve recognized a need to change and are committed to doing what it takes to change.

Green Belt

You’re well under way implementing your financial-management plan. You’ve budgeted for at least 3 months in a row and have worked many of the kinks out. Your budget actually reflects reality.

You meet with your spouse about every two weeks to keep things on track. You often have to implement the 30-minute rule and meet several days in a row to prevent total melt-downs.

You’ve taken all credit cards out of your wallet and are using cash for all of your “in-person” spending. As a result, for the first time you feel like you have control over your spending. You’ve even started developing your own unique ways of managing your cash and have a tendency to give spontaneous testimonials about the virtues of cash whenever someone acknowledges your use of a cash envelope.

You’re well under way saving for a short-term emergency fund. You may not have it fully funded yet but you already notice feeling much less stressed having at least something in place. For the first time in your life, you may have even experienced an emergency and had the money to pay for it. You have created an initial net worth statement and have a general idea about your overall financial status.

If you saved $5 on your phone bill, you could probably redirect it rather than letting it disappear. You no longer pay late fees or bank fees. If necessary, you’ve made major changes in your lifestyle to ensure you can live well within your means.

Brown Belt

You’ve been on a zero-based budget for over 6 months and things are really humming. You may have occasional refinements, but things are mostly on cruise control. You’re able to manage your finances on one meeting a month and are able to get through most meetings without any arguments.

You’ve gone through at least one set of envelopes. You find that you’re keeping the cash envelopes the bank gives you when you cash a check or make a withdrawal because they are a better size than regular envelopes.

You’re friends have started noticing that you pay cash all the time and have asked you about it. You find yourself preaching the cash gospel and sharing your success whenever you can.

You have a fully-funded short-term emergency fund and have started reducing consumer debt or increasing retirement savings. You have a strong sense of control over your finances and can see significant improvement every time you refresh your net worth report (which you do at least once a quarter). You and your spouse have reconciled your financial differences and have a new-found sense of unity when it comes to finances. You’ve created a list of rules concerning what you both consider to be an emergency as well as what you want to do with any unexpected windfall money. By making these decisions ahead of time while you’re calm, you avoid big arguments when these events occur.

Black Belt

You laugh in the face of emergencies (mua-ha-ha) and can easily and confidently deal with anything thrown at you. Seriously, for all practical purposes financial emergencies don’t really exist for you any more. If you save $5 on a phone bill, you’re financial system allows you to know about it and easily redirect it exactly where you want. You have complete financial control over every dollar.

You no longer worry about finances. Instead of worrying about how to pay the bills on time, you think about what investments to make or which debt to pay off next. You’re amazed and shocked that people even pay late fees (you obviously are having a bout of selective amnesia). You are aggressively on track to pay off all consumer debt and/or save for retirement. In fact, sometimes you find it hard to spend extra funds because you’re so excited to become debt-free that you want to reduce your debt instead.

You finally feel like where you spend your money is a reflection of your true values. You and your spouse see eye-to-eye concerning finances. You only have major financial discussions when your financial situation changes dramatically.

You not only calculate your net worth quarterly, but also have calculated when you’ll become financially independent.

You kind of wish you’d get fired so you could find a job you really like (you have a full emergency fund and could get by for 3 to 6 months without any income). You only have to spend about 30 minutes a month on average managing your finances. You’ve cut up all your credit cards because you just don’t need or want them anymore.

Your belt level isn’t about debt, savings, or your net worth.

Some of you may have noticed that my description of the belts didn’t include savings percentages or require you to be debt-free. Your belt level isn’t about debt, savings, or your net worth. It’s about your ability to control your money, ensuring that each dollar is directed where you want. I’m sure I’ll get a lot of flack for saying this. Of course, savings and debt elimination are cornerstones of a solid financial foundation. But to enable you to save and pay off debt, you first have to get a handle on your inflows and outflows. As you gain greater levels of financial control, you can easily reach your savings and debt-reduction goals at an ever-accelerated rate.

The good news is, you can become a financial black belt even if you still have debt or haven’t reached your long-term goals. Of course, if you are a black belt, it won’t be for long before you do. As you progress in your career and get raises, or as you receive windfalls, you will be able to direct those extra funds with great focus and power to eliminate debt and reach your long-term goals. That’s the power of a black belt.

Take your finances to an “11″

I can’t avoid referencing this segment from This Is Spinal Tap. If you haven’t seen it, you should take a look.

I know many people who live within their means, pay off their credit card bill every month, and think they have arrived in terms of financial management. But the fact is, you can do these things and still be a financial white belt. I know this for a fact because I’ve been there.

There was a time when our income greatly exceeded our expenses. We saved ten percent and gave to our church. We also lived large and bought just about anything we wanted and were still living within our means. For the most part, we just accumulated a bunch of “stuff” and made a lot of emotional, at-the-register purchases. As we look back we kick ourselves for not using that money in a more conscious way. Had we been financial black belts, we could have greatly accelerated our journey to financial independence. Today, even though we have downgraded to a single income and increased our expenses (mortgage, child), we are doing more with what we have now than we did with two incomes, no children, and low living expenses. As a result we have been able to reach financial goals with tremendous speed and ease.

I’m not saying you have to choose between having fun with your money and saving it for later. As a black belt, you can set aside funds for frivolous spending and still aggressively meet your financial goals. The key is to spend consciously, making decisions as they relate to your values and your finances as a whole. If you plan wisely, you can have the best of both worlds.

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Q: what do you think about not spending anything on credit cards? everyone else is in trouble so why not use cash only!”

For the past few weeks I couldn’t get this statement off my mind. It’s one thing to have a strong position . It’s quite another to insult those who follow a perfectly legitimate and arguably superior system of financial management.

To resolve this issue, or at least let the blog-reading community decide for themselves, I challenge Ramit to a good-spirited showdown: Credit Cards vs. Cash. Ramit can present the credit-card arguments and I’ll present the cash/debit arguments. The readers on each side can also chime in. I read a similar showdown about productivity a while back and thought it was useful.

Please leave a comment and let us know what questions or views do you have about credit cards vs. cash? What questions would you want to see addressed if a showdown takes place?

If Ramit accepts we’ll decide the terms, time, and format. Let’s have Ramit express his spirited feelings in a more articulate and useful way.

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One of the first steps of sound financial management is tracking your spending. Once you track your spending and are able to see where the money goes, it’s easier to attempt to control your spending. How can you control something when you have no idea what it is you need to control? The bottom line is, tracking your spending goes hand in hand with controlling it.

Tracking, but no control

However, despite the wonderful resources available to track your spending, it still seems to be out of control for most people. Money management programs such as Quicken and MS Money are great tools to help you track your spending. In fact, electronic methods of payment such as debit and credit cards are also great at helping you track your finances. Every transaction can be easily downloaded or viewed. But if these tools are so wonderful at tracking expenses, why are most people’s finances out of control?

Despite the ease of tracking spending using credit cards, credit card debt is rampant. Americans carry, on average, $5,800 in credit card debt from month to month (www.cardweb.com). The Federal Reserve states that, on average, the typical credit card purchase is 112% higher than if using cash. It seems the convenience of using credit cards makes it a little too easy to spend money.

Control, but no tracking

On the other side of the fence are cash and check transactions. While spending with paper currency gives you a higher degree of control (especially cash), it’s a pain to track. Nobody enjoys balancing their checkbook, compulsively saving receipts, or entering expenses into a spending notebook.

The secret to tracking and controlling your spending effortlessly

So what’s the solution that will allow you to track what you spend and maintain total control over your spending? The answer is CASH.

“What? Cash? I thought you just told me that cash is a pain to track? Plus I LOVE the convenience of my credit card.”

Ok, before you blow me off, just hold on for one more minute. I’m not saying that ALL spending needs to be cash, just the categories that are out of control. As my wife and I worked out our financial plan we realized there was a very small set of categories that were out of control. These will vary from person to person but our hard-to-control categories were:

o Grocery

o Household

o Eat Out

o Clothing

o Personal

This is by no means an exhaustive list. Figure out your own hard-to-control categories and you’ll know which ones you should use cash for. Your other expenses will be dealt with separately and I’ll explain how you should manage them in another post. As a first step, we just want to get these categories under control.

So, here are the steps to tracking and controlling your spending effortlessly. And the great news is you can start it TODAY!

1) Identify which categories are problematic (you tend to overspend).

2) Commit to not buying ANYTHING in that category with a credit card.

3) Go to the bank and withdraw the amount you think you will or should spend on the category UNTIL THE END OF THE MONTH.

4) Put that money in an envelope and write down the date, how much you took out, and the category. To simplify things you can just write this information on the envelope, but feel free to record it in any trusted place.

That’s it! Financial peace has just been achieved. Well, not quite. One of two things will happen. 1) You won’t spend all the cash and will have money left over at the end of the month or 2) you will spend all the cash before the end of the month and need more.

If the first scenario happens, great! Keep the money in the envelope and just add to it at the beginning of the next month. On the other hand, if you spend all the money and need more, don’t stress! Just go withdraw the additional cash that you think you need for the rest of the month and record it on the envelope.

Either way at the end of the month you will now have an idea of how much is needed for that category and will be able to estimate next month’s amount more accurately. Don’t worry about getting it exactly right for now. It will typically take doing this for about 3 months until you have a really accurate estimate.

Even then, these problematic categories are problems because they tend to fluctuate so much. If you’re tight financially, this is a great time to see if what you think you’re spending is in touch with reality. It’s also a perfect way to control your spending by deciding before hand how much you really think you should spend on that category. Just like they always taught me in Sunday School, it’s important to decide ahead of time how you’re going to respond in tough situations. Similarly, you should decide how much you want to spend BEFORE you’re standing the grocery aisle trying to justify purchasing that extra bag of cookies.

Now, if you already track your spending electronically (e.g. in Quicken or online) you should be able to make very accurate estimates from the get go. If that’s the case, great! Your just one step ahead and this process will be a little easier. Even so, you may have trouble tracking some spending such as single transactions that cover multiple categories. Wal-Mart is one of the biggest offenders. I can’t tell you how many times, in the name of tracking every penny, we agonized over a Wal-Mart receipt trying to determine which portion was grocery, household, medical, etc.

Goals of the process

While going through this process there are a few goals you should work towards.

1) Figure out how much you really spend.

2) Make your spending habits more conscious.

3) Control your spending.

Figure out how much you spend (get in touch with reality)

One of the huge benefits of going through this process is that over a few months you will get a very accurate idea of what you spend with very little effort. One thing many of you will have noticed is that you won’t have a perfect “to the penny” record of what you spend. Rather, you will just know the total amount you spent for the month. Enjoy this fact. Enjoy the freedom, the need to not have to calculate every single transaction. You just open the envelope and if there’s money you can spend it.

At the end of the month it will be very clear if you didn’t budget enough; your envelope will be empty and you will feel like you just didn’t have quite enough.

The analytical crowd may cringe at not tracking every cent but let me ask you, what’s the benefit of tracking every penny versus the total amount? There are very few situations in which it really matters. These days, most of the expenses will be at Wal-mart anyway. The goal is really just to get an overall amount that you tend to spend. By not tracking every penny we will still have an accurate budget but it will be accurate on a summary level rather than a detailed level. As we address your non-cash expenses you’ll see that you WILL know how much you spend every month to the penny but you won’t necessarily have a record of WHERE you spend your cash expenses.

Now I can still see the analytical people out there still cringing. If you REALLY want to track every single purchase, go ahead. If you really have no idea where you’re spending your money, it would be very useful to see where it’s going. If you currently use credit cards you can just look at your statement. Otherwise, feel free to keep receipts and enter them into a notebook or Quicken. In fact, my wife and I had used Quicken faithfully for years so we already knew where we spent our money. Most people have a pretty good sense where the money goes. They just need a way to control the outflow.

Make your spending habits more conscious

Really the goal for now really isn’t to reduce your spending, although for most people that will be a natural result. Instead, you just need to make your spending more conscious. Don’t just pull out plastic and not worry whether or not you have the money.

One great thing about cash is that it’s very tangible. Most people have a visceral reaction to spending cold hard cash. It can be hard to see those Georges sniff, Hamiltons (baby) sniff-sniff, and Franklins triple-sniff fly out the window. Plus it’s a very visual medium. An empty envelope definitely sends a signal that credit cards simply can’t duplicate. I can’t tell you how many times I told myself I’d pay with a credit card and just worry about where the money would come from later (I only did this in a previous life, of course).

Control your spending

Notice that I said “control” your spending, not “reduce” your spending. The main point right now is to simply control what you spend. Decide ahead of time how much you are going to take out; how much you think is reasonable for that category. By making that conscious decision you have already increased your chances tremendously that you won’t overspend. If you run out, you will have to make a very conscious decision whether or not to withdraw more. True, it’s not as convenient to withdraw more many than just using a credit card. And that’s exactly why you won’t spend the 112% more that I mentioned earlier.

Credit cards in their place

By promoting a cash-based spending system, I’m not saying credit cards are bad or evil. I used credit cards for years and paid off the balance each month. I still carry a credit card with me for emergencies and reimbursable business expenses. If fact, I actually work for a company that provides merchant accounts (the ability to accept credit cards) to small businesses.

However, the very statistics I use to promote credit card acceptance at work proved to be the reason I decided to stop using them for most purchases. At our company we constantly pitch that customers spend 2-3 times more when paying with a credit card versus cash or check. While this is a great way for a small business to grow their sales, it’s also happens to be a great way for you to grow your expenses. Credit cards are like that kid telling your first grade son potty jokes; they just aren’t a good influence on your personal finances.

What about debit cards?

Debit cards play an important role in managing your finances and will be discussed in later posts. Debit cards combine convenience with a more responsible approach to spending; the money has to be in your account or you can’t spend it. They are great for expenses that don’t vary much. In fact, we used to pay for gas with cash but after a while we realized that we didn’t really reduce our spending by paying with cash and it was a LOT more inconvenient having to walk into the convenience store. The bottom line was that I didn’t drive to work less because I was paying with cash so it made sense to use the debit card.

Give cash a “30 day trial”

So here’s the challenge. Try this today! Try it for a month. You’ll be surprised at the insights you gain. Sure it’s a little more inconvenient but one of the ultimate benefits will be stress-free financial control and you probably wouldn’t be reading this if that weren’t attractive to you. I encourage you to take a look at Steve Pavlina’s article on the 30 day trial concept. It would be a great approach to get your finances kick started.

Please post your comments and experiences as you try this out. If you happen to already use cash, let us know how you manage it physically (via envelopes or some other way).

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