The Ultimate Guide to Understanding Debt
Debt is bad… or is it?
A common misconception people have is that all debt is bad. After all, you’re put at the mercy of the person or institution that lent you money.
The truth, however, is not as clear-cut as it seems. Let us help you gain a better understanding of what debt is and how some debt can help you earn rather than lose.
What is Debt, Really?
Debt, at its core, is money owed by one party to another. In a debt arrangement, the borrower is permitted to make the loan. It also states the terms of the loan, such as the date for repaying the balance, interest rate, and more.
Two types of debt exist—secured debt and unsecured debt. Secured debt is when the borrower uses an asset as collateral for the loan. If the borrower fails to repay as agreed, the creditor can seize the asset. Conversely, unsecured debt does not have the backing of an asset. Debt collection for unsecured debt can result in legal action if the borrower fails to repay.
Some of the most common forms of debt are:
Credit Card Debt
Credit card debt arises from being unable to pay the monthly balance on your credit card. This form of unsecured debt is unfortunately very common, with the United States’ total credit card debt reaching around $438.8 billion in 2019. Credit card debt can be challenging to get rid of due to high interest rates and rigid payment schedules.
This is money borrowed from a financial institution—banks, credit unions, or online lenders—to be used for almost any reason. Having your house repaired or purchasing an appliance can be reasons to take out a personal loan. A typical personal loan will provide money to the borrower in a lump sum and repaid to the lender in fixed monthly installments.
What sets a student loan apart from a personal loan is that the former is specially designed for funding education. You can apply for this from either private and federal institutions. While student loans can be less expensive than other loans and are easier to apply for, they can be tricky to manage and may keep you in debt for longer.
A mortgage is a form of debt in which people and businesses can purchase real estate without paying the full price upfront. The loan is paid over several years with interest. If the borrower fails to repay or “defaults” on the mortgage, the property is foreclosed and sold to clear the debt.
Businesses often take on debt to take advantage of growth opportunities. Business loans and lines of credit can be used to finance expansions, hire more employees, or boost cash flow during a crisis.
Good vs. Bad Debt
If the debt increases your net worth or has future value, it’s good debt. If it devalues or takes away money from you regularly, it’s bad debt.
Debt doesn’t need to be bad overall. It can also be a tool for growth and profit. On the one hand, borrowing money for something that can generate income or increase your wealth over time is a move that benefits you in the long run. On the other hand, if you incur debt for something that is losing its value or decreases your wealth, then it can be considered harmful.
Knowing how to spot the difference between good and bad debt can empower you to make proactive financial decisions while avoiding threats to your financial health.
Take this situation as an example: you take a loan of $50,000 to invest in buying new equipment for your established restaurant business. The loan will incur 7% interest and is payable over the course of two years. This loan becomes an example of good debt, as it helps improve your restaurant. In turn, better service can easily boost your restaurant’s income, making it possible for you to pay off the loan with ease.
Other examples of good debt include taking out a loan to repair fixtures in your rental apartment. By making repairs, you can raise the value of your property and rent it out for more money.
Here’s another example: you borrow $100,000 to purchase a duplex that already gets rented out. The property makes $10,000 yearly from rent, and the loan you take out has 12% interest.
While this may seem like a worthwhile investment, the income from the property is only 10% of the total amount. Adding the 12% interest on top of this income, you’re more likely to lose money than gain it. In this case, this situation counts as bad debt.
Purchasing a new TV or car with loans is also a form of bad debt. Appliances and automobiles depreciate in value over time. Cars, specifically, also cost money to maintain regularly, draining your savings more.
Debts can be Beneficial, Too
The key to managing debt is to leverage it for growth and avoid taking too much all at once. With too much debt, interest rates and losses can easily snowball, making it extremely difficult or impossible to pay all of them off.
If you find yourself sitting on too much debt, here are some quick tips to help you settle them.
Increase sources of income
Getting a side job or selling unwanted belongings can give you additional cash to settle your outstanding balances.
Cut unnecessary expenses
From skipping on your daily to-go coffee to putting your wants on the back burner, keeping spending to a minimum will save you money that you can put into paying debts.
Find the right strategy for debt payment
Choose to either pay the small balances first or tackle the debts with the highest interest rates; the important thing is to build your momentum to continue clearing your debts.