In many situations, debt can be a significant burden. In other circumstances, though, it’s possible to use debt to further your financial goals.
While some financial gurus may advise that no debt is good debt, loans are sometimes necessary to pursue long-term goals, like buying a car or a house. It’s important to consider your situation, goals, and values to determine how to handle debt in your financial plan.
No matter what, though, you should always make a repayment plan before taking out any type of loan. Today’s blog explores different types of debt, including a few you should always try to avoid, and others that may work as a means to an end.
What Is Bad Debt?
There are certain types of debt that are universally considered to be bad, primarily because they typically have a negative impact on a person’s finances instead of a positive one.
The average interest rate on credit cards that assess interest is 16.28%, according to the Federal Reserve. If you have a rewards card or a credit card for fair or poor credit, your rate can easily climb to 20% or higher.
Credit card debt is particularly nefarious because of how payments are handled. Unlike an installment loan, which has a set monthly payment schedule, credit cards give you a minimum payment, which is only a small fraction of what you actually owe.
As a result, instead of having a clear idea of when you’ll be debt-free, you could end up carrying a balance for several years, especially if you continue to charge more purchases to the card.
Having a high credit card balance can also damage your credit score — the higher your balance is relative to the card’s credit limit, also called your credit utilization rate, the worse it is for your credit score.
Payday Loans and Other Short-Term Debt
If your credit is less than stellar, you may feel like you don’t have a lot of options. There are lenders out there that offer short-term, high-interest loans that can help in a pinch, but in almost every situation, borrowing money this way only makes your situation worse.
For example, the average annual percentage rate (APR) on a payday loan, which includes interest and fees, is nearly 400%. Moreover, 80% of payday loans are renewed or rolled over into new payday loans because the borrower can’t afford to repay the debt. With each new loan, you’ll get new interest and fees tacked on, making it increasingly difficult to escape the cycle.
Auto title loans may also be appealing if you own your car, but they also charge triple-digit interest rates, and if you can’t repay the debt, you’ll lose your car.
Some lenders may also offer bad-credit personal loans, which aren’t as expensive as and offer longer repayment terms than payday and auto title loans. But even these may charge interest rates upwards of 100%, which can do more harm than good.
Personal Loans for Discretionary Spending
Using a personal loan to consolidate high-interest debt or finance a home renovation could be a good option. But if you’re thinking about borrowing money to fund a vacation or make some other large discretionary purchase, you may end up regretting the decision.
What Is Good Debt?
While some may argue that all debt is bad, certain types of credit can improve your financial situation as long as you have a repayment plan.
The student loan debt crisis is real, and it’s important for parents and universities to help college students to find ways to reduce how much they need to borrow to attend college. But in general, taking out student loans could be considered an investment in your future career.
Also, student loans tend to have relatively low interest rates, especially if you’re borrowing from the federal government.
Too much student debt can be financially debilitating, though. To avoid borrowing too much, look for opportunities to get scholarships and grants through your school and private organizations. Also, consider attending an inexpensive school and, if you can, take on a part-time job to earn some money while you study.
For the vast majority of Americans, buying a home without a mortgage is virtually impossible. The good news is that mortgage loans are among the most inexpensive forms of financing. What’s more, using a mortgage loan to buy a home can improve your overall well-being if you make on-time payments.
And while it’s not a good idea to consider a primary residence to be an investment, homes generally do appreciate in value over time, which could result in a nice windfall when you eventually decide to sell.
Auto loans can be considered both good or bad, depending on the situation. Vehicles generally depreciate in value, and the price of the car itself is only one of the many costs associated with owning a car.
In many cases, though, people need a vehicle to get to work or school, and if you don’t have enough cash on hand to buy a car outright, an auto loan may be a necessity.
Also, if you have good credit, you could get an auto loan with a very low interest rate, making it an affordable debt.
Where it can go downhill, though, is if you borrow more than you can afford to pay or you have poor credit. That’s because some auto loans can have interest rates as high as 25% — which is worse than most credit cards.
And if you purchase an expensive car without considering your budget and other financial goals, it could end up limiting your ability to improve your financial health.
Using a personal loan for discretionary spending isn’t ideal, but taking one out to consolidate high-interest credit card debt can sometimes be a step in the right direction.
On average, personal loans charge lower interest rates than credit cards — 9.65% versus 16.28%, according to the Federal Reserve. They also have a set repayment schedule, so you can ditch the minimum payment trap.
Also, balance transfer credit cards can be a great way to consolidate and pay down debt. These cards typically offer an introductory 0% APR promotion over as many as 20 months, depending on the card. This approach can make it possible for you to eliminate your debt interest-free, saving you hundreds of dollars.
Keep in mind, though, that debt consolidation tools like these are ineffectual if you don’t reevaluate your spending habits and avoid racking up more debt on your original credit cards.
The Bottom Line
In certain situations, debt can be used as a tool to improve your financial situation. In others, though, it can be a major roadblock, making it difficult to achieve your goals.
As you think about your relationship with debt, it’s important to consider your reasons for borrowing money. It’s also a good idea to look for ways to avoid borrowing money — or at least taking on more debt than is necessary.
If you do need to take out a loan, be sure to research the best options and make a repayment plan beforehand. Sometimes, small amounts of low-interest debt may help you to pursue financial goals you may not otherwise be able to achieve on your desired timeline.
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Information contained in this blog is for educational and informational purposes only. Nothing contained in this blog should be construed as legal or tax advice. An attorney or tax advisor should be consulted for advice on specific issues.