Debt is one of those subjects we don’t discuss in polite company, but it couldn’t be more important in our daily lives. Once we distinguish between the different types of debt, we can get to work improving our financial health. Is it good debt or bad debt? Will it help or hinder me? Those are the questions, and here are the answers.
There are two types of personal debt, good debt and bad debt. Obligations that increase your net worth, such as home mortgages and student loans, are considered good debt. Bad debt is that which doesn’t add equity, like credit cards, payday loans, home rental, and automobile leases.
If you are tired of spinning your wheels and feeling like you live paycheck-to-paycheck, here is what you need to know about eliminating and avoiding the bad debt, building wealth, and securing your future. You work hard, and your money should, too. With some thought and planning, you can ensure your retirement and sleep better at night.
Types of Personal Debt
- Secured debt is backed by an asset or collateral, such as a mortgage or car loan, and is “secured” by your home or vehicle, and interest rates are lower because of reduced risk to the lender.
- Unsecured debt is based on your credit history and includes credit lines and signature loans. Lenders trust that you will repay this type of transaction based on your past performance; however, interest will be a lot higher. Collateral is not required to secure unsecured debt.
- Revolving debt allows you to borrow more while still carrying a balance, for instance, credit cards. It’s challenging to pay off a debt when you are constantly increasing the amount owed.
- Non-revolving debt is a fixed loan with a set number of payments over several years, like home and automobile loans. These are easier to budget for because they are due at the same time every month.
- Toxic and Sneaky debts are the ones you should avoid. Any purchase that depreciates falls into this category: automobiles, furniture, appliances, and even some homes can lose value before the loans are satisfied.
- You will never get your investment back with toxic debt. Free trial offers, 90 days the same as cash, and no payments for one year are considered sneaky debt. These are easy to lose track of and can end up costing you.
When borrowers use an asset they already own to secure financing, this is known as secured debt. You risk losing it if you can’t make your payments. Automobiles and homes are the most common collateral for secured debt.
Failure to make monthly installments can result in foreclosure or repossession of your vehicle. Interest rates are often lower with this type of transaction because the lender has some insurance that you will uphold at your end of the agreement.
Every time you apply for these types of loans, your credit score is impacted negatively, so you should limit how often you seek them.
The most common example of unsecured debt is a credit card. It also includes medical bills, signatures, and personal loans. Interest usually is higher since the lender has no absolute assurance that you will pay them back.
Based on your good credit and history of repayment, no collateral is requested. Failure to repay this type of debt can adversely affect your credit score, not to mention lawsuits and garnishments may be brought against you.
If you are found liable, lenders may attach your wages or other income, and you will then be “forced” to repay it. Income deductions can be devastating when you rely on your paycheck for daily expenses and other obligations.
In other instances, a lien may be placed on your property and must be satisfied before you can sell it.
This category allows consumers to borrow more money while they still have a balance. Credit cards and home equity lines of credit are good examples.
As you pay off the obligation, you are able to access financing without another application process. This can save you from more paperwork and hits to your credit score, but since they are ever-increasing can be very difficult to pay back.
Revolving debt should be used sparingly because it can escalate quickly into an insurmountable burden.
Home mortgages and automobile loans are considered non-revolving. They have a beginning and an end date; repayment is plainly spelled out.
Student loans fall into this category, too. Once the application is approved, you can’t borrow any more on that particular obligation. Interest rates and fees are spelled out.
An amortization schedule details how your payment is applied; what proportion goes to the principal and what amount is interest. A thirty-year mortgage will be paid off in precisely thirty years unless you have missed an installment or made principal-only payments to shorten the term.
Toxic or Sneaky Debt
Even so-called “good debt” can quickly go south. When the housing market changes, you could find yourself owing more than your home is worth. Lenders may like a thirty-year mortgage, but you’d be much better off with a ten- or fifteen-year loan. Adding extra payments when you are able will reduce the length of time you are paying off your home and can save you a bundle in interest charges.
Automobile financing is another debt that can sneak up on you. New cars depreciate in value the moment you drive them off the lot and continue to lose value every year after that. Some car dealers will offer terms of up to seven years to lower your monthly payment, and many people gladly sign on the dotted line.
They may not consider just how much extra money they are paying in interest and finance charges. A term of 36 months is preferable to a six- or seven-year obligation. Vehicles are rarely worth the loan balance, and you will seldom receive the amount of your investment when it comes time to sell.
Student loans have made many young Americans miserable when it’s time to pay them back. It would be best if you never borrowed more than what you would earn in your chosen field in one year. Graduates may find themselves facing an uncertain job market, and that student loan debt can look pretty big and ugly.
Don’t forget about grants and scholarships, which don’t need to be repaid, when planning for college. Trade schools offer an affordable alternative to traditional four-year degrees and offer two-year programs that can save thousands of dollars.
Skilled labor is always in demand and usually pays better than some degrees.
An added bonus is that you won’t be starting your career with massive debt. Introductory offers of low or no interest may sound like a great deal, but consumers might be tempted to let the grace period lapse and be stuck with interest and penalties after all.
Beware of free trial subscriptions as well. The advertising may state that it’s free for thirty days, and you can cancel any time. The trouble starts when you forget about it and miss the cancellation deadline, adding more obligations to your already stretched budget.
You may not even remember signing up for it until you see the money leaving your checking account. Credit card reward programs that offer cash back on certain purchases are rarely worth the interest you are still paying. Don’t be fooled by extravagant advertising.
Good Debt vs. Bad Debt
Some debts are arguably better than others, but is there ever really a “good” debt? After all, owing someone or something can be a considerable cause of stress and discord in your marriage, even in your well-being.
Debt can keep you up at night and cause you much anxiety. If you were to lose your job suddenly, how would you meet your obligations? If something unexpected happens to the primary wage earner in the family, how will the family survive?
Bad debts can haunt you for years, adversely affecting your credit score and future security. Retirement seems far off when you’re young, but the reality is that it sneaks up quicker than you might realize. When approaching the age when many retire, you may find yourself saddled with debt you can’t hope to repay.
It seems logical, then, to avoid going into debt if you possibly can. Homeownership may be the American dream, but you should shop within your means. That may mean purchasing a smaller house than you would prefer. Save up for a down payment to reduce the amount you will need to be financed.
Remember that you will still have to purchase title and home insurance, pay property taxes, and maybe Home Owners Association (HOA) fees. Plan for college expenses by applying for grants and scholarships that don’t require repayment.
We must get out of our “buy now, pay later” mentality. Build your savings, pay down your debts and learn to live below your means. You will discover new freedom and peace of mind. The best debt is no debt!