Debt occurs when you borrow money and assume the responsibility of paying it back later, usually with interest. Some of the money you pay back each month goes toward the principal, otherwise known as the money you borrowed, and the rest goes toward the interest payment, otherwise known as the cost of the debt. Debt is essentially a way to borrow from your future self, and it can be a good thing or a bad thing depending on the purpose and the terms of the loan. When used wisely debt can be extremely useful in building wealth.
Generally speaking, you incur bad debt when you use it to purchase items that depreciate, or lose their value. These are items that offer little hope to improve your financial situation. For example, using a credit card to buy clothes, furniture or even food, is considered bad debt, because as soon as you walk out of the store the items are worth a lot less that what you paid for them.
If you decide to take on debt, you should use it to your advantage. Good debt gives you the opportunity to create wealth. This includes borrowing for things, such as wisely targeted education, housing, or refinancing more expensive debt at better terms. With student loans you can improve the probability that your future income will be higher (but only if you strategize your major and correct college well).
College graduates tend to make more money than people without them, or at least they did before 1998.
With mortgages, the leverage you have in your house allows you to benefit when your home appreciates. If you buy a $400,000 house and put 20% down, you have put $80,000 of your own money into the house. If the house appreciates to $500,000, you are entitled to the full $100,000. In other words, while you own just 20% of the house, you realize 100% of its appreciation. Finally, getting better loan terms will save you money each month as the cost of debt is lower. The money you save can be put to better use, and help you to improve your financial situation.
You should be aware of the many types of loans available. Some of the more common types of loans including revolving loans, closed end loans, secured loans, unsecured loans, and payday loans.
Revolving loans, such as credit cards and lines of credit have credit limits that you can make purchases against. Each time you buy something, your available credit decreases. As you payback the principal of the loan, your credit goes up again by the amount repaid.
Closed end loans are loans that cannot be borrowed against. The lender loans you a certain dollar amount, which cannot be extended. These include student loans, auto loans, and mortgages. As you make payments, the balance of the loans fall, but you cannot borrow any more against them.
Secured loans are loans that rely on assets as collateral for the loan. If you fail to repay the loan, known as defaulting, the lender can seize the assets and sell them to recover their costs. Because the lender has recourse, the interest rates tend to be lower. Note that title loans, which use your car as collateral, are often the exception to the low rate loan. In fact, in some states title loans are illegal and fall under predatory lending, due to their extremely high interest rates.
Unsecured loans are loans in which you do not have to put up any assets guaranteeing repayment of the loan. These loans may be harder to get, since they rely mainly on your credit history and income. The interest rates tend to be higher than for a secured loan since there is often little recourse to the lender should you default.
Payday loans – stay away from these. These are short-term loans borrowed against your next paycheck as a guaranty for the loan. The loan rates on these types of loans are notoriously high. These lenders attempt to exploit the borrower as the borrower is typically in a tight spot, financially. These lenders have a history of walking a thin line with regard to legality and preying on desperate people.
Before deciding to take on debt, it’s important to ask yourself a few questions to make sure it’s a good idea.
- Is there a better way to come up with the money? If you can pay for it in cash then you won’t have the added cost of interest.
- What are the terms of the loan? What is the interest rate, how long will you be paying off the loan, and what are the monthly payments? Higher interest rates and a longer payment period mean a more expensive loan, but perhaps lower monthly payments. Lower interest and a quicker repayment period mean a cheaper loan, but higher monthly payments. You should try for the lowest cost loan, but if must have lower monthly payments then determine whether it’s worth it.
- Does the loan fit within your budget? If not, can you make room in your budget by shifting or reducing expenses? Will it crowd out or delay your financial goals, like saving for retirement or for a down payment for a house?
- Will you still be paying for the item after it has outlived its use? For example, you may not want to take out a 7-year loan for a new computer since it will likely become obsolete before paying off the loan.
- Will taking on more debt hurt your credit too much? Remember, the more debt you take on, the worse your credit will get. Will you want to take on another loan in the future and if so, will this loan affect the terms of the future loan?
- Is this the best loan? Look around for better loan terms. The terms can vary significantly from creditor to creditor. Will it help to get a cosigner?
- Can you delay the purchase? If you’re patient, then you may be able to save for the item or may be better off financially down the road.
You should not borrow unless you’ve given it some serious thought. Borrowing too much or paying too high of a cost can have long lasting effects on your financial well-being.
The take aways on debt are as follows:
Not all debt is created equal, some can be used for good, such as those with the potential to improve your financial situation. While other can be bad, offering poor tradeoffs
There are several types of loans available to consumers, each of which may be particularly relevant to the items you want to buy. Stay away from the high interest loans that seek to take advantage of desperate circumstances.
When deciding whether to take on a loan, give it serious thought and research the one that best fits your needs while minimizing cost.