In the last few months we have seen reports that the U.S. Government’s outstanding debt has exceeded $22 trillion, student loans now total over $1.6 trillion and over 7 million people are over 90 days past due on repaying their car loans – yes,90 days past due. When you read headlines like these, my mind starts racing to figure out if taking on personal debt is poisonous or if debt can be helpful to life. In the FinancialVerse, it all depends on how you going to use the debt.
As a refresher, debt is money you borrow from banks, family members, friends and financial institutions and is usually evidenced by you signing a written agreement or note explaining how you will repay the debt and under what terms you have borrowed the money. Debt has many forms including credit cards, installment loans, student loans, mortgage loans, payday loans, and car loans. Each type of loan has different terms and costs. The cost for the debt you borrow is called interest expense. In addition to interest expense you will sometimes give up an ownership interest in the property acquired (e.g., mortgage and car loans) until the loan is repaid, agree to repay the loan over certain time frames (e.g., 48 months), sign different legal agreements, and pay different rates of interest expense depending on the loan type.
Interest expense varies based on the type of loan you use. The annual cost of the loan can range from single digits (e.g., 4%) for a mortgage to over 100% (yes, 100% annual interest) for payday loans. You need to understand the manner in which interest is charged on the loans you take out.
One way to understand the total cost of the money you are borrowing is to understand the Annual Percentage Rate or APR of the loan. This percentage is required to be disclosed to you when taking out a loan based on state and federal Truth in Lending laws. The APR shows the full cost of the loan, including any fees you are paying the lender to get the loan. It is the best way to make sure you have the real cost of the loan to understand and compare.
When Should People Use Debt?
In today’s FinancialVerse, people should only use debt to get cash to buy carefully considered big-ticket, expensive things that they haven’t pay for fully or when funds are needed for important goals like college education, a home or a vehicle used to get to work. In rare circumstances, people may need temporary funds to help absorb the costs of an unexpectedly large medical bill or other unexpected cost that exceeds their emergency fund. These types of borrowing make sense, provided you can repay the loans with your existing or future expected cash inflow (in the case of a college education).
Contrast this type of borrowing with what we see today – where consumers use high interest cost debt like credit cards, retail store cards and payday loans to buy things they don’t really need, pay regular monthly bills or to maintain a lifestyle that they cannot afford in the long-term. This type of debt, when added to the debt taken on for big-ticket purchases, is sapping the financial strength of households. It is forfeiting their financial futures to pay minimum monthly payments and high interest rates for years and years.
How Much House Expense Should You Have?
The largest monthly outflow for most people relates to their housing expense – either mortgage related costs or rent. Here are two key considerations when determining if you are taking on too much housing costs:
You need to limit your total housing costs, including mortgage or rent payments, real estate taxes and homeowners or renters insurance to a range. Keeping housing costs under about a third of your income should leave plenty of money to cover other necessities like food, transportation, childcare and insurance.
Borrow wisely: Defaulting on a mortgage, home equity loan or home equity line of credit comes with the risk of losing your home.
Most Common Types of Debt
Let’s look at the four most common types of debt you will encounter in the FinancialVerse:
Mortgage Debt
Houses are generally the most expensive purchase most people will make in their journeys. To make this big-ticket purchase, many individuals need to secure a mortgage on the property being purchased. There are a few different mortgage types to consider including Federal Housing Administration or FHA loans, Veterans or VA loans, conventional loans and home equity lines of credit. Each loan type has its own interest rates, amortization schedules, repayment terms, down payment requirements and other requirements.
Starting for the 2018 tax year, the interest paid on a home equity loan will only be deductible if the related loan is used to buy, build, or improve the home securing the loan subject to certain limitations.
Student Loans
There are two types of lenders for student loans: federal and private:
The government guarantees federal loans. They come with some perks that may not be offered by private lenders, including income-driven repayment options, loan forgiveness programs and fixed interest rates. Plus, some federal loans are subsidized, which means the government will foot the bill for the interest on the loan while the student is in school.
Private loans come from banks, credit unions or schools. In some cases, nonprofit agencies provide a guarantee for student loans or lenders may self-insure. A private loan may have a variable interest rate, which means that the interest rate you pay can change.
Car Loans
Many people need a car and make the decision to buy one, but quickly realize that in comparison to owning a home or investing in an education, cars are a depreciating asset. As they repay the car loan, they are building little or no equity. Car loans can be obtained at banks, credit unions, and at car dealerships. The average new car loan term can range from 24 to 84 months.
For borrowers with great credit (FICO 8 scores between 781 and 850), the average new car loan rate was 3.17% at the end of 2017. On the other end, borrowers with the worst credit scores (between 300 and 500) got an average new car loan rate of 13.76%, according to Experian.
Besides the interest rate, be sure to check whether there are any penalties for early repayment. One thing to look for is whether the loan is calculated as simple interest, which lets you avoid paying interest if you’re able to pay the loan off early. Alternatively, the interest could be pre-computed, which adds the interest to your balance. If you pay the loan off early, you owe the interest you would have paid over the life of the loan. Or, the lender may charge a fee called a prepayment penalty, to let you out of the loan ahead of time.
Unless you love repaying debt, avoid shopping for a car loan based on the monthly payment. If you’re unable to put down a significant amount of money up front, low monthly payments typically come with long repayment plans—which add up to more interest paid over the life of the loan.
Car loan terms have been stretching in recent years to accommodate higher car prices and consumer preferences. Long loan terms may also hinder your ability to sell the car before the loan is paid off if the amount owed is more than the resale value of the car. Avoid buying a car that is more expensive than you can afford, even if you're able to finance it. Do shop around for a car loan before taking the loan offered by the dealership. Banks or local credit unions can many times offer you a better rate.
Credit Cards
Credit cards can be great tools if used properly. They’re convenient and easy to use and may even throw some dollars your way if your card offers cash back as a reward or offers points rewards that can be exchanged for goods, services and travel.
After you apply for a card, credit card issuers review your credit report and decide whether they want to give you a line of credit. Depending on your income and credit history, lenders choose how much you are allowed to borrow and the rate of interest they will charge.
Most credit cards come with variable interest rates that are tied to the prime rate with rates of interest that can reach the mid-20% range. The prime rate moves up or down with interest rates set by the Federal Reserve.
Credit card issuers have many options for borrowers. Some cards offer balance transfers, some have great rewards, and some may be best for students or for those who are rebuilding their credit. Store-branded cards and gas cards may give you a break on purchases made at the store or gas station, but these cards sometimes carry higher-than-average annual percentage rates.
Another way of categorizing credit cards: Is it secured or unsecured? Unsecured cards are regular credit cards. Secured cards are typically aimed at people with no credit or low credit scores and require a deposit before you can start spending.
Making a payment late may trigger a higher annual percentage rate. Reading the fine print attached to your card is important. Cardholders should be aware of what they agreed to when they signed up for the card. Overall, the best way to take advantage of credit cards is by not carrying a balance. This way you get to reap all the rewards, but with none of the costs.
Summary
When you add it all up, we as a society are burdened by too much debt. In the FinancialVerse, you should only take on debt if you have carefully determined that the purchase is necessary and you can easily repay the loan from your cash inflow. If that’s not possible, you should postpone or forego the purchase.
Go to debt.org. for more information and resources on how to obtain, manage and pay off debt.