Not all debt is bad(Read article summary)
Debt can be a useful tool if you know how to manage it wisely. Here are eight types of debt and tips for managing them.
Debt has gotten a bad rap lately, and for good reason. Recent NerdWallet data show that the average U.S. household with debt carries $15,762 in credit card debt and $130,922 in total debt, with the average consumer spending more than $2,500 a year on credit card interest. A number of well-respected financial self-help gurus even tout programs that advocate a cash-only, debt-free life.
So, should sensible people say no to debt? Probably not — because not all debt is bad. If you manage debt in a smart, planned way, you can exploit it to increase your wealth rather than let it use and deplete you.
How debt works
In simple terms, borrowing money is like paying for any kind of service. You pay to have a person to clean your house or fix your car, and when you borrow money, you pay for that service as well.
Lenders charge borrowers for the use of their money, and the more worried the lender is about getting paid back, the higher the cost. “Secured debt” is less risky for a lender — and costs less for the borrower — because an item of value like a house or car can be collected if the borrower doesn’t pay. When a lender has little or no way of guaranteeing payback — like with a personal loan or a credit card — debt costs more.
This is precisely why a good credit score is so crucial for getting a good interest rate. If you look at it from a lender’s point of view, you can see the concern. A good credit score means that the borrower has a reasonable amount of debt with regard to income, low credit balances, positive credit behavior over a long period of time and a record of paying bills on time. The lender feels confident that the borrower will pay back the loan on time.
Types of debt
There’s no doubt that debt can be a useful tool. Just think about how long it would take to save up to buy a home entirely in cash. Employing debt in a careful way can help you build a successful financial life. This list shows the kinds of debt that you could incur, from most desirable to least (indebtedness to parents, significant others or generalized guilt not included!):
- Home mortgages, home equity loans or reverse mortgages are essentially the least expensive type of debt you can incur and offer the best value or outcome you can get from borrowing money. These days you can potentially get a fixed-rate mortgage for around 2.75%. Since it’s unlikely that most people can afford a home without debt and this type of debt is relatively cheap, most consumers can take on mortgage debt with confidence. Using the equity in your home to borrow money through a home equity loan is another low-interest way to borrow if you are sure that you can pay the loan back. A reverse mortgage, where you borrow against the value of your paid-off home, can offer a way for retired people to meet their monthly expenses if they are short on cash.
- Student loan debt can also pay off handsomely in the long run. Earning a degree from a reasonably priced college in a well-paying professional field can ensure a lifetime of steady work and consistently high earnings. However, incurring $120,000 of student loan debt for a degree in an obscure major from a private college would probably be a poor choice in terms of debt.
- Auto loan debt is a type of reasonably priced debt that may be necessary. It’s certainly less attractive than mortgage debt because cars depreciate quickly, while homes generally appreciate. But today’s cars are expensive and yet essential for most of us to get to work, so auto loans may be unavoidable. Choosing the most dependable, least expensive vehicle that will meet your needs will help ensure this type of debt is of value to you.
- Medical bill debt can be a necessary evil. If you or a loved one gets sick or has an accident, you’re going to be hard-pressed to say no to all available medical care, no matter how expensive it is. But once the crisis is over, you can be left with crippling bills. Medical debt can often be managed at a low interest rate if you work with the medical provider to make monthly payments. If you’re in this situation, be sure to take the initiative to manage this debt so that it doesn’t get sent to a collections agency, where it could hurt your credit score.
- Credit card debt can be a useful tool for managing your money because it helps during emergencies. Credit cards are safer and more convenient than carrying cash, and they allow you to easily make large purchases. Using a credit card also helps you build a financial credit history that in turn helps you get insurance, rent a home or get a mortgage more easily and at lower rates. Some credit cards also yield travel and other rewards. But the primary disadvantage of a credit card is the same as its primary advantage: It lets you spend money you don’t have. Months or years of just making the monthly minimum payment add a lot to your original bill when the credit card company is charging you 21% interest. That kind of credit card debt marks the point on this list where debt is no longer potentially augmenting your financial well-being.
- Personal loan debt from a bank or credit union may be necessary to pay for problems or emergencies that crop up. However, it’s less desirable to use a personal loan to pay for a vacation or a wedding. Make a promise to yourself to use a personal loan only to solve a problem and instead save up for that vacation or wedding with a savings account so you avoid debt that doesn’t move your financial life forward.
- 401(k) loan debt — when you borrow money from your 401(k) retirement plan — is another type of debt that is best avoided. Even though you may be able to borrow at a competitive interest rate, you can run into penalties if you can’t pay the loan back in the prescribed period. And if you lose your job, your employer can require that you pay the loan back immediately. It’s true that you can avoid penalties in certain circumstances, like for homeownership, education or medical costs, but it is really a mistake to borrow from your 401(k) unless you are in dire straits. You don’t have to buy a house or go to school, so it is better to wait until you can afford to do so without tapping retirement money. Most Americans are falling short in saving for retirement, so borrowing retirement money for any reason other than a desperate need is usually a mistake.
- High-interest-rate loan (title loan, payday loan or “check-into-cash” loan) debt has no place in a healthy financial life. You’ll pay a huge amount of interest if you use this type of loan. Though the fees seem small, say $15 for a two-week, $100 loan, often borrowers end up continually rolling over their loans, extending the term and incurring additional fees each time. The Federal Trade Commission explains the problems with these kinds of loans: “The cost of the initial $100 loan is a $15 finance charge and an annual percentage rate of 391%. If you roll over the loan three times, the finance charge would climb to $60 to borrow the $100.” Although this type of loan is so expensive that it really should be avoided, it is quite common. According to industry trade group the Community Financial Services Association of America, payday lenders serve over 19 million (about one in six) American households — mostly in lower socioeconomic levels. Before you take out a loan, consider payday loan alternatives. Experts also recommend using apps like NAV or ActiveHours to access your paycheck early, or selling items you don’t need. And if you must turn to a payday loan, compare rates among banks, credit unions and payday lenders.
Avoiding and minimizing unwanted debt isn’t any easier than reducing your waistline. Both take discipline and sacrifice. Neither reduction experience is very fun. However, seeing your debt go down and then disappear would be really fun. Ultimately, feeling in control of the debt you purposefully decide to incur is ideal.
Remember, not all debt is bad, and some debt is probably necessary to achieve the goals you set for yourself and your family. So make sure you educate yourself about debt to make your financial life as positive and abundant as possible.
This article first appeared at NerdWallet.