Surprisingly enough, not all debt is created equal. It comes in many forms, from mortgages and auto loans to credit cards, personal loans, home equity loans, and more. With so many options, Gen Xers must understand what’s considered “bad” debt.
Understanding Secured vs. Unsecured Debt
Most debt falls into one of two categories: secured debt or unsecured debt. The primary difference is whether an asset is involved as collateral for the loan. A home or auto loan is a typical example of secured debt because the lender may repossess the asset (your house or car) if you stop making payments. Because collateral is involved, these loans tend to have more favorable terms than unsecured loans.
Examples of unsecured loans include credit cards and personal loans. Because there is nothing for the lender to take ownership of if you stop paying, they consider the loan riskier. The interest rate will typically be higher for unsecured loans.
“Bad” debt generally refers to any debt with high-interest rates; in some cases, annual fees may also be included. One of the most common culprits of creating bad debt is credit cards. With interest rates easily in the 18%, 20%, and even the 25% ranges, credit card debt can quickly snowball into an unmanageable issue.
While making big purchases on a credit card might seem like an easy solution, there can be long-term consequences if you don’t pay the balance immediately. Before swiping your card for your next big purchase, try following these five steps.
Step #1: Determine How Much It’ll Really Cost
If you have a big purchase on the horizon, you may have a general idea of what it’ll cost. In many cases, however, plenty of extra add-ons can creep the total cost even higher. If you plan on putting the purchase on a credit card and carrying the balance, remember that the higher the principal amount, the more you’ll pay in interest. When managing a high-interest loan, those small add-ons can start growing exponentially.
Let’s say you’re going on a large family vacation. Plane tickets and hotel accommodations are oversized ticket items, but the anticipated expenses don’t stop there.
Take into account transportation to and from the airport (or long-term parking), dining out, excursions, transportation during your trip, tips or service fees, new clothes or packing essentials, and any additional resort fees, visa fees (if you’re going abroad), taxes, and miscellaneous charges.
Before committing to your purchase, do your best to create an itemized list of expenses. You should get as clear a picture as possible of your total so there are no unwanted surprises after the fact.
Step #2: Instead of Borrowing, Create a Savings Timeline
Knowing how much a big-ticket item will cost is essential since it should be your short-term savings goal. You know how much something will cost, so you can start breaking up your savings goal into manageable milestones over time.
For example, if you plan to spend $5,000 on your family vacation eight months from now, break your savings goal monthly. When that $5,000 is spread over eight months, it totals out to $625 per month. From a motivational standpoint, $625 is a much more attainable goal to work toward every month.
Now, it’s time to make room in your spending plan for that extra savings. Identify small things you can cut from your regular spending without hurting your financial obligations. For example, paying your mortgage and utilities is non-negotiable, but you may be able to eat out a few times less during the week or cut back on your tee time. Find small but doable ways to redirect your discretionary income toward your savings goal.
Step #3: Utilize a Separate Savings Account
If you don’t already have a separate savings account for small savings goals, use this opportunity to set one up. Neglecting to divide your savings into a separate account makes it more tempting to use the funds for other purposes. Tracking where you are on your savings goal can be hard when you don’t have the funds separated. Your day-to-day spending accounts are no place for your savings.
Step #4: Shop for Interest Rates
As we’ve already discussed, financing is not ideal and can grow out of control quickly. But if you must borrow money at a high-interest rate, don’t settle for the first offer you see. Do your research, and try to find the credit card with the lowest annual percentage rate, or APR. The APR is an annual percentage rate when shopping for credit cards, though it’s used to calculate interest rates during the billing cycle.
Remember that the APR offer on credit cards is often tied to your credit score. If you have some time before making a big purchase, you should, in addition to setting aside savings, work to improve your credit score — especially if it’s on the lower side.
According to Experian, you can do a few things to improve your credit score quickly. These include:
Make all payments on time (even if it’s the minimum payment)
Address any previously missed payments or past-due accounts
Pay down current balances
Limit how many hard inquiries you make
Keep the ratio low between your credit usage and available balance
If you aren’t sure where your current credit score stands, you can pull a report by making a “soft inquiry.” This shouldn’t hurt your credit score like a “hard inquiry” from a lender would.
Step #5: Tap Into Other Forms of Equity
You may have other options besides the high-interest debt of using a credit card. For example, if you’re a homeowner, you may be able to take out a home equity loan. Because this is considered a secured loan, the interest rates are typically lower.
Of course, this is a decision you should consider carefully, and there may be better options for you. But if you have equity in your home, you can borrow against that equity.
Typically a home equity loan is a lump sum credit, which could help cover the cost of a home renovation or other major purchase.
Another option is a home equity line of credit or HELOC. A HELOC is a revolving line of credit that can be used as needed. For example, you could get approved for a $100,000 line of credit based on the equity in your home, but that doesn’t mean you have to access all of that money in one lump sum. You could pull a couple thousand here or there to use as needed for various expenses. Using a HELOC to help cover college costs or pay off higher-interest debts is also possible.
Bonus Step #6: Work With a Financial Advisor
If you’re ever unsure about taking on more debt or managing your current financial standings, talking to an experienced financial professional can be helpful. Our team at Bienvenue Wealth is more than happy to sit down and discuss your options with you. Don’t hesitate to reach out and schedule a time to talk.