The Many Faces of Debt
Skillful use of debt can be a key element in the building of a sound financial future for a family, or for building a vast business empire producing jobs for thousands. Understanding the different types of debt and the proper ways to use them can be the key to accumulating wealth that passes from generation to generation. Misusing debt, or even using the wrong type of debt, can act like an insidious poison that spreads undetected, devours most of a family’s disposable income, and drives the joy from daily life, replacing it with fear, desperation, and a sense of hopelessness. How can it be that so many people know so little about the various types of debt? The basic concepts are simple enough.
Types of Debt: Secured and Unsecured
Ask a friend to tell you the difference between a mortgage and credit card, and they are likely to assume that your question is the first part of a riddle or a joke. You may get an answer like “a mortgage is what you use to buy a house; a credit card is what you use to buy football tickets on-line or a case of beer”. Hopefully that is not the extent of their understanding of the differences between secured and unsecured types of debt.
A more sophisticated answer might be that a mortgage is an example of a secured loan. Secured loans are less risky for bankers because there is a physical asset they can repossess the event of default. For that reason, secured loans often carry lower interest rates and longer repayment terms. Under current US law, home mortgages are usually tax deductable. Auto loans are another common example of a debt secured by a physical asset that can be repossessed by the lender if necessary.
Credit cards are the premier example of the unsecured type of debt. Since there is no physical asset to repossess in the event of default, interest rates are generally much higher than for secured loans. Credit cards are easy to get, convenient to use, and unfortunately the most frequently abused type of debt. The balance on a credit card can vary up and down from month-to-month, with the cardholder only required to pay the minimum balance each month. Unsecured installment loans, on the other hand, usually involves a fixed sum that is paid down in a series of equal payments. Student loans are an example of a type of unsecured installment loan, though the loan balance may increase as the student progresses through college or graduate school. Payments on student loans are often deferred until after graduation.
Secured And Unsecured Types Of Debt: How Much Is Too Much?
Experts say that if the sum of your secured and unsecured debt payments is more than 36% of your gross monthly income, you have too much debt, and should get to work on lowering it immediately. Debt payments in the range of 20% of gross monthly income are probably OK, depending partly on the types of debts involved. Individuals who use debt wisely try to keep their monthly payments closer to 10% of gross income.
Two Other Types of Debt: Smart Debt and Foolish Debt
Examples of situations in which taking on additional debt is probably a smart decision:
- A well established family business with low existing debt and predictable cash flow that is turning away business because of a production bottleneck that could be resolved with a $10,000 dollar loan with payments less than half the anticipated increase net profit.
- A household with adequate cash reserves and monthly debt payments around 10% of gross monthly income with an opportunity to reduce energy costs by $1200/per year by upgrading their HVAC system using a five year low interest loan with annual payments of $900.
Examples of situations in which taking on additional debt is maybe not such a great idea:
- A couple with no cash reserves and monthly debt service costs over 36% of gross monthly income that makes an impulse decision to use a credit card to take advantage of an unsolicited “Special Discount Offer” on a one week cruise vacation.
- Making any purchase that “maxes out” the credit limit on one or more of your cards.
Debt Self Rescue – Fighting Back
If the time has come for you to get serious about reducing your debt burden, how do you start? Here are a few ideas to get used going:
- Go to a nearby nonprofit debt counseling service, and layout all the types of debt you have accumulated.
- Have the counselor assist you in setting up a monthly budget with the largest dollar allocation to debt repayment you think you can tolerate. Schedule a return visit for a month after you begin living with your new budget in case adjustments are necessary.
- Make the largest possible payment on your highest interest debt while still making at least minimum payments on all others.
- If you have an opportunity to consolidate high interest unsecured debt by taking out a lower interest secured debt loan such as a second mortgage, investigate that possibility carefully. Discuss the pros and cons with your counselor.
- Remember that small everyday savings do add up. Leaving your credit card at home can help you take advantage of some of them.
- Stay in touch with that debt counselor for the advice and encouragement they can offer along the way, and be sure to take them out to lunch when you reach your debt reduction goal.