Debt. Most of us are familiar with it. Used wisely, it can help generate equity, build your credit score and even prepare for the future. From mortgages and credit cards to car and student loans, the New York Fed reported Americans’ overall debt reached $13 trillion in 2017. To avoid being bogged down by too much debt, you should know the details of your current financial situation. Think carefully before jumping into the wide, wide world of debt.
The 50/15/5 Rule
It may be a good idea to follow the 50/15/5 Rule when it comes to your debt. Simply stated, no more than 50% of your take home pay should go toward essential living expenses. This includes housing, transportation, food, child care and insurance. 15% should be set aside for retirement savings and 5% of should go to short-term savings.
Types of Debt
There are basically two types of debt: installment and revolving. Installment debt covers loans for things like your house or car, and student loans. Revolving debt covers things like credit cards. The primary difference is that installment loans have a set period of time while revolving debt can be potentially carried forever.
Installment debt is usually preferable because it may provide tax deductions in certain situations. Also, it doesn’t usually affect your credit score the same way revolving debt can. For instance, the amount of credit card debt you carry versus the amount of credit you have available is called credit utilization. Credit utilization is a significant part of your overall credit score.
Regardless of the type of debt you carry, the real difference between “good” and “bad” debt is how you use it and your ability to repay it.
Your house is probably the most expensive purchase you will ever make. And more than likely, you will have to take out a mortgage to afford it. Most experts agree your housing expense shouldn’t be more than 30% of your take home income. (Housing falls under the “50” in the 50/15/5 Rule discussed above.) Others contend your house should cost between 3 and 4 times your annual salary.
If you’re buying your first house and don’t have a large savings account, the Federal Housing Administration (FHA) offers a program that requires as little as a 3% down. Under the program, the FHA guarantees your loan. However, you have to pay extra for the guarantee. This installment loan can last for 15 or 30 years.
If you’re a member or eligible surviving spouse of a member of the U.S. Military, you may be able to secure a VA Loan. The Veteran’s Administration will back your loan and may not require a down payment if the sales price is equal to or less than the appraisal value. Another benefit is that private mortgage insurance (PMI) isn’t required. This installment loan can last for 15 or 30 years.
Conventional loans aren’t insured by the government like FHA and VA loans. If your down payment is less that 20% of the purchase price, you will be required to purchase private mortgage insurance (PMI). PMI can be expensive and is an on-going annual expense until your loan-to-value ration hits 80%. Once that happens, PMI is no longer necessary. This installment loan can last for 15 or 30 years.
If you have good credit with the ability to make the loan payment, you might consider an interest-only loan. With this installment loan, you pay interest on the mortgage for a term of 5 to 10 years. Once the interest-only term is up, monthly payments increase. The new payment is based on the loan balance and interest over the remaining years of the life of the loan. Many people either refinance or move at the end of the initial interest only period to avoid the increase.
Home equity loans and lines of credit (HELOC)
Similar to a mortgage, you may be able to take money out of your house through a home equity line of credit (HELOC) or home equity loan. An appraisal may be required and the bank will look at your ability to repay the loan. The HELOC allows you to borrow against your home equity up to the limit set by your bank. A home equity loan will give you one lump sum of money.
Credit Cards are convenient and easy to use. Some of them even offer great perks like cash back, airline miles, etc. After applying for a card, the issuing company check your credit report and then determines your interest rate and how much you’re allowed to borrow.
Generally speaking, credit cards have variable interest rates that are tied to the prime rate. The Federal Reserve sets the prime rate and it moves up and down. This means the interest rate on your credit card will probably fluctuate too.
Some cards offer balance transfers or rewards while others are designed for students or someone rebuilding their credit. There are also store and gas credit cards that may give discounts on items purchased at their store or gas station.
While credit cards can be useful, making a late payment may result in fees and/or trigger a higher annual percentage rate. The best way to take advantage of credit cards is to make sure you don’t carry a balance. Paying off your card each month ensures you get to enjoy the rewards and/or discounts without incurring additional costs.
In the United States, cars are a fact of life for many people. Unfortunately, they’re a depreciating asset. Unlike your mortgage or student loan, a car loan doesn’t build equity and it doesn’t make an investment in yourself. Found at banks, credit unions, and car dealerships, loan turns can range from 24 to 84 months.
If you have a credit score between 781 and 850, the average new car loan interest rate was 3.17% at the end of 2017. However, if your credit score falls between 300 and 500, the average rate went up to 13.76%. In addition to your interest rate, make sure you understand how interest is calculated. If your loan is calculated as simple interest, you can avoid paying interest if you pay the loan off early. (Be sure to see whether there are any penalties for early repayment). Conversely, if interest is precomputed, it’s added to your loan balance. That means if you pay the loan off early, you’re also paying interest based on the full life of the loan.
When it comes to student loans, you have a choice between a federal or private loan.
Benefits of securing a federal loan include fixed interest rates, loan forgiveness programs, and income-driven repayment options. They’re backed by the federal government and may be subsidized which means the government pays your interest while the student is in school. Finally, when the repayment period begins, you might want to refinance at a lower interest rate.
Loans for higher learning can also come from schools, credit unions, or banks. There are even some nonprofits that will guarantee student loans, or a lender might self-insure. Private loans may have a variable interest rate, so your monthly payment may change. Similar to federal student loans, you may be able to refinance at a lower interest rate when the repayment period begins.
The Wide Wide World of Debt
The wide wide world of debt encompasses many different kinds of debt. However, regardless of the type of debt, your financial health will be impacted. Whether that impact is positive or negative is up to you. Make sure you review your finances regularly, and don’t take on more debt that you’re comfortable with (and can afford).