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Debt 101 - Everything You Need to Know About Debt
There are many different types of debt - some considered "good" debt, but most are bad debt. Many people don't think they are really in debt if the only money they have borrowed is for a mortgage, student loans, medical bills or car payments. By definition, debt is the act of owing another person something and if you owe someone money - regardless of who it is or what it is for - then you are in debt. Owing other people or companies money is NOT FUN! It causes enormous amounts of stress and restricts your freedom to do the things you really want to do. Let's take a look at the different types of debt.
Auto Loans - When you borrow money for a vehicle it is an auto loan. This is a secured debt, which means if you can’t pay the loan back the lender can take your vehicle. This is a better debt than unsecured but a car payment is usually the second largest monthly payment a person has, which ties up a lot of your income.
Home Loans or Mortgages - This is what I consider the only “good” debt. Homes typically appreciate, or go up, in value. This is also usually the largest monthly payment a person has, as a home is probably the most expensive thing you will ever purchase. You can usually write off the interest on your taxes, which does help some.
HELOCs or Second Mortgages - This is a loan borrowing on the equity in a home. Say your first mortgage is for $150,000, but your home is valued at $200,000. You have $50,000 in equity and many people choose to pull this money out in the form of a second mortgage. When you purchase a home if you don’t have 20% to put down you have to pay Principal Mortgage Insurance, or PMI. Many people take out a second mortgage to cover that 20% and they can avoid PMI. Many people also take out second mortgages to pay for home improvements, vacations, cars, school, etc.
Student Loans - Many people consider student loans a good form of debt. I am not so sure. When you graduate (if you graduate) from college all you really have is a piece of paper to show for it (ok maybe some extra knowledge). This is essentially an unsecured debt. It is also not bankruptable. So unless you die you have to pay this money back. You need to think extra hard before you ever borrow money for school. Student loans can be through the federal government or through private lenders and you can pay on them anywhere from 5-30 years. That is a really long time to pay for a degree.
401k Loans - Many people have retirement plans through their work called 401k’s. You can borrow against these retirement savings accounts to pay for school or buy a home. You are forced to pay it back because they take the money right out of your paycheck. Essentially you are borrowing from your future. The catch is, if you leave the company or the company goes under, you will usually have to pay back the entire loan immediately, which is something most people can't do.
Payday Loans - Payday loans are the worst type of debt a person could ever have. It all starts off so innocently in needing just a couple of hundred dollars in advance of your next pay check. These extremely short term loans have astronomical interest rates. Because the fees and interest are so high you are paying back much more than you borrowed, which will leave you in a bind for the next pay check, and the next pay check, etc. The cycle just continues until you can’t pay anymore.
Medical Debt - Medical debt is something that most people can’t really plan for and frequently you don’t have an option as to whether you borrow the money or not. If you need medical care then you need medical care. Doctor’s offices and hospitals are very good about working with a person to come up with a payment plan that will work for you. Usually you don’t pay interest on the loans either. This is still money owed though and can go to collections if you don't pay.
Personal Loans - When you borrow money from a friend or family member this is a personal loan. Borrowing money from friends or family usually ends badly. If you do have to do it, make sure you get it in writing as to how much, if there is going to be interest, and exactly how you will be paying it back, including when. This will help on the relationship end of things. Many people put personal loans low on the priority list of things to pay back, but I think it should be high on the list. Borrowing money from friends or family can ruin relationships and cause a lot of hard feelings.
Credit Card Debt - This is another bad form of debt. Using a piece of plastic to pay for the things you want and need will cost you much more in interest and stress than the item would have cost you had you paid cash. The average American household carries over $14,000 in credit card debt all the time. If you quit using your charge card today, it will likely take you years and years to pay back the debt. The interest rates are usually high and this type of debt is unsecured.
Owing people or companies money might seem like something that can't be avoided. I disagree though. We have made it through most of our marriage with only a mortgage payment. When you don't have monthly payments then you are able to pay for things with cash upfront. The more monthly payments you have (i.e. the more money you owe each month) the less likely it is that you can pay cash for much of anything. Unfortunately it is a negative cycle that anyone can easily fall into. But if you work hard to get out of debt, then you will realize how much better it is not to owe someone else money. Once you are free of the monthly payment cycle you will have a better chance of staying out of debt.