Understanding Debt -- Everything You Need to Know

Debt is a tricky thing. Handled wisely, it can help you reach your dreams. Handled poorly, it will do the opposite. After all, debt can pay for a graduate degree that doubles your salary within five years ... or it can lead to unmanageable interest payments and-gulp-bankruptcy

Yup, the word debt can sound scary. And it’s true–many of us haven’t been using this tool responsibly lately. A U.S. Census Bureau report showed that, in 2009, outstanding credit card debt per cardholder totaled nearly $5,700. Even worse, 1.57 million Americans filed for bankruptcy in 2011. 

Despite these harrowing statistics, using debt wisely can be the very definition of living richly. It’s an integral part of buying your own home and for many people, buying a car or becoming qualified for their dream job. Read on to find out what using debt wisely really means.

 

Debt in a Nutshell


In short, debt is money borrowed from someone with the promise of paying it back at some point, often with interest. That someone could be the bank, credit union, credit card issuer, the government, a furniture store or even your mom, among many other places.

When you take on debt, you get a lump sum of money up front and you pay it back in installments. You also pay the lender interest every month for letting you borrow the money. For example, if you take out a loan for $1,000, and the interest rate is 1% per year, you’ll pay $10 over the course of the year for holding the full amount of the loan.

In most cases, the lender will send you a monthly bill stating how much you are required to pay that month. You have to pay the minimum, but you can choose to pay more in order to pay off the loan faster and save yourself money on interest.

 

Why You Need to Understand Debt


As of January 2012, average consumer credit card debt stood at over $7,000. Among households that had revolving debt, the average was $15,400. On top of that, student loan debt is on the rise–it jumped 4.6% from 2011 to an average of $35,000.

Despite the fact that credit card debt fell during the Recession (mainly because banks were forgiving bad debts) it’s expected to rise again in 2013, along with defaults. In addition, one in 810 households are still being foreclosed on, and one in six student loan borrowers are in default. Understanding debt can help you avoid these scenarios.

 

How Debt Works for You … or Against You


Whether debt is beneficial or deadly is determined by two factors:

Interest: This is the money you pay the lender for the privilege of having the money upfront. This interest will compound, which is another way of saying it snowballs. And the higher the interest, the more quickly it will snowball. Interest is the main reason why debt sometimes gets out of control.

Whether the debt is taken on as in investment in your future: If you take on the debt in order to leverage, say, greater earnings in the future, then the debt has furthered your financial goals. If the debt won’t yield any future reward, it isn’t an investment but a burden.

But when deciding what to pay off first and whether it’s even a good idea to take that type of debt on in the first place, these designations are good rules of thumb:

 

Good Debt


Good debt usually has a low interest rate–6% or less–and is often seen as an investment in your future happiness and financial stability. These are three common types of good debt:

Student loans, which can increase your salary and lifetime earnings, plus improve your quality of life
Mortgages, which can help you buy your own home, instead of spending money on rent
Business loans, which help you start your own business–which will hopefully lead to higher earnings and a fulfilling career

Not only do these kinds of debt normally offer low interest rates, but the interest may even be tax-deductible! Real estate has the added bonus of sometimes increasing in value.

However, good debt can easily become bad debt if it is taken on without a solid plan for repaying the loan. For instance, if you took out a college loan of $150,000 that lands you a job paying $31,000 out of college, then the debt-payoff ratio is probably dismal enough to make it more like bad debt than good. Also, any debt is bad debt if you aren’t taking responsibility for paying it off.

Bad Debt


Bad debt has higher interest rates, and is the kind of debt you can probably stay out of if you manage your money wisely.

Credit card debt, if not paid off every month, can quickly accumulate. If you aren’t paying your balance every month, it’s time to redo your budget (or get one) and start living within your means.
Car loans are important if you need a car to get to work, but unfortunately cars are depreciating assets. That means they start losing value as soon as they are driven off the lot. Plus, the interest rate on car loans is usually higher.
Consumer loans charge high, even predatory, interest rates. If you have some or a lot of consumer loan debt, again, you likely need to revisit your budget and begin living within your means.

For an example of how bad debt can quickly multiply, consider credit cards, which have interest rates that can be as high as 24% or more. If you have $5,000 in credit card debt, that’s $1,200 a year in interest alone!

If you don’t make any payments, the next year you’ll be charged $1,488 in interest because you’re being charged on the $5,000, plus the interest you racked up the year before. See how interest can start really adding up? In some cases (especially with student loans), people find themselves only able to make payments on the interest, and not able to pay back the actual loan.

 

 

Your Steps


If you are thinking about taking on debt:

There are some people who have foresworn ever having any kind of debt. But unless you plan on paying in cash for a home someday, you might want to take the route of just learning how to manage your debt well now. Every time you take on debt and pay it off (most often by using a credit card and paying it off every month) you’re building a credit history, which is a good thing. Here’s are some rules to follow:

1. Don’t take on debt you don’t need.
Debt can be tempting, especially when it seems like it can let you buy your dream home or a fancy car, or just finally add a pair of Burberry boots to your closet. But the cardinal rule of debt is to not take it on if you don’t need to. If possible, consider downgrading to something more affordable, or just doing without until you can save up for it. (If you want to learn how to build savings, read our checklist.)

2. Know your financial situation.
Before you even start thinking about taking on debt, you first want to be very familiar with all aspects of your finances. What is your annual income? (Or, if you’re considering student loans, your expected annual income?) Are you sure that your income will stay steady or grow? How much extra room do you have in your budget for debt repayment? What kind of cash or investments do you have available to you? How much debt do you already have? Can you afford to take on more? Knowing your numbers is key to making smart decisions.

3. Do your research.
When looking at an interest rate, you want one that is lower (5% instead of 15%), compounded less often (monthly or yearly instead of daily) and most likely fixed—as in always the same. As many former homeowners learned the hard way, an adjustable interest rate can come back to bite you when it jumps from a manageable 5% all the way up to 15% and suddenly you can’t afford that loan anymore.

Don’t ever take the first option offered. There’s almost always something better out there, whether from a more reputable source or with a lower interest rate. For example, credit unions usually have better interest rates than big banks, and much better rates than predatory payday lenders. If you’re offered a credit card, keep looking to find a better interest rate or better perks. If you need a student loan, look for federal loans before you turn to private lenders.

Every loan has fine print, which you should read. Yeah, we know, it’s super boring. But buried within the fine print are all those little things that could cost you thousands of dollars–things like whether your interest rate might jump, what happens if you can’t pay and more. Even if it takes three hours of Googling the terms in your credit card agreement, or sitting with the loan officer at the bank, get to know all the terms and what they mean for you.

If you already have debt:
Once you do have debt, you want to treat it as a financial priority. Here’s how:

1. Prioritize it.
Except in dire financial situations, you don’t have to live like a monk. But if you have debt, you shouldn’t be living lavishly either. Think of it this way: Every time you choose to go out to dinner instead of making a payment on your debt, you’re choosing to rack up more interest. So try to pay of your debt as soon as possible with payments much higher than the minimum required. If you’re wondering how to make more room for higher debt repayments, having a budget and sticking to it is key. (Learn how much you should be contributing to your debt with our I Want to Set Up a Budget checklist.)

The one exception to paying of your debt as soon as possible is your mortgage payments, which are designed to last for 15 years or more so you can afford the monthly payments. However, if you want and are able to pay it off faster, don’t let us stop you! You’ll save big on interest.

2. Don’t neglect savings while trying to pay a debt.
When you have debt hanging over your head, it can be tempting to shovel every last cent toward paying it off. But the second you get handed a big medical bill, you’ll wish you had kept some money in savings. Plus, if you have no cushion whatsoever, you’ll have to accrue more debt in order to pay for those emergencies–and adding more debt on top of already-existing debt could make you feel bad enough that you give up altogether. For that reason, you should work on building up your savings at the same time that you pay down your debt.

3. Pay off bad debt, particularly credit cards, first.
If you have more than one type of debt, prioritize paying off credit cards first, since the interest grows on these balances every day. Next up is other debt, including car loans, personal loans or student loans–for these, you should prioritize the highest interest rates first. So, for instance, the car loan with the 11% APR should be paid before the student loan with 6% APR. (You can see how this works on the website unbury.me.)

This doesn’t mean stop paying for your other debts altogether! Keep making the minimum payments, but shuttle as much as you can toward your biggest debt priority, which will save you money on interest. It’s a great mental boost to sweep one type of debt off your plate so you can focus on the next.

4. Keep Track
Make sure you always know how much you owe to what lender, and how much interest you are being charged. The best way to do this is to enter your credit cards, student loans, mortgages and other debt accounts in LearnVest’s My Money Center, which will show you where you stand at all times.

5. Consolidate Where You Can
If you have more than one mortgage, several credit cards or more than one student loan, it helps to consolidate it all with one lender. That way you can more easily keep track and make payments. If you have several credit cards with debt, try rolling it all on to a low- or no-interest rate credit card.

 

Remember …


Debt doesn’t have to be a bad thing. If you follow these rules, it can help you reach life goals like buying a home, establishing a fulfilling career or just easily shopping online—without putting yourself through stress or hardship.

Need help managing your money? LearnVest's free Money Center will help you create a budget and our free stories are always here to educate and entertain you.

Read more from LearnVest:
-- 4 Ways to Trick Your Brain Into Banishing Bad Money Habits
-- How I Found Financial Freedom After Paying Off $20,000 in Debt
-- 5 Bad Money Habits That May Be Genetic

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