First 4 digits of a credit card

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When people pay off debt, many of them rush to close credit card accounts. Indeed, the process can be quite therapeutic. You pay off a credit card, and, to celebrate your freedom from the chains of the debt (and being on the wrong side of compound interest), you cut up the card and cancel the account.

Unfortunately, this may not be the right thing to do — at least as far as your credit score is concerned. If you are interested in maintaining your credit score, you might want to think twice before canceling that credit card. Your credit could be damaged by a canceled credit card account.

What the Credit Industry Really Wants

You know that in order to get loans at a decent interest rate, you need a good credit history. However, the credit system is not set up to reward responsible financial behavior. Instead, the credit system is set up to reward the use of credit. The main goal of the credit industry is to encourage you to get in a position where you are carrying debt so that you pay interest, but not so that you are in over your head. Credit card companies want you to be able to pay.

Canceling a credit card does not help the credit industry, and so there is a way for you be penalized for making such a move. Remember: To a credit card company, the best customer is not someone who pays a balance off every month. The best customer is someone who carries a balance that he or she can make payments on without going financially under.

Canceled Credit Card = Lower Credit Score

For most of us, playing the credit game is a necessary evil, especially since it’s not just mortgage lenders looking at your credit score. Some insurers will quote you higher rates if you don’t have good credit, and some employers might want a credit check as part of background screening. It may not be fair or right, but it is reality.

When you cancel a credit card, something happens to what is known as your credit utilization. Your credit utilization is a representation of how much of your credit you are using. It accounts for about 30% of your credit score. After payment history, credit utilization is the most important aspect of your credit score.

Let’s say you have three credit cards with a combined credit limit of $12,000. For simplicity’s sake, we’ll say that you have a $4,000 limit on each card. You are carrying a balance on two of the cards, $1,500 on each card, for a total of $3,000. At this point your credit utilization is 25%, which isn’t bad. In fact, anything in the range of 20% to 30% is considered just fine, and doesn’t really affect your credit score negatively. (Of course, for your own personal finances, it would be best to have 0% credit utilization, but the credit industry doesn’t actually want that.)

However, if you cancel the credit card that you don’t have a balance on, the whole equation changes. Now, instead of having three credit cards with a $12,000 limit, you only have two credit cards with a combined limit of $8,000. Suddenly, that $3,000 you still have as a balance represents a credit utilization of 37.5%. You are moving into dangerous territory as far as your credit score is concerned.

When to Cancel Your Credit Card

Of course, your credit score can recover. However, it is a good idea to consider waiting to cancel your credit card. Your best bet is to wait to cancel your credit card until the following conditions are met:

  • You have paid off your other credit cards as well.
  • You don’t plan on applying for credit (especially a home mortgage) in the next six months.
  • You are unlikely to have a major life change, such as switching jobs, in the near future.
  • You’re insurance premium for the next six months has just been established.

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Credit cards

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One of the things you have to be wary of when using credit cards is falling into the rewards trap. As credit card offers start reappearing in mailboxes, it can be tempting to get a shiny new rewards credit card. After all, credit card rewards can provide you with a number of perks, from free airline tickets to discounted merchandise to cash back.

Unfortunately, sometimes we get so focused on racking up rewards points that we forget to make sure that we are really using our credit cards efficiently.

Don’t Buy Things for the Rewards Points

One of the biggest traps is buying things for the rewards points or the cash back. There are plenty of great cash back rewards credit cards out there, and they seem quite generous at the time. Additionally, it can be tempting to spend, spend, spend in order to run up rewards points that can be redeemed for airfare or merchandise. Unfortunately, this can end up being a short road to debt — and to filling your home with thins you do not need.

Follow the same rules with rewards credit cards as you would with cash. If you don’t actually need it (or really want it), don’t buy it. Getting something just because you “need” a few more points is rarely a good idea.

Pay Off Your Balance Each Month

This is a mantra you are probably used to hearing from personal finance writers all over. And for good reason. Those personal finance writers and experts that recommend keeping a couple of credit card accounts active are very careful to make sure that you know carrying a balance is a bad idea. And it is.

If you are carrying a balance, you are paying a high rate of interest. Even with a good credit score, your interest is probably fairly high. Consider: If you are paying 13.99% interest, but only getting 1% cash back on most of your purchases, that interest is more than destroying any benefit you have. Even if you get 5% cash back on some of your purchases, you are still falling way behind if you are carrying a balance. The same is true of reward points. What good is that free airline ticket if you’ve already paid for it more than once just in interest charges?

When you are using a rewards card, it is only advantageous if you are paying off the balance each month. That way, you aren’t paying interest, and you are truly being rewarded.

Things Could Be Changing

There is also a chance that rewards cards may become less rewarding in the future. Recently, Visa and MasterCard settled a suit with the government, and agreed to no loner keep merchants from offering discounts to consumers willing to pay with lower-cost forms of payment, including cash and credit cards that charge lower fees. You might be surprised at what sorts of fees are charged to a merchant when you use a rewards card. If there really is a difference in fees, you might be better rewarded by paying with a non-rewards card, debit card or even cash, if the the merchant is offering a discount.

The important thing, though, is to think about what you are buying, and why. And stop to consider whether or not you are really being rewarded by your credit card rewards program.

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A wrecked car in Durham, North Carolina.

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About three years ago, when we bought our home, it occurred to me that we were putting ourselves at a bit at risk. I am the primary breadwinner, and we hadn’t made provisions for what could happen if I could no longer work. Buying the house really made me think about whether or not my family was truly protected. We had add a bigger term life insurance policy to reflect the obligation of owning a home, but life insurance wouldn’t help if something happened to my hands or arms and I could no longer type.

So I decided to buy a disability insurance policy. The policy is not terribly expensive, and it covers loss of income due to a number of issues. It has provided a great deal of peace of mind — especially for my husband, who worries every time I go camping that some catastrophe will occur to limit my ability to do my work. You might need disability insurance as well.

If you are concerned about what could happen to limit your ability to work, consider a disability policy. This can help ensure that the unexpected doesn’t cripple your financial situation as well as affecting your body.

What to Look for in Disability Policies

Like all insurance, it is important to consider your needs, and then look for a policy that provides you with the coverage you require. It is important to be on the look out for fine print and other terms that could affect your ability to receive coverage. Here are some things to be on the look out for:

  1. Your premium: Many disability policies allow you to lock in your premium. You can get either a non-cancelable policy or a guaranteed renewal policy. There is a difference. The non-cancelable policy means that your premiums and coverage can’t be changed — as long as you pay your premiums. A guaranteed renewal policy, on the other hand, allows you to renew without changing coverage, but the premium can go up.
  2. Changes to your coverage: There are also conditionally renewable disability insurance policies that can change the terms of your coverage, and may not even allow you to renew. These also allow insurers to raise your coverage rates at any time — even if the policy isn’t up for renewal.
  3. Definition of “disability”: Another consideration when choosing a disability policy is the definition the company uses for disability. Some policies will pay out if you can’t do your current occupation, even if you can work otherwise. Some policies will only pay out if you can’t do any work at all. There are also pay out rules based on making up the difference in income if you have to do a different job due to your disability.
  4. Collection time period: Make sure you understand the collection time period. Some policies will allow you to start collecting as early as 30 days after the disability is in effect. However, you may have to pay more. Other insurance companies will require that you wait 720 days — that’s almost two years! It is a good idea to choose something in the range of 90 to 120 days to begin collecting your benefits.

In the end, you need to be careful and evaluate your needs. Figure out how much you would need to replace your income, and consider getting that amount of coverage. Other considerations can include whether or not your partner has an income, how close you are to receiving government and other retirement benefits, whether or not you are eligible for Social Security disability benefits, and other sources of help. And, of course, before you sign on the dotted line, make sure you understand the restrictions related to your disability policy.

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STOCKTON, CA - APRIL 29:  A sign advertising r...

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The falling home values that came with the mortgage market crash and recession have resulted in a number of homes showing negative equity. These underwater mortgages could possibly put a strain on the economy if they result in foreclosure. However, it is not a foregone conclusion that foreclosure will result when you have negative equity.

For the most part, those at greatest risk of foreclosure due to being underwater are those who have run into financial problems and can’t get a refinance because of their negative equity. If you are underwater on your mortgage, you have more options than you might expect. Here are 5 possibilities for your financial situation if you’re underwater on your mortgage:

  1. Keep making your payments: If you can afford your mortgage payment, and you aren’t planning on moving anytime soon, it might be worth it to just keep making your payment. If your home serves as shelter, you are comfortable in it, and your financial situation is reasonably secure, eventually you will no longer be upside down. You will pay off your mortgage eventually, and then you will own your home outright.
  2. Mortgage modification: You might qualify for mortgage modification. This can be helpful if you are having difficulty making payments. At the first sign of trouble, contact your mortgage lender to apprise them of the situation. If you qualify for a mortgage modification, things could work out so that you end up with a payment you can afford, allowing you to stay in your home.
  3. Sell the house: If you can find a cheaper situation, it can make sense to sell the house. You will have to do a short sale in order to do this if you have negative equity. In a short sale, the bank accepts less than you owe for the house. You are either forgiven the difference (watch out: the IRS considered this taxable income), or you are offered an unsecured loan for the remaining amount, and you make smaller payments on this smaller loan.
  4. Strategic default: Some who are underwater on their mortgages, and who feel as though they can’t make payments and get out of the problem, are choosing to walk away, rather than stick it out. Of course, your credit will be in danger with this option. However, you can still live in your home until the bank forecloses, and you can save up some money since you won’t be making payments anymore.
  5. Bankruptcy: Another option is bankruptcy. If you have a lot of other debt, and you have assets in retirement plans, this could be an option. If you keep current on your mortgage, you might even get to keep your house as you restructure the rest of your debt. But your credit will be completely trashed for the next seven to 10 years.

Before you go forward with any of the above options, though, it might be worth it to consult with an attorney, as well as a financial professional. You want to make sure that you understand your options, and the implications of your actions.

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