The chances are good that you have some sort of debt. Without a proper understanding of debt, you can quickly dig yourself into a deep, unending financial hole that could lead to bankruptcy. This post will explain the key features of any loan and the types of debt that you should be aware of. It will also explain the pitfalls of debt.
What is debt?
The words Debt and Loan are essentially the same, and we use them interchangeably. If you like semantics, then a loan is a specific amount one borrows from another individual or party, and debt is the total amount of loans one has outstanding. For example, John has 3 loans of $5,000 each, which means he has total debt of $15,000.
1. Debt is about Risk
A key concept to understanding debt is that it’s highly intertwined with the measurement of perceived risk.
Say your sister Barbara wants to borrow $500 to pay the security deposit on an apartment, because she got a promotion and transfer to California to manage her company’s new office there. Your brother John also wants to borrow $500 to pay his rent. He already has $5,000 in debt and doesn’t have a job right now, as he just got out of rehab last week.
If you hope to ever see your $500 back, whom would you rather lend to? Barbara without a doubt.
Now let’s say you’re a bank, which is basically a store that buys and sells loans. The fee you charge people for borrowing money is known as interest, which means you charge the borrower a fee every month, calculated as a percentage of your total loan.
Both Barbara and John come asking you for $500. Would you charge John the same amount to borrow money as you would Barbara? Definitely not. John is a much riskier bet. Chances are good you might never see your money back, so if he wants a loan, he’ll need to pay you more. As such, John would get a loan with a much higher interest rate than Barbara.
2. Features of a Loan
Secure vs Unsecured Debt
Now that we understand risk, let’s go back to your brother John. You decline to lend him the money, so he sweetens the pot and offers to give you his 2017 Toyota Corolla if he doesn’t pay you back the $500. You now realize that his loan is backed up by something of value, which decreases the risk that you won’t be able to recover your $500. You can agree to those terms. In fact, because your risk level has decreased, you’ll even lend to him at a lower interest rate. In this example, the car is called collateral, and the debt is called a secured loan, because the loan is guaranteed by an asset.
There are multiple types of secured loans: Home mortgages use your house as collateral, Auto loans use the car as collateral, Title loans use the title to a vehicle or asset as the collateral.
As a rule of thumb, a secured loan is always less risky for lenders than an unsecured loan. As such, you should always expect lower interest rates for secured loans. Because the only collateral a lender has on an unsecured loan is your reputation (aka your credit score), they tend to charge higher interest rates and be pickier about whom they lend to.
Warning: I would highly recommend against ever trading an unsecured loan for a secured loan. That would be like betting the house on a bad poker hand, just because you’re low on chips.
3. Variable vs Fixed Interest Rate
When banks lend money, they can either charge you a fixed interest rate that doesn’t change throughout the life of the loan, or they can charge an interest rate that adjusts to market value or their whims.
Obviously you’d rather have a fixed interest rate so you can know how much you have to pay exactly each month. Yet, many people choose variable interest rate loans because, when given a choice, variable rates are consistently lower than fixed rates.
One common trap many borrowers fall into occurs when they choose variable interest rate loans to buy a home, because the lower rates put the mortgage payment within reach. However, once interest rates rise, their monthly mortgage payments also increase, and if they can no longer afford the payments, they forfeit the house.
4. Payment Schedule
Most lenders calculate a payment schedule for you. Each month, you pay your interest fee and a portion of the loan’s outstanding balance. Home loans call this mortgage payments, and credit cards call it “Minimum Payment”. You should always see how long it would take you to pay off the bill. Credit card companies are notorious for calculating their minimum payments to only cover a small portion on your outstanding loan. This guarantees you’ll pay years. Worse, if a lender only charges you interest each month, you’ll be paying interest on that debt until the day you die.
5. Credit Limit
Lenders will each calculate how much debt they believe you can handle in total. They will usually consider your salary, your current total existing debt, and your expenditures.
If a lender approves you for a line of credit (such a credit card), this always comes with a credit limit, which essentially dictates how much additional debt they trust you to take on. Spend beyond the credit limit, and you’ll quickly learn the joys of having your card declined.
6. Types of debt
Now that we know the basic features of debt, let’s examine some of the most popular debts. I listed these by order of interest rates, from lowest to highest.
Home Mortgages / Refinance
Loan Type: Secured (the house)
Fixed vs Variable: Both
Interest rates: Very Low
Thoughts: If you’re going to choose variable interest rates, make sure you can afford house payments if the rates go up.
Loan Type: Secured (the car)
Fixed vs Variable: Usually fixed
Interest rates: Low
Thoughts: Many dealerships offer low or 0% interest rates during holidays you can take advantage of. If you’re buying a used car, the dealership may still offer financing, but more likely you’ll need to go to a bank for the loan. Because a bank doesn’t have a sales quota they need to meet, their rates will be higher than what you can get at the dealership.
Bank Line of Credit
Loan Type: Secured (Your home) or Unsecured
Fixed vs Variable: Variable
Interest rates: Low
Thoughts: You need to apply and be approved for a line of credit. Banks usually want some type of collateral to guarantee the loan. Once approved though, this essentially acts as a high limit credit card, except if you fall behind on your payments, the bank takes your house.
Loan Type: Unsecured
Fixed vs Variable: Fixed
Interest rates: Medium
Thoughts: Many online vendors now offer competitive rates for personal loans. You’ll need a decent credit score for approval, as they have no collateral against you. If you have a lower credit score, your interest rate will likely be high. Make sure you consider all other options before entering a high rate loan.
Family / Friend Loans
Loan Type: Depends
Fixed vs Variable: Depends
Interest rates: Depends
Thoughts: Family and friends can be a lifeline, and they may offer great terms, but let’s be honest: the collateral here is your relationship. Tread carefully when mixing the personal with the professional.
Loan Type: Unsecured
Fixed vs Variable: Variable
Interest rates: Very high
Thoughts: This is the gateway drug to a life in unending debt. Banks make billions every year off of credit cards with their fees and high interest rates. I would recommend any of the prior loans before getting into credit card debt. The only exception would be for individuals with high credit scores that can qualify for a 0% introductory offer that some credit cards have. And even with those, I’d pay off the debt before the high interest rates kick in, usually within 6-12 months.
Title & Payday Loans
Loan Type: Unsecured and Secured
Fixed vs Variable: Fixed
Interest rates: Exorbitantly high
Thoughts: Calling this highway robbery would be an understatement. These lenders are so predatory, many states have now outlawed them. Please consider selling your kidneys before taking money from these sharks. If you are in this situation, debt settlement or bankruptcy may be a better alternative, but each of those options have pros and cons, so one should research before making a decision. A great resource is Steve Rhode’s Ultimate Guide to Checking Out a Debt Relief Company.
6. Good Debt vs Bad Debt:
Debt is not always bad, although it always contains inherent risk. This section lists the major reasons people go into debt, and whether those are sound moves.
Leveraging is the act of using a loan to increase profits. For example, I can buy a house with cash for $100,000 and rent it out at $1,000 a month ($12,000 a year). That means I’ll make a 12% profit on my investment every year (12k/100k). However, if I only put down $25,000 and borrow the remaining $75,000 at 5% annual interest, I actually increase my profitability. 5% interest on a $75,000 loan is $3,750 a year. $12,000 Rental Revenue – $3,750 in interest fees, means I have profit of $8,250, or 33% profit off my initial $25k investment. Expanding on that concept, I can either use all my $100k to buy a single house and get $12k profit, or I can leverage myself and buy 4 houses by borrowing $300,000. My Total profit would be $33,000 a year instead of $12,000 a year. However, if the market crashes, then I’m short $300,000 in loans, and the payments on those can quickly become overwhelming.
Many people incur credit card debt to go on vacation or sustain a lifestyle they cannot afford. We highly recommend against this, as eventually you’ll need to pay back what you borrowed. That then reduces your ability to pay for your existing expenses, as you’ll always be catching up on paying off prior purchases.
c) Existing debt
Many people also incur debt to pay off existing debt. For example, Rebecca has $5,000 in credit card debt with an interest rate of 25% a year. She could take a personal loan at 8% to pay off her credit cards, and then make payments on the cheaper loan. This process is called Debt Consolidation and there are pros & cons to this method. The goal is to find better terms with a new loan to help you pay off credit card debt and to consolidate all of your debt into one payment. You should only do this if you are serious to get out of debt as many folks do not use all of the lower interest loan proceeds to pay off his/her debt. This can become a greater problem and keep you in debt longer.
Understanding debt is imperative to your financial well being. Although debt is not always bad in the case of a mortgage, the goal is to always get out of debt and to experience debt freedom.