Debt is a reality of life for most of us, and, when done right, can be a great tool to help you manage your finances. In fact, never borrowing money can negatively impact your financial health overall. But there are risks involved, too. If you use credit incorrectly, the interest payments on your debt can add an element of risk.
Understanding how debt works and where the risk comes in can help you use credit smartly and avoid the pitfalls of bad debt.
Different types of debt
In general, there are two types of debt: secured debt and unsecured consumer debt.
When the money you borrow is linked to an asset of some kind, the asset “secures” the debt. A mortgage is secured by the house. If you were to default on your mortgage payments, the lender could seize the house to cover the loan. Car loans and home equity loans are secured debt, too.
Consumer debt, on the other hand, tends to be unsecured. It’s not linked to an asset. Credit cards are unsecured debt — there is no easy way for the lender to recoup missed payments. Because of this, credit cards usually have much higher interest rates than secured debt, like a mortgage. This is the kind of debt you want to avoid, since the interest payments can add up. But if you pay the credit card off every month, it can be a great tool to help with cash flow. Plus, the rewards points can boost other areas of your financial plan.
Credit cards can also offer you more protection against fraud than a debit card, check, or cash. The regulations for credit card fraud are slightly different and it tends to be easier to spot and report suspicious activity. Plus, the world is shifting toward digital payments, and credit cards are often the best tool. So, while using credit cards can be risky if you don’t pay them off, they’re not inherently bad.
The way you balance secured or unsecured debt also affects your credit score. The type of debt you carry is one of the five factors used to calculate the score. Generally, secured debt is considered “safer” than unsecured debt, so having a large balance on your mortgage wouldn’t necessarily impact your credit score, but a large balance on your credit card may.
If you’re working toward a big purchase, like a house, you might be able to use credit cards (or other debt like a car loan) to help you build your credit score and put you in a position to get the best terms on a mortgage. Consistently paying off any debt will help your credit score more than the type of debt you have.
Interest rates: What you need to know
With debt, there are two main types of interest rates: fixed and variable. Fixed interest rates tend to be a bit “safer” since you know what rate you’ll be paying and can build it into your financial plan. With variable rates, the interest rate is subject to change. Usually, the amount it changes is tied to market rates, so if the Federal Reserve raises rates, it’s likely the interest rate on any variable loans will increase. The same may hold true if the Fed lowers rates, but lenders can sometimes be more eager to raise rates than lower them.
The higher interest rates on credit card debt tend to be variable. So, if you have any existing debt, you could see your interest payments unexpectedly increase simply because the market rate changed. That adds an element of uncertainty and risk to your overall financial plan, which is one of the reasons we advise clients to avoid consumer debt when possible.
Finally, it’s important to know that there’s a difference between the pure interest rate listed on a loan and the amount you pay. Usually, the actual rate you pay is known by its acronym, APR, which stands for Annual Percentage Rate.
Often, loans come with fees or other associated costs. The APR is the total amount you’ll pay each year with those additional costs included. Lenders are required to list the APR as well as the interest rate on any mortgage or loan product. When you are comparing different terms, be sure to focus on APR since it’s a more accurate reflection of what you’ll pay. Credit cards also come with APRs based on an interest rate calculation.
How debt fits in overall
The main thing is making sure you use debt as a tool, rather than a way to live outside your means. The best way to do this is to make sure you have a plan.
Often, we recommend clients pay their balance each month. And if you have any high interest debts, we can work to help you prioritize paying it down to minimize the risk of high payments. Plus, the sooner you can pay down high-interest debt, the more money you save in future interest payments.
For this same reason, low-interest debt may not be a concern. If you have a mortgage with a 4% rate, it may not make sense for you to aggressively pay down your home. The money you’d spend paying that debt off early could do more for you if you invest it.
If the potential returns from investing your money are higher than the cost of your debt, it may be better to invest the money than pay down debt. In other words, if you have an extra $100 each month, and the stock market historically averages returns of about 8%, investing that $100 may earn you more than you would save using that same $100 to pay your mortgage off ahead of schedule.
If you are thinking of taking out a loan or using your credit card more than normal, we can work with you on a strategy do it smartly. Debt in and of itself isn’t good or bad. You just want to use it to help you reach your goals, versus interfering with them.
