This is a guest post for Skills You Need.
Want to contribute? Find out how.

Understanding Debt

See also: Everyday Math

Chances are good you have some sort of debt. Unfortunately, though, without a proper understanding of debt, you can quickly dig yourself into a deep, unending financial hole.

This page will explain the key features of any loan and the types of debt that you should be aware of. It will also explain the benefits and pitfalls of debt, and offer advice on how to get yourself out 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 party, and debt is the total amount of loans one has outstanding. For example, Steven has three loans of $5,000 each, which means he has total debt of $15,000.

Debt is about Risk

A key concept to understanding debt is that it’s highly intertwined with the measurement of risk.

Say your sister Alex 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 Steve 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? Alex 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 (see our page on Understanding Interest for more).

Both Alex and Steve come asking you for $500. Would you charge Steve the same amount to borrow money as you would Alex? Definitely not. Steve 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, Steve would get a loan with a much higher interest rate than Alex.

Features of a Loan

Secure vs Unsecured Debt

Now that we understand risk, let’s go back to your brother Steve. 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.

See our page on Loans and Savings for more on Secured and Unsecured loans.

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.

 

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.

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 be paying for years. Worse, if a lender only charges you interest each month, you’ll be paying interest on that debt until the day you die.

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.


Types of Debt

Now that we know the basic features of debt, let’s examine some of the most popular debts out there. I list 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.

  • Auto Loans

    Loan Type: Secured (the car)
    Fixed vs Variable: Usually fixed
    Interest rates: Low
    Thoughts: Many dealerships offer low or 0% interest rates you can take advantage of during holidays. 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 that they need to meet, their rates will be higher than those 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.

  • Personal Loans

    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 personal with the professional.

  • Credit Cards

    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 from 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.


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.

  1. Leveraging

    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 on 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 four 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.

  2. Lifestyle

    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.

  3. Existing debt

    Many people also incur debt to pay off existing debt. For example, Sheila 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.

If your debt is unaffordable or you have experienced financial hardship, you may consider debt management, debt settlement or debt relief. Each of these avenues have different pros and cons, so each option should be fully understood before making the decision to pursue a specific path.


Getting out of Debt

There are many things that you can do to start the debt freedom journey today. Here are five simple steps to help you get out of debt:

  • Understand and Track All of Your Debt

    In order to pay off your debt, it’s important that you understand and track all of your debt. Without knowing how much debt you have, it will be near impossible to get you out of it. This can be done through a variety of ways such as using a notebook, adding your finances to excel, or downloading a budgeting application.

  • Prioritize and Simplify Your Life

    In Marie Kondo’s best-selling book, The Life-Changing Magic of Tidying Up: The Japanese Art of Decluttering and Organizing, Marie asks the reader, who is pursuing tidying up, to ask themselves the question of whether an item sparks joy. This is an important question as the readers realize that many items cluttering their lives do not provide joy.

    First, look at items that you currently own and ask whether they spark joy in you. If the item does not spark joy, and is not vital, you may be able to sell that item and use the funds to pay off debt.

    Second, before you make another purchase, ask yourself whether that item will give you joy to help justify the purchase. This can help you prioritize future spending.

  • Budgeting

    Budgeting is an important step to help folks get out of debt. Once you understand your debt, it’s important to put your income, expenses and debt into a budget to give you 100% clarity on your financial situation.

    See our page on budgeting for more information.
  • Pay Down Your Debt with A Strategy

    There are two primary methods to pay down your debt and each has its own pros and cons. The Snowball Method is the method where you pay off your smallest debts first. This is a psychological win for individuals as they can see how the debt decreases over time. The Avalanche Method is the method where you pay off the highest interest-rate debts first. This is the most cost-effective way, but you may not see any debts being paid off for some time.

  • Create an Emergency Fund

    Many people take out debt because of personal emergencies, such as losing a job or medical emergencies. These are unavoidable, and we cannot expect life to pass without anything unexpected happening. When finances are going well, we recommend that you start saving up cash to help you pay the bills for at least 6 months. This will help you better weather any storms that come.


About the Author


Ben Tejes is the Co-Founder and CEO of Ascend Finance, a platform to help people achieve self-improvement in the area of personal finance. He is a writer for the Ascend Blog where he writes to help people get out of debt and experience financial freedom.

TOP