An Overview of the Most Popular Forms of Debt and How to Use Them
There are many different forms of debt, and it seems like millennials have made it their mission to practice using each type. Some debt is great and can help you build wealth. Other debt just ends up costing you more than you should have paid. Below, we break down the different types of debt, and how to use them to make money and avoid losing it.
Even though millennials talk a big game when it comes to student loan debt, more of us have credit card debt than student loan debt. On the debt spectrum, credit card debt is the absolute worst type of debt you can have because it is EXTREMELY expensive. When you use your credit card, your credit card company pays for your purchase and deducts the charge from your available credit. At the end of the month, your credit card company sends you a bill for the purchases that they’ve paid for, so you can pay them back. If you don’t pay them back in full, they charge you interest on your balance, and that’s how they make money.
The average interest rate on credit cards is about 18%! To put into perspective just how high of an interest rate that is, if your credit card company had invested the money it used to pay for your purchases in the stock market instead of issuing you credit, it could expect to receive an annual return of 10%. Instead, you’re paying them almost DOUBLE that! If you think the finance industry is full of a bunch of money-hungry people trying to steal every penny they can, and you carry a credit card balance, you’re the one making them rich. Credit card companies make enormous returns on all of the stuff you buy but don’t pay off. If you carry a balance on a credit card, the best financial decision you can make is to come up with a plan to pay it off ASAP.
How to Use a Credit Card the Right Way
Even though I just talked a lot of trash about credit card debt, credit cards can be beneficial. The caveat is that you need to pay off your full balance every month. If you pay your credit card off every month, you won’t be charged any interest, and depending on your credit card perks, you could actually save money.
If you earn credit card points for your purchases, your credit card company is essentially giving you a discount. I use the Capital One Venture card for all of my purchases and earn 2 points for every dollar I spend. That translates into $.02 back for every dollar spent or a 2% discount. These points can then be used to purchase things like flights or Ubers. I also don’t get charged currency exchange fees when I travel to other countries and use my Venture card. While getting all of these perks for making purchases with my card, I’m also building a great credit history and increasing my credit score. So, credit cards can be great if they’re used properly. If you’re looking into getting a credit card, NerdWallet is a great resource to use to compare cards. Just remember to not break the number one rule when it comes to credit cards, never carry a balance.
Oh, the most hated loans of all, student loans. While student loans are super annoying and can take many years to pay off, they’re not a bad type of debt to have. Student loans are used to further your education and invest in your future. Look at your student loans as the investment vehicle that allowed you to increase your future potential earnings. Whether we think college is too expensive or not, the fact is that having a college degree does increase your salary potential. A Business Insider survey found that the earnings gap between high school grads and college grads is smallest in Nebraska, but college grads still earn 38% more there. That’s the lowest earnings gap. Washington DC, New York, and California all have earnings gaps over 100%. That means college grads in those states are averaging more than double the salaries of non-college grads. Over their lifetime, college grads will earn an average of $1 million more than non-grads. So, stop hating so much on your student loans. Think of them as an investment.
How to Use Student Loans the Right Way
While student loans are a great tool to help you get a college degree and increase your future earnings, there are important things to consider when taking out student loans. When looking into what degree you’ll be pursuing, you should consider your future starting salary and your future debt payments. If you’re expected to earn $30k a year at graduation and you want to go to a private school in New York City, your future salary probably won’t justify the cost of your tuition. On top of your tuition, how are you planning to pay for housing and books? If you’ll be taking out more loans to pay for those things, you need to factor that into your cost vs expected salary evaluation as well. If you really want to cut down your student loans, the best way to do that is by picking a cheaper school, or by applying for scholarships and grants.
Cars are a depreciating asset. That means that their value decreases over time. Do you know anyone who has sold their car for more than they bought it for? Probably not. The only exceptions to this are for some restored, historic, or rare vehicles. I hate to break it to you, but your Honda Accord doesn’t fall into that category.
When you take out an auto loan you have to pay interest on that loan, so the price you end up paying for the car is actually higher than the sticker price due to the interest you’re charged. The only way to justify the additional cost of interest is to, at minimum, recoup the interest expense when you sell at a later date. Since the price of your car is declining, that will never happen. Therefore you’re just paying more for the car than it was worth.
How to Use an Auto Loan the Right Way
Unless you need a car right now because yours was totaled or stolen, you shouldn’t take out an auto loan. Instead, you should look at what the trade-in value is on your current car, what the price of the car you want is, and start saving for the difference. A great way to save for this is to use a high-interest savings account, so you can earn interest on the money you’re saving. (See this post for more info on opening a high-interest savings account.) Once you have enough money saved, you can trade your car in for the new one, and pay for the balance in cash. That way, the price you end up paying is for the true value of the car and you won’t pay additional money in interest.
Millennials are at the age where many of us have recently purchased, or are looking to purchase our first home. Most people consider buying a house an investment because houses are an appreciating asset. That means that unlike cars, their value goes up over time. If you buy a house now and want to sell it in the future, you should be able to sell it for more than the price you purchased it for. Since houses appreciate, taking out a mortgage isn’t a bad idea, but what most people fail to do is to save for a large enough down payment for their house. The median down payment on a home for first-time homebuyers is 7%, but the recommended down payment is 20%. While you can qualify for loans with a down payment of as little as 3%, that doesn’t mean you should buy a house with only 3% down. If someone buys a house for $200k with 3% down, their mortgage will be $194k. The average interest rate for a mortgage is around 3.5% and the most common loan length is 30 years. With only $6k down, this person will end up paying an additional $119k in interest over the life of their loan, meaning their house will cost them $319k by the time their loan is paid off. If they had put down 20%, or $40k on the same home, they would only end up paying $98k in interest. With 20% down, they would have paid $21k less than the buyer who only put down 3%. On top of the additional interest expense that comes with making a lower down payment, you may also have to pay mortgage insurance, which will make the cost of your home even higher.
$21k may not seem like the biggest deal to you since you’re expecting the value of your home to increase, and appreciation will cover that right? Not necessarily. The more you spend on things like interest and mortgage insurance, the more your home will have to increase in value in order to cover these costs. There is no guarantee that your home will appreciate enough to cover these additional expenses, and if it doesn’t, you will end up losing money on your home even if you sell it for a higher price than you paid for it initially.
How to Use a Mortgage the Right Way
The first thing you need to do is evaluate your current financial situation and how much debt you have from the previous 3 debt types we’ve discussed. You should calculate your debt to income ratio (DTI) to see if you’re financially able to take on more debt. (See this post to learn how to calculate your DTI.) Once you’ve done that, you should open a high-interest savings account and set up automatic deposits to begin saving for your 20% down payment. It may take you a few more years before you can buy your house, but it will put you in a much better position to use your house as an investment that makes money instead of loses it. You should also use a mortgage calculator to see how much you will actually end up paying for your house with interest included, and evaluate if you think you will be able to sell the house for more than your total cost in the future.
Unlike other loans like a mortgage or auto loan that you take out for a specific item, personal loans can be used for pretty much anything. This ranges from consolidating other types of debt to paying for your wedding. As we know, loans come with an additional cost in the form of interest, but loans are also financial obligations. That means that you must always make your minimum payment or you run the risk of defaulting on your loan. Taking out a personal loan to pay for something you want, like an extravagant wedding, will leave you paying more for your wedding than you intended and make you less financially stable.
How to Use Personal Loans the Right Way
Personal loans can be great refinancing tools. As we discussed at the beginning of this article, credit card interest rates are SUPER HIGH. If you have a lot of credit card debt, taking out a personal loan with a lower interest rate to pay off your credit cards could end up saving you a lot of money and shorten the length of time it takes you to pay off your debt.
While student loans are often thought of as having low-interest rates, that isn’t always the case. Taking out a personal loan with a lower interest rate may help you save some money on your student loan interest. However, student loans also have other tax and repayment benefits, so you should do a lot of research to make sure it’s actually more beneficial to use a personal loan over your student loan before making the switch.
So there you have it! Debt can be beneficial if used wisely, but it can also be detrimental when used improperly. Since we use debt for so many things, it is important to understand the advantages and disadvantages of any debt you have or are considering taking out. Banks and lenders are in the business of making money off of your money; so don’t take their word for it when they tell you they have the best option for you. Do your research and thoroughly understand if you should finance your purchase with debt, and if so, find out where you can get the lowest cost debt.