Rules of Thumb for Credit Decisions - Personal Finance

Key Principle

Credit decisions are made under time pressure, emotional excitement, and information asymmetry. These heuristics distill the textbook's analysis into quick decision rules that prevent the most costly mistakes. Every rule maps to a documented behavioral trap or cost mechanism.

Why This Matters

The recurring theme across both chapters is that stated costs obscure true costs, and that borrowers systematically anchor on the wrong number -- the monthly payment instead of total cost, the stated rate instead of APR, the teaser rate instead of the post-promotional rate. Rules of thumb short-circuit these anchoring errors by providing pre-computed decision boundaries.

Credit Card Rules

Match card to behavior, not rankings. Full-payers: prioritize no annual fee and long grace period. Balance carriers: prioritize lowest APR. "The rate of interest on the card is irrelevant" for full-payers (p. 215); "the length of the grace period isn't all that important" for carriers (p. 215).
The grace period is binary. Pay in full = zero interest. Carry one dollar = interest on everything. "Almost" paying off the balance gets none of the benefit (p. 197).
Never use cash advances for routine spending. Interest accrues from day one at rates 7-8 points above the merchandise rate, plus a 3% transaction fee (pp. 196-197).
Carry at most two cards. One rebate card for daily spending (paid in full), one low-rate card for deferred purchases. Cancel unused accounts in writing -- unused credit capacity counts as contingent liability to future lenders (p. 217).
ADB method doubles the cost. Two cards with identical APRs can produce dramatically different charges: ADB including new purchases costs roughly double ADB excluding new purchases (p. 211).
Rewards only pay if you never carry a balance. Rebate cards carry higher rates. Any carried balance negates the reward through higher interest costs (p. 199).
Verify statements within 60 days. After that window, dispute rights expire and errors become permanent (p. 214).
Retail store cards are the most expensive credit. 18-22% APR consistently, and families accumulate five or six without tracking aggregate cost (p. 201).

Consumer Loan Rules

Compare APR, never stated rate. Simple interest: APR equals stated rate. Discount method: APR exceeds stated rate. Add-on method: APR is roughly double the stated rate (pp. 240-245).
If it's add-on interest, walk away. "Add-on loans are very expensive. Indeed, they generally rank as one of the most costly forms of consumer credit" (p. 245). A "6.5%" add-on loan costs more than an "8%" simple interest loan (p. 252).
Shop lending sources in order: credit union, bank, finance company. "Membership in a credit union provides the most attractive borrowing opportunities available" (p. 230). Finance companies are last resort only (p. 230).
Get preapproved before visiting a dealer. Separate vehicle price, financing, and trade-in into three independent negotiations. Dealer financing has a built-in conflict of interest (pp. 225, 231).
The loan term should not exceed the asset's useful life. "The product purchased on credit should outlive the payments" (p. 190). "If a 15-year loan is the only way you can afford the car, then face it: you can't afford the car!" (p. 205)
Low payments and low total cost are opposites. Extending the term reduces monthly payments but increases total interest. Ask: "Which is more important: low payments or a low APR?" (p. 251)
Reject credit life insurance. "Very costly and does little more than give lenders a lucrative source of income" (p. 246).
Home equity loans cut borrowing cost in half -- but your house is the collateral. The double benefit of lower rates plus tax deductibility is real, but "if you can't repay the loan, you could lose it!" (p. 205)

General Credit Health Rules

Debt safety ratio: stay below 20%, target 10-15%. Total monthly consumer credit payments divided by take-home pay. Excludes mortgage. At 20%, you are at the maximum; above it, you are overextended (p. 192).
Stress-test the ratio. Ask "what happens if my income drops by half?" A ratio at 17.6% can jump to 24.3% with an income shock -- same debt, radically different risk (p. 221).
Run a debt inventory every 3-4 months. List every consumer obligation including informal family loans. Informal loans hide from cash flow analysis but still count as debt (p. 235).
Apply the two-question test before every loan. (1) Does this purchase fit my financial plans? (2) Does the debt service fit my monthly cash budget? Both must pass (p. 232).
Building credit is slow; destroying it is fast. Delinquencies stay on file 7 years, bankruptcies 10 years. "Raising your FICO score is a lot like losing weight. It takes time and there's no quick fix" (p. 210).
FICO is 80% behavioral. Payment history (35%) + amounts owed (30%) + length of history (15%) = the three factors you control. Demographics are not in the score (p. 210).
Each failed credit application makes the next one harder. Hard inquiries damage your profile. Self-screen before applying: no bankruptcy on file, no serious delinquencies, no denial in last 6 months (p. 207).
Use savings before credit for emergencies. Credit should be the backup to savings, not a replacement (p. 188).

Red Flags

Using one form of credit to pay another. Cash-advancing from Card A to pay Card B means debt has become self-reinforcing -- you are servicing debt from debt, not income (p. 191).
Paying only the minimum. A $3,000 balance at 15% with 3% minimums takes 14 years to repay with $2,005 in interest -- 66.8% of the original balance (p. 190).
"No payments, no interest" offers. Full price often due at moratorium end; high retroactive interest from purchase date if not paid in full; 0% is frequently a teaser that jumps (p. 234).
Borrowing to cover normal living expenses. This is a mid-stage danger sign in the progression toward credit crisis (p. 191).
Consolidation without a spending freeze. Freed-up credit lines invite resumed spending. "If you continue to be undisciplined about repaying your debts, then you could end up with one big credit problem instead of a bunch of small ones!" (p. 217)
Accepting dealer financing without comparison shopping. Dealers earn a portion of finance income and are incentivized to secure the highest rate possible (p. 231).
Ignoring the balance calculation method. Same APR, different method = double the finance charges. 95% of issuers use the most expensive method (ADB including new purchases) (p. 211).
"The only way a recession can push you over the edge is if you're already sitting on it!" (p. 218) If you are near your limits in good times, any disruption tips you into crisis.

Good Examples

Card selection done right: A full-payer choosing Card B (no fee, 16% rate) over Card A ($75 fee, 9% rate) saves the fee without paying a penny in interest. A balance carrier choosing Card A saves more in rate reduction than they spend on the fee (p. 221).
Loan shopping done right: Aaron Woods compares a "6.5%" add-on loan against an "8%" simple interest loan. Converting to APR reveals the add-on costs ~12% effective -- the "higher" stated rate is actually cheaper (pp. 252-253).
Borrow-vs-cash done right: Jackson Hunt calculates net cost of borrowing at +$499.44, confirming cash is cheaper. No guesswork, no folk wisdom -- just the spread (p. 247).

Key Quotes

"Unless credit is used intelligently, the 'buy now, pay later' attitude can quickly turn an otherwise orderly budget into a budgetary nightmare." (p. 187)

"The product purchased on credit should outlive the payments." (p. 190)

"When you're taking out an installment loan, be sure to find out whether simple or add-on interest is being used. And if it's add-on, you might want to consider looking elsewhere." (p. 245)

"People who let their credit balances build up are limiting their future flexibility." (p. 216)

Related References

Credit Management Implementation Playbook - Step-by-step processes that operationalize these rules