Understanding the types of debt that you have and the variables surrounding that debt is key to coming up with a plan of action to control your debt. Knowing your principal balance, or that amount you owe, and the interest rate, or the amount the lender is charging you to borrow, is just the tip of the iceberg. Let’s discuss some of the most frequent types of debt and what those types are typically used for.
Credit Cards
Credit cards. The enemy of debt freedom fighters everywhere. With interest rates averaging around 16%, credit card debt holes can be some of the hardest debt to dig out from. Credit cards are, essentially, personal lines of credit offered by the credit card companies to individuals to use in their daily lives. These are different than debit cards which are issued by your bank and tied to your bank account and which can only be used up to the balance that you actually have in your account.
Credit cards are the main debt source that allows people to live far beyond their means. They are then trapped in a hole they cannot escape. How they work is simple. Once approved for a credit card, you can use it to purchase most of the items they use in their daily lives. There are exceptions of course, but most items can be purchased with a credit card. We all know too many stories of people swiping their cards without a worry in the world, only to face the consequences later.
Credit cards come with a minimum monthly payment. This payment must be paid each month the card has a balance on it. If there is a balance left on the card at the end of the period, interest will accrue on that. The strategy that many use, including myself, is to charge daily expenses to the credit card. The balance grows throughout the month, but is then paid off in full to avoid any interest on the debt. This is a great way to rack up credit card points to use for things like vacation! Or you can get cash back on purchases! That all depends on which credit card you have. The problems start when you only make minimum payments.
How Credit Cards Keep You Down
Let’s look at an example of an individual with $10,000 of credit card debt at the current average credit card interest rate of 16.14% as of April 8, 2020, per creditcards.com. Many cards have rates that are much higher than above. We will assume that the minimum payment is 2% of the total outstanding balances until 2% of the outstanding balance is less than $25 in which the minimum payment will then be $25 and payments begin in January of 2020.
The chart above shows that by only paying the minimum payment, the $10,000 debt will not be paid off until 2053. And that is the borrower not using the credit card at all for 33 years! Over those 33 years, you will pay over $18,000 in interest, $18,806.29 to be exact, for using the original $10,000!! That new cell phone just got way more expensive.
You can see how credit cards can be a dangerous trap if misused. Monthly payments can skyrocket the higher your total debt goes. You can have many credit cards which can be maxed out, totaling tens of thousands of dollars. You can see how this could seem impossible to get out of!
Student Loans
Student loans are used for students to attend college. Per a report from CNN, U.S. borrowers currently have over $1.6 trillion in student debt! That is 12 zeros!
Student loan debt is either public, owned by the U.S. Department of Education, or private, owned by a private lending institution such as a bank. We will focus on public debt due to over 90% of all student debt is owned by the U.S Department of Education.
Public Student Loan Debt
There are two kinds of federal loans, subsidized and unsubsidized. Subsidized loans are the better of the two but come with many more restrictions on who is eligible and how much you can receive a year. The main advantage of subsidized loans is that the interest on the loans does not accrue while the student remains in school, as the federal government takes care of these interest payments. This could save a borrower thousands of dollars and years of repayments. Unsubsidized loans do not have this benefit. Fortunately, both types defer any payments until after the students graduate from college. This gives a student time to get on their feet before payments begin.
Federal student loans come with some perks. First and foremost, there are many scholarships available to current students. These will help lower the debt load accumulated while in school. These will help reduce all student loans, not just Federal loans. They are an extremely important resource for all current and future students. I wish I had taken more advantage of these while I was in school.
If a borrower cannot pay their loans after graduating, loan payments can be deferred until the borrow has the means to pay. Unfortunately, the loans being deferred still accrue interest. This will increase the total amount owed, but gives the borrower time to get themselves on their feet. There are also different payment plan types, such as income-based repayment, to tailor your monthly payment to fit your needs.
The caveat to the items above which will help you get a plan in place to repay your loans is that student loan debt cannot be forgiven through bankruptcy. This essentially means that the government will do everything in their power to make sure they get their money!
Mortgage Debt
Most commonly a 30-year loan, mortgage debt is what is used to purchase a house. The building is used as collateral to secure the loan which means that the issuer of the loan has a right to the property in the event that the person who takes out the loan cannot pay the loan any longer, called defaulting. This collateral provides the security that is needed for the debt issuer to feel comfortable giving out the loan.
There are various types of mortgage loans all with differing years, interest rates, and payment plans. My mortgage is a 30-year loan at 4.25% interest with payment once a month. This is the standard way a mortgage is set up. While the years and payment plan is typically straightforward, with loans for 30 years, 15 years, etc. and payments made once a month or twice a month, the interest rate could be a fixed or variable interest rate.
A fixed interest rate is a rate that doesn’t change. The 4.25% rate on my mortgage is the same as it will be until it is paid off. Variable rates are when the interest rate changes after a certain period of time. A common type is the 5/1 Adjustable Rate Mortgage. What does that mean? The interest rate on the loan is the same for the first 5 years, then changes each year until the loan matures. The interest rate will change to reflect the current market conditions. If mortgage rates are increasing, then your rate will increase while it will decrease if rates are decreasing. With market conditions the way they are today, I would be shocked to see variable rates go anywhere but up!
Mortgage Insurance
Typically, when a home buyer does not have a down payment of a minimum 20%, the home buyer must pay an extra amount called Mortgage Insurance (typically called PMI, or Private Mortgage Insurance). This insurance is a policy to protect the lender in case the borrower is unable to pay. This insurance will make the lender whole in the case of a loss. Once the borrower makes enough payments to cross over the 20% equity line, the borrower can typically request that the insurance policy be cancelled, and therefore, will no longer have to pay the additional insurance premium each month.
Why 20%? The lender is taking on additional risk by giving more money up front instead of the traditional 20% down payment being made. The thought goes that a 20% down payment protects the lender even in the event that the property price decreases up to 20%, which is a substantial decrease. With no or little down payment, the lender requires additional protection in case of a downturn in the housing market.
The above listing and descriptions are by no means meant to be all-inclusive. There are endless types of debt with even more different terms that the debt can have. Each type has its own intricacies which can either help you in your quest or increase the difficulty ten-fold.
Time to Begin Your Battle!
Once you understand your debt, you will have the foundation needed in order to start your journey to debt freedom. Review your debt balances and determine what types of debt you have and the terms attached to those loans. The main terms to know are what is your payment schedule, the interest rate on the loan, and what your monthly payment is.
After gathering all of this information, it is time to begin building what I believe is the most necessary of weapons in the battle to vanquish your debt. Your budget!