If one lesson about credit could be taught to every schoolchild, it should be this.

Paying off your credit cards every month is a good way to ensure that you’ll always live within your means. You’ll have the flexibility to weather bad times and take advantage of good times if you’re not carrying a credit card balance around.

You won’t be paying thousands of dollars—and more likely, tens of thousands of dollars—in unnecessary interest during your lifetime.

Consider this. Someone who carries a $5,000 credit card balance will pay somewhere around $70 a month in interest. If she were to invest that money instead, it could grow to nearly $250,000 over her working lifetime, assuming an 8 percent average annual return. That’s a pretty big price to pay for the convenience of not paying cash.

Credit card debt also plays a big role in bankruptcies and other financial catastrophes. The actual crisis might be caused by job loss, divorce, or other setbacks, but it’s their heavy burden of credit card debt that usually causes people to file.

Carrying a balance also leaves you vulnerable to the various games that credit card companies play, such as these:

Michael in Westford, Vermont, got a notice from his credit card company that his rate could soar to a stunning 29.99 percent if he was late with a single payment—to the issuing company or any other. Like most credit card companies, his issuer would periodically check Michael’s credit reports and jack up his rates if any problems were detected:

“These new rules appear to be bait and switch tactics to me,” Michael fumed. “[They] give you low rates and find a way to get you to the default rate.”

The only winners in this game are the ones who don’t play—who don’t carry credit card balances from month to month and who never pay interest.

Despite what you might have heard, that’s actually the norm in America.

Most American households have no credit card debt, according to the latest Federal Reserve study of consumer finances. About a quarter of American households have no credit cards, and another 30 percent or so regularly pay off their balances. Half of those who do carry some credit card debt owe $2,200 or less.

That statistic you might have heard, that “the average American owes more than $9,000 in credit card debt,” is bogus—even though the number is usually attributed to CardWeb.com, a legitimate research company that tracks credit card trends.

What CardWeb.com statistics actually show is that the average debt per American household with at least one credit card was $9,159 in 2004. To get that number, CardWeb simply divided the total outstanding credit card debt by the number of American households that it says have at least one credit card—88 million.

Using averages can be misleading, because a relative handful of consumers with huge credit card balances can skew the statistics.

It’s kind of like measuring the “average” net worth of a group of 20 people when one of them is Warren Buffett. Even if the other 19 were stone cold broke, the “average” wealth of a person in that group would be more than $2 billion.

On a less-extreme scale, that is what’s happening with the CardWeb statistic. The Fed statistics show that fewer than 1 in 20 households actually owes more than $8,000, but the big balances by those few households skew the average.

If you’re one of those who thought you were “average” in carrying credit card debt, realize you’re not—and get ahead by leaving the debt behind.

A whopping 43 percent of American households live paycheck to paycheck, with less than $1,000 in liquid assets. That’s according to SMR Research, which has studied detailed income, asset, and debt statistics gathered by the Census Bureau.

Other researchers contend that only one in three American households has sufficient savings to weather even a short stretch of unemployment. Given how volatile the economy can be and the debt loads that many people carry, that’s just begging for trouble.

Many people focus on the difficulty of scraping together enough cash to survive three to six months without a job. What these folks don’t understand is that an emergency fund can be enormously freeing.

I was working for the Anchorage Times in Alaska when the venerable, old paper announced one day that it was going out of business. We had less than 12 hours of notice. The announcement was made about 1 P.M., and the last edition rolled off the press around midnight.

People around me worried aloud about how they would pay their mortgages, their credit cards, and their child support. But when I went home and totaled the numbers, I realized I could live for six months on my savings without touching my retirement funds or altering my lifestyle all that much. If I made a few cutbacks, I could last a year.

The peace of mind I had that day, and in the month or so that it took to find my next reporting gig, is almost indescribable. Knowing that you can lose or walk away from any job is incredibly powerful.

You might think that you don’t make enough money to set aside a reserve, but people who have studied the issue have found that whether you save has relatively little to do with what you bring in.

Steven Venti of Dartmouth and David Wise of Harvard used Social Security lifetime earnings and net income assessments for 3,992 households whose heads were near retirement age. Here’s what they found:

In other words, the vast majority of the differences in wealth had nothing to do with income, life events, or how the money was invested.

What did make the difference? How much the families chose to save. Venti and Wise determined that those who had a goal of saving built wealth, regardless of their circumstances.

Saving isn’t easy, and if you’re busy paying down credit card debt, it also might not be your first priority. But, as a starter, try to keep at least $1,000 in cash handy. Toss in any tax refunds you get, and as soon as possible set up an automatic transfer so that the money is whisked from your paycheck to your emergency fund before you even see it.

You’d be wise to keep the money somewhere safe and accessible, such as a savings account or a money market mutual fund. For a while in the go-go 1990s, it was fashionable to believe that people could put their emergency funds in the stock market and make great returns. The bear market that started in March 2000 pretty much squashed that theory. You don’t want your fund to lose 50 percent or more of its value right when the economy is tanking and your boss decides that your job is now superfluous.

If you’re a homeowner, consider opening a home equity line of credit as a stand-in for an emergency fund until you can get the appropriate amount saved. For this strategy to work, though, you have to leave the line unused. Don’t be tempted to rack up more debt by borrowing needlessly against your home.

This is much easier said than done, of course. Health insurance can be expensive and, for many people, tough to get. That’s why more than 45 million Americans are uninsured, and why medical bills are a factor in half of all personal bankruptcies filed in the United States, according to research by Harvard professor Elizabeth Warren.

(By contrast, medical bills are a negligible issue in Canada, which has universal health insurance. It’s one of the reasons why Canada’s bankruptcy rate prior to 2006 was less than one-third that of the United States.)

Even people who have health insurance are often blindsided by huge medical bills. Alana’s policy required her to make 30 percent co-payments—which was affordable when the Indianapolis woman sought routine care, but not when her daughter was born critically ill:

“My daughter... spent several weeks in intensive care. Add this to already maxed-out credit cards,” Alana said, “and it was a recipe for disaster.”

Alana wound up filing bankruptcy to wipe out thousands of dollars in doctor and hospital bills.

Some people who are young and healthy think they don’t need coverage, but no one can predict when an accident or major illness might strike. If you have coverage through your employer, by all means take advantage of it. If you don’t and your income is low, check to see whether your state offers bare-bones coverage.

Another solution: a high-deductible or “catastrophic” policy, perhaps combined with a health savings account. You’re required to pay the first $1,000 or more of medical expenses before your coverage kicks in, but your out-of-pocket expenses are capped in the case of accident or major illness. High-deductible policies tend to cost 25 percent to 50 percent less than a full-coverage HMO policy, depending on how much you’re willing to pay out of pocket.

If you buy a policy that’s compatible with the new health savings accounts, you can put an amount equal to your deductible into an HSA and write the contribution off on your taxes. You can withdraw the money for medical expenses at any time, tax free; any money you don’t use can roll over tax deferred from year to year. You can find out more about HSAs at www.hsainsider.com, or by talking to a knowledgeable insurance agent.

When evaluating a policy, either individually or through your employer, make sure to ask about the “lifetime cap.” This is the limit on how much the insurer will pay out in total. You want a cap of $1 million or more, if possible. Beware of the “insurance” that is sometimes marketed to small businesses that caps payouts at some ridiculously small amount, like $10,000. You could blow through that amount in a single day at the hospital, and such coverage is no substitute for the real thing.

Take a look, too, at your liability coverage. This is the part of your homeowners’ and auto insurance that protects you against lawsuits. Make sure your liability limits on each of your policies is at least equal your total net worth.

I’d like to include a pitch for disability insurance, as well, if it’s available through your employer. You’re much more likely to be disabled and unable to work than you are to die before you retire, yet most people don’t have a long-term disability plan. You can also try buying an individual policy, although these have become rather expensive in recent years.

Skyrocketing foreclosure rates vividly demonstrate the dangers of stretching too far to buy a house. Yet even as lenders tightened their standards in the wake of the mortgage mess, it was still possible to borrow far more than you could comfortably repay. Mortgage payments used to be capped at 26 percent to 28 percent of your gross monthly income, but many lenders today still let homebuyers borrow up to 33 percent, and some go even higher.

Lenders know you probably will do whatever it takes to keep your home, even if it means short-changing your retirement, giving up vacations, and driving yourself deep into debt. Homeowners’ desire to hang on to their houses despite “insurmountable debt,” according to researchers Sullivan, Warren, and Westbrook, is a leading contributor in Chapter 13 bankruptcies.

Many homebuyers also underestimate all the ancillary costs of buying a home, such as maintenance, repairs, improvements, and decoration. At the same time, lenders are falling over themselves to extend you credit because homeowners are generally viewed as more stable and financially responsible than renters.

Lillian and her now ex-husband were actually conservative when they bought their first home, keeping their mortgage payments to just 20 percent of their gross income. The problems started immediately, though, as lenders rushed to give them money:

“It was heady to have so many offers of loans after we purchased our home,” Lillian wrote. “We soon found ourselves borrowing to buy carpeting, insulation, storm windows, landscaping, and even a new pick-up truck.

“Within three years, we were insolvent,” Lillian continued. “Then the worst happened... My husband lost his job, and our insolvency was more than inconvenient, it was critical.”

In reality, nobody else—not your lender, your real estate agent, or your relatives—can tell you how much house you can really handle. That depends on a number of factors that others typically don’t know, such as how much you need to save for retirement, how many children you want to have, and how tied down to a house you want to be.

Buying a house today is a lot different than a generation ago, when rampant inflation meant big annual pay raises. Those made a mortgage payment look smaller and smaller as years passed. People back then were also more likely to be covered by a traditional pension, which meant they didn’t have to save gobs of money to pay for their own retirements. And fewer families had two wage earners, which meant Mom could always go to work if Dad lost his job. Today, many families need both salaries to pay the mortgage, and the loss of one is a disaster.

Those are among the reasons why it’s often smart to limit your total housing payments—principle, interest, taxes, and insurance—to 25 percent of your gross monthly income. You might be able to go a bit higher if you have no other debt or a great pension that lessens your need to contribute to your own retirement. You might want to aim a little lower if you plan to have kids and want one spouse to stay home to care for them.

Student loans are often referred to as a “good” debt—the kind of borrowing that will increase your earning power and thus more than pay for itself.

Unfortunately, lots of students are taking a good thing way too far.

Michelle of Indiana emailed to say she owed $120,000 in student loans—and was making just under $50,000 as an assistant professor in her field. She had consolidated all of her federal loans and deferred payment when she could, but the cold hard truth was setting in:

“I am staring at a debt that I cannot repay. Our salaries have been frozen for the next two years due to state budget problems, and I’ve calculated that even paying the minimum on all my loans would leave me with less than 100 dollars to live out the month. Is bankruptcy my only option? I’m not seeing a way out of this.”

I had to give her some news that was even worse than she was expecting. Student loans can almost never be wiped out in bankruptcy court. Federal law requires that student borrowers prove repayment would be an extreme hardship—a tough standard to meet “unless you’re totally permanently disabled,” in the words of Los Angeles bankruptcy attorney Leon Bayer.

You’ll do yourself a huge favor by limiting how much you borrow. Your student loan payments shouldn’t total more than 10 percent of your first job’s monthly pay. Although how much that lets you borrow depends on the interest rates you’ll pay, you can pretty much figure that your total student loan debt shouldn’t equal more than that first job’s annual pay.

What if you discover that you’re already in too deep? If you haven’t gotten your degree yet, you can save yourself some pain by transferring to a less-expensive school or taking a year off to work. If you’re already out, consider consolidating your federal loans to stretch out the payments. You might even need to work a second job for a while to raise the cash to retire this debt.

William made a respectable income, yet constantly felt strapped for cash. He wasn’t living any higher than his neighbors, he thought, and considerably more frugally than some. So what was wrong?

Like many people, William’s fixed expenses had risen along with his pay. He carried a hefty mortgage, along with payments on a nice car, a home equity line of credit, and some student loans. Child care was another big expense, as were groceries, utilities, insurance, and gas. When he actually crunched the numbers, he found more than 70 percent of his take-home pay was going to what he considered his basic, mandatory expenses. When he added in his more-variable expenses—clothing, dinners out, walking-around cash, and so on—he found he was spending more than 90 percent of his take-home pay every month, leaving him precious little breathing room.

That’s why Elizabeth Warren, the Harvard bankruptcy researcher, recommends limiting your fixed, “must-have” expenses to no more than 50 percent of your after-tax income. That way, you can devote 30 percent of your pay to your “wants”—the stuff that’s nice if not necessary to have—and 20 percent to savings, which can include the money you use to pay down your debt.

“Must haves,” as she details in the book she coauthored, All Your Worth, include your housing payments, utilities (including phone and cable or satellite), groceries, insurance, child care, child support, transportation expenses, and minimum payments on your other loans. Trimming those to 50 percent of your after-tax income can be tough, particularly if—like William—you feel you “deserve” to live a certain lifestyle. But doing so, Warren says, can help people finally achieve balance in their lives. They’ll have enough money to pay down debt, save for the future, and still have fun once in awhile.

In the boom times, lenders loved to push home equity loans or lines of credit as the “solution” to your debt problems. In fact, these loans often cause more problems than they solve:

Turning to your retirement funds isn’t much better, as I detailed in Chapter 6, “Coping with a Credit Crisis.” The taxes and penalties that are due on premature withdrawals will equal up to half of any money you take out. You’ll also be missing out on the future tax-deferred returns that money could have made; you should figure that every $10,000 withdrawal costs you at least $100,000 in future retirement income.

Even loans against 401(k)s are risky, because you typically have to pay the money back promptly if you lose your job, or the balance will be taxed and penalized as a withdrawal.

A much better course, for most people, is to pay off credit card debt out of current incomes whenever possible. Leave retirement funds for retirement and your home equity, if you have any, for true emergencies.

Identify every credit account that your ex could access. If the account is listed as joint, rather than individual, your spouse can probably use it. If the account is listed as individual and is still open, call the creditor to find out whether your spouse is listed as an authorized user.

You might be able to get your spouse removed as an authorized user with a phone call to the card issuer, but follow up in writing.

With joint accounts, your best bet is to close them whenever possible, although you might have to settle for “freezing” the account with the creditor if you owe a balance. (This kind of freeze is supposed to prevent either of you from using the card, as is different from the credit report freezes I detailed in Chapter 5, “Credit Scoring Myths.”)

Unfortunately, though, sometimes a spouse can talk a creditor into lifting a freeze, which is why it’s important to put your request in writing, note that you and your spouse are divorcing, and make it clear that you won’t be responsible for any charges made after the freeze is in place.

If you do have a balance, it should be transferred as soon as possible to the card of the spouse who will be responsible for paying it off.

What if your spouse can’t get credit in his or her own name? If the divorce isn’t final, you might want to take on the debts and get a larger property settlement to offset the extra burden, rather than leave your future credit score in the hands of someone who could so easily trash it.

If the divorce is final, you might need to take over the payments to prevent further damage to your credit rating. Your divorce decree might allow you to take your ex back to court for reimbursement, but either way, you shouldn’t leave your credit in his or her hands for a second longer.

A few months after you make your requests, get another copy of your credit reports to make sure the accounts are listed properly. If an account that was closed is listed as open, or if the balance on a frozen account has grown, follow up immediately with the creditor.

Divorce negotiations can drag on almost endlessly, but just one late payment can really hurt your credit. You might need to make a few payments on debts that will ultimately be your spouse’s, just to make sure they don’t go delinquent while you’re still responsible for the account.

Ideally, you should either sell the asset and split up the proceeds, or refinance the loan so that you’re no longer on the hook. If refinancing is an option, make sure it gets done before the divorce is final.

Sometimes, though, your ex won’t want to sell and won’t have the income or credit to swing a refinance. If that’s the case, set some kind of time limit on how long you’re willing to stay on the loan.

If your ex wants to continue living in the family home with your kids, you might agree that the house will be sold when the youngest is 18. Make sure this agreement is part of your divorce decree, and ask the lender to send loan statements and payment coupons to you so that you can make sure the loan is getting paid. At the very least, you should be able to get Internet or phone access to the account so that you can monitor the situation.

If you’re already divorced, you might still want to get access to the account and make the payments if your ex is falling behind. Again, your divorce decree might allow you to take him or her back to court for reimbursement.

If your ex could refinance but won’t, you might have to resort to bribes—a cash payment or more time with the kids in exchange for getting a new loan.

Whatever your arrangement, don’t sign a quitclaim or let your name be taken off the title as long as your name is still on the loan. You don’t want to be responsible for the debt if you no longer own the asset.

If you’re in a particularly nasty divorce, or if your spouse is unethical, you might wind up a victim of identity theft. After all, your spouse knows your Social Security number, your address, and just about any other detail required to open up a new account in your name, run up a balance, and leave you holding the bag.

Your ex could even file a bankruptcy in your name, because many districts don’t require identification when a bankruptcy is first filed. By the time the first hearing rolls around, the bankruptcy has already been logged in the huge central database combed by credit bureaus and will show up on your credit report. Such a bogus filing is a crime, but that doesn’t prevent some vengeful exes from doing it.

A credit freeze, which prevents anyone from opening an account in your name, is probably the best solution if your state allows it. If not, ask the three credit bureaus to put a fraud alert on your files. You also should get regular copies of your credit reports—at least twice a year—to monitor for anything suspicious.

If a phony bankruptcy has been filed, you’ll need to hire a bankruptcy attorney who knows how to get the filing expunged.

Although the vast majority of mortgage companies use FICO scores in their lending decisions, a few don’t—and that can benefit someone whose ex is creating problems.

Albert, for example, wants to buy another home after the Army transfers him to a new station. Even if he succeeds in getting his ex to refinance the loan, his credit score will still be affected by all the late payments.

Albert could benefit from a lender that doesn’t sell its loans to investors like Fannie Mae and Freddie Mac that require the use of credit scores. If the lender keeps its loans in house, rather than selling them on the secondary market, it’s often more flexible with its lending standards.

Albert’s best bet might be to find an experienced mortgage broker who can evaluate his situation and get him in touch with a lender that can base its decision on his behavior, rather than his ex’s.