The first principle of borrowing if it be a personal loan, mortgage, auto loan, and/or credit card loan is that when you take out a loan, there is an understanding by both parties the lender and the borrower, that the borrower, or YOU will pay the loan back over a set period of time, plus interest, which is like your payment for the ability to take the loan.
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Key Terms:
Principal - how much you take the loan out for
Interest - how much the loan grows over time
Balance - how much you still have left to pay offImportant: If you are making payments, the balance will shrink with each payment. If you're not making payments, the balance will grow with interest.
Interest Rate Refresher
Interest is expressed as an interest rate, which is the percent of the total loan that will be added to the loan over a set period of time.
Usually, interest rates describe how much your loan will grow over a year.
Compounding Period
But the actual calculation of how much to add might happen more frequently. This is called the compounding period.
For example, say you had a 5% annual interest rate on a $10K car loan that compounds daily. That means each day, 0.014% interest will be calculated and added (5%/365 days in a year)
Compounding Interest
Your loan continues to grow over time, since interest is compounded on a routine schedule.
Plus, with compounding interest, it can grow exponentially (assuming you're not making payments). Each compounding period, the interest percentage is added based on the amount of the initial loan PLUS any interest that accrued.
As the balance grows, the amount that gets added each time in interest grows too.
Example Without Payment
Here's an example to help solidify understanding.
Take that 5% annual $10,000 car loan. Say the loan compounds monthly. That means every month your interest will be .417% (5% / 12 months per year)
after 1 month, you'll owe +$41.70, so $10,041.70
after 2 months you'll owe +41.87 (+.417% of $10,041.70) so $10,083.57 total
after 3 months you'll owe +$42 = $10,165.62
after 4 months you'll owe +$42.22 = $10,167.84
This is calculated to demonstrate how interest continually adds up and compounds over time especially when you don't make any payments. The above calculation assumes you are not making payments and that is not what we are doing anymore on our road to financial wellness, income independence, and freedom!
Example With Payment
Here's another example with payments to help solidify understanding.
Take that 5% annual $10,000 car loan. Say the loan compounds monthly. That means every month your interest will be .417% (5% / 12 months per year)
Let's say you make a payment of $500 each month on that same loan, our first few months will look like:
after 1 month, $10,000 - $500 = $9,500. 0.417% of $9,500 = $40,
so new total = $9,540
after 2 months, $9,540 - $500 = $9,040. 0.417% of $9,040 = $38,
so new total = $9,078
after 3 months, $9,078 - $500 = $8,578. 0.417% of $8,578 = $36,
so new total = $8,614
after 4 months, $8,614 - $500 = $8,114. 0.417% of $8,114 = $34,
so new total = $8,148
Numbers are rounded for simplicity.
Determining Interest Rate
The interest rate you get depends on:
The type of loan
State of the economy
the federal interest rate set by the federal reserve, which impacts interest rates on bank loans, credit cards, etc.
Your credit score or trustworthiness when it comes to repaying the loan
The lender will determine your trustworthiness or creditworthiness based on your credit score.
Taking on Debt
Once you meet eligibility criteria to qualify for the loan, you will apply and the lender will approve you for the loan with terms and conditions. If you sign and agree to these terms and conditions, the money your borrow, now becomes your debt.
There are a few different types of debt, but for our purposes, let's look at 2 important distinctions.
Consumer vs. Non consumer debt
Secured vs. Unsecured debt
Consumer Debt
Consumer debt is debt taken on to purchase household items for consumption rather than investment, for stuff that won't earn value over time (for example; car loan or taking a loan out to buy fancy furniture for your home)
Credit card debt is a type of consumer debt.
When you swipe your credit card, it's like taking out a mini loan from the credit card company to pay for that item.
Non-Consumer Debt
Anything that's not consumer debt is called non-consumer debt, pretty simple right? For individuals, this includes any debt to purchase something that's an investment.
A common example of non-consumer debt is a mortgage. You take out a loan to purchase your home, and as you pay back your loan, you're earning ownership or 'equity' in your home.
Purchasing a home is an investment, because if the value of your home increases, you've made money!
Secured Debt
Another important distinction in types of debts is secured debt vs. unsecured debt.
A debt is 'secured' when there is an associated asset that acts as collateral if you can't pay off the loan.
With a mortgage, if you stop making payments, the bank can seize your home. With a car loan, you could lose your car to repossession.
!This distinction is important if you're not able to pay off your debts, but now that we're focused on building financial wellness, we won't cross that bridge! If you are in a tough spot there are credit repair, debt consolidation companies, and various options to get you out of this spot.
Secured Debt - the type of debt where there is an associated asset that acts as collateral if you can't pay off the loan back, like a mortgage or car loan.
Unsecured Debt - the type of debt where there is no associated asset, so the lender doesn't have anything they could seize if you can't pay off the loan - they usually therefore have relatively higher interest rates.
Collateral - an asset, or property, or possession that you offer up as a guarantee when you take a loan - if you fail to pay off the loan, the lender can seize the asset. Unsecured Debt
A debt is 'unsecured' when there isn't any collateral asset. Credit card debt is an example of un-securable debt.
Unsecured debt usually comes with higher interest rates, because they're riskier from a lender's perspective. IF you can't pay your credit card bill, there's nothing they can seize to make up that money. They just have to wait for you to pay the bill as they report the credit agencies your late or non-payments.
Debt is Common
It's common for people to have some sort of debt. Between student loans, credit card debt, mortgages, etc. debt is a part of life!
But too much debt an strain your budget and cause lots of stress and worry.
There's a 'sweet spot' amount that experts consider to be ok, calculated using the debt to income ratio
Debt to income ratio: a measure of how much debt you have relative to your income, calculated by dividing all monthly debt payments by your take-home income - a ratio above 20% is considered riskyCalculate Your Ratio
To find your number, add up the amount of payments you owe towards debt each month. Divide that number by your monthly take-home income.
A debt-to-income ratio below 10% is ideal, and a ratio somewhere 10-20% is ok, and means you're in decent financial shape.
If your ratio is over 20%, that's when it starts to become trouble - you may find its hard to make your payments, and debt may squeeze your budget.
For example, if you have a$300 car payment and a $250 student loan payment due each month, and your monthly take-home income is $5000. Your ratio is $550/$5000, which is around 11%. This is a healthy number. However if your take home is $3000 then that debt-to-income ratio jumps to 18%!
"Good" Debt
Some debt, can be good debt which is beneficial for your financial health and future.
Debt that enables you to purchase things that earn equity is considered good debt, because any extra money you have to pay as interest will be offset by the money you earn as the value of your asset appreciates. These are investments.
A mortgage is a classic example of this type of debt.
Invest In Your Future
Debt that benefits your future earning potential is often considered as good debt. Student loans for example, as you invest in yourself and education, it is expected that you will command higher earnings after completing your coursework. Even certifications if taken with a loan can be an investment. Cloud, project management, and lean certifications have a low minimum investment in comparison to college with high reward in earnings potential.
Investing in your future could also entail you starting your own business and creating economic value in which you can pay yourself, pay taxes, create employment opportunities and earn a profit. Usually, if done correctly small business owners can save on more taxes than personal tax filing.
Bad Debts
Compared to good debt, bad debt doesn't have any investment benefits, either in terms of appreciating assets or future earnings.
In addition, bad debts have very high interest rates so they can grow out of control if you aren't making on time payments. A common example of this is an auto loan, personal loan, or credit card debt.
Credit Card Debt
If you're paying off your whole credit card statement each month (paying off everything you purchased that month), you're not accumulating any credit card debt, and you're back to owing $0 at the start of each cycle.
When utilizing credit cards, this is the best way to use debt as leverage, especially to earn cash back or points on your purchases. This is how you come out ahead. You borrow money from the lender, but pay back the borrowed money before the statement closing date or interest addition date. You'll have to note what the creditors normal billing cycle is. It could be 30, 29, 28 days, weekly interest, and/or daily interest.
If you do this you won't pay any interest, and you'll be earning cash back and or travel reward points. This requires great discipline and planning to execute properly.
You are not required to pay off the credit card entirely each month. If you don't you will 'carry a balance' - the amount you owe will roll over into the next month, and starts accruing interest. Required minimum payments are often as low as $15-35, but don't get caught in the trap of paying minimum payments, only if you're in a financial crunch. Paying the minimum payment will keep you in debt and paying a ton of interest for years.
Credit Card APR
Credit card interest rates, described as APR in terms of annual growth, are notoriously super high, often as high as 20-25%! You really don't want to carry a balance if at all possible.
Best practice says don't charge more to your credit card than you can afford to pay back right away, and pay the entire statement balance each month.
Using Credit Cards
Credit cards are not in themselves bad, as long as you use them responsibly you can reward yourself handsomely. When used wisely, they make life convenient, help your prove your creditworthiness with on time payments, and even allow you to earn rewards as previously stated which is basically free money!
It's credit card debt and carry over balances, that we want to avoid like the plague.
Payday Loans
Another particularly bad type of debt is a payday loan. This is a type of loan offered to people who need extra money to cover expenses and make ends meet before their next paycheck arrives.
These loans are looked at as predatory, because the interest rate can be as high as 350%! This means if you can't pay the loan back within a year, the amount you took out could nearly triple! These companies prey and take advantage of people that don't have many other options.
Make A Plan - Choose a Payoff Method
If you have debt that you're working towards paying off, the #1 rule is to have a plan of attack! Have a plan of which debts you're going to prioritize paying off, and how much you plan to pay each month towards each debt.
Consult your budget to see how much extra you can put towards paying high-interest debt.
For credit cards, this means paying your whole balance each month + a little extra to pay down accrued interest from previous statements.
Check out our budget guide here:
Check out our eBook on Debt Payoff Strategies here
Debt Payoff Methods
The general rule of thumb is to focus on "bad debt" first, because these are racking up more and more debt via interest the longer they go unpaid.
There are 2 popular approaches when it comes to paying down debt:
Snowball method
Avalanche method
Snowball Method
With the snowball method, you pay off debts that have a smaller balance so you an get them out of the way and have one less debt to think about.
Pros: you'll feel the benefit quicker as you hit encouraging milestones, and have fewer loans to keep track of so it's less mentally taxing
Cons: you may wind up paying ore in the long term with lingering high interest rate debt.
Avalanche Method
With the avalanche method, you prioritize payments towards the higher-interest debts regardless of their balance, because these debts will grow the fastest.
Pros: you'll pay less in the long term because tackling high interest debt first means less compounding interest overall.
Cons: it may take longer to pay off any single loan, which requires more determination, and keeping track of a larger # of debts may be more mentally taxing.
Rate Negotiation
If you are having trouble chipping away at credit card debt, lowering your APR could help.
Most credit cards have a variable APR. IF you're not already at the low end of the range, call up the credit card company and ask for your APR to be lowered.
To strengthen your argument:
highlight any history you have of on time payments
mention if your credit score has gone up recently
explain any circumstances that has led to temporary financial hardship (without going into too much personal detail)
mention that a lower APR would incentivize you to pay off more of the principal each month to get out of debt.
Consolidation
If you have debt on multiple credit cards, you can try to combine them to make it easier to pay off (and hopefully get the lowest possible APR)
Set up a debt management plan through a credit counseling agency to roll multiple debt payments into 1 fixed monthly payment
Apply for a balance transfer credit card: get all your debts consolidated into 1 new credit card, often with 0% promotional APR for the year. But you'll need a good credit score to qualify, and at the end of the year, a pretty high APR kicks in.
Apply for a personal loan with a lower interest rate compared to your credit card, and use the loan to pay off your credit card debt.
To strengthen your argument:
highlight any history you have of on time payments
mention if your credit score has gone up recently
explain any circumstances that has led to temporary financial hardship (without going into too much personal detail)
mention that a lower APR would incentivize you to pay off more of the principal each month to get out of debt.
Make A Plan - Execution
Make a list of all the outstanding debts you have
Check the interest rate for each loan
Decide which loans are higher priority to pay off
Check your budget to calculate how much you can put towards debt payments each month
Make a plan for the order and timeline of paying off debts
Set a reminder or create a calendar event to remember to make a payment each month
Contact your creditors to negotiate payments that will fit your budget
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