We all have a debt encounter, either from borrowing money from a close friend or an installment payment plan that we can’t pay full in cash. With numerous offers that we often see on malls and social media outlets, the temptation of debt becomes hard to resist. It is not a surprise that several financial studies suggest that debt is the primary cause of financial trouble.
We easily fall prey to the endless loop of debt. While there are certainly arguments that no debt is good, it is believed that debt is not always bad either. For others, borrowing money is the only alternative to afford big-ticket items.
In order to get better at handling your finances for a healthy financial future, take note of the information to learn more about different kinds of debt.
What is Debt?
Debt is any money borrowed from one party to another or when you pay something in installment for something you bought. In simple terms, debt is money owed to other people for buying things you can’t afford.
No matter what the size of your debt is, big or small, debt is debt. Once you throw yourself into debt, you do not just live to provide for your family but also for the person or establishment you owe the money from. It means you are in the clutches of someone else until you pay off the money they lend. You can’t take full control of your finances until you settle what you owe.
There are various kinds of debt, and the solution to effectively manage them is to identify which is which. Although differentiating them can be easy, some debt are pretty tricky to judge.
Secured Debt
Secured debt frequently involves strict evaluation of credit history and assets or any guarantees as collateral. In cases where lenders fail to pay off the loan, the collateral is pledged or handed over to the lender.
For example, the lender grants you money if you take a loan to buy a car. If your loan payment flunks, the lending can take over car ownership and sell it to another party to recover funds you failed to return. Secured loans can have relatively more economical interest rates, contingent on collateral value.
Unsecured Debt
Unsecured debt is a type of debt that is not backed by any form of collateral. Such kind of loan is highly risky since the money lent may not be redeemed at all, but lenders can take legal proceedings to recover outstanding balances. Lenders charge higher interest rates due to their precarious nature.
When taking out a loan or buying on credit, regardless of secured or unsecured, the most crucial consideration is whether the debt acquired is bad debt or good debt.
Good Debt
The aphorism “it takes money to make more money” best explains what good debt is. This type of debt adds to wealth and creates good financial value in the future.
One good example of good debt is business loans used to build or expand business and revenue. A student loan also possesses good value, increasing earning potential, thus opening more doors of opportunity to wealth. There are also real estate loans or mortgages, which give the opportunity to purchase a home, allowing you to own an asset that is most likely to appreciate in value over time.
Basically, every debt that assists in generating income and network building can be deemed positive. Good debt typically have lower interest rates and enable big goals in life within reach. However, no matter how great the opportunity it may constitute, too much or excessive debt of any kind can turn into a bad one.
Bad Debt
Bad debt are loans made for things that quickly depreciate and do not produce long-term gains. They usually come with high-interest rates.
We have credit cards as an example. Credit cards can be a medium to finance large expenses while earning some points. But its interest could also spiral out of control if not managed carefully. Although not all credit card purchases are considered a bad debt, a maxed-out credit card can come out a bad debt if you take on purchases more than what you can furnish.
Bad debt can also come from purchases for the purpose of consumption, such as:
- Consumables. None can argue that you need food, and other consumables, however, buying them through a high-interest credit card is surely not a good use of debt. Either pay full in cash or settle card payments right after billing.
- Cars. Loaning a car isn’t great from a financial viewpoint because it quickly loses value the moment you leave the car lot. If buying a car is necessary for your daily work survival, look for an auto loan with low to no interest. Even though you will still be paying a huge amount on a depreciating asset, you won’t, at least, need to pay unreasonable interest for it.
- Clothes. Of course, we all need clothes. But did you know that clothes are usually worth less than half of what buyers pay for them? This goes for average brands, so how much more for designer brands that cost fortunes? Instead of getting into debt by buying Louis Vuitton, Gucci, Dior, etc., pay close attention to pre-loved or used-clothing boutiques, and you will see how much you can save from them.
To avoid bad debt that carries sky-high interest rates, apply the general rule when it comes to bad debt: Never buy what you can’t afford.
Simple Ways to Pay Off Debt
Are you drowning in debt and have no single idea how you will ever pay them all off? You are definitely not alone. Many people have been searching for simple ways to cut down debt and eventually completely pay them off.
Before you begin planning for your debt repayment, take time to identify what kind and the amount of debt you have. By considering these things, you will be able to map out a personalized repayment plan that perfectly suits your resources.
- Create a budget. Creating a budget is fundamental in relieving issues concerning debt. Consistently track every penny that comes in and goes out to understand where most of your money goes. Although coming up with a concrete budget plan can somehow be overwhelming, there are certain techniques you can adapt to make it easier, like the 50/30/20 rule. The rule indicates that 50% of your money should be allotted for your needs, such as food, utilities, insurance, and mortgages. The 30% of your earnings go to your wants, and the remaining 20% should be allocated for savings and debt repayment.
- Utilize debt snowball method. Simplifying snowball method, all you have to do is list down your smallest to largest debt. Dedicate extra money to pay small debt first while making minimum installments on other obligations. The snowball method is proven efficient because it involves little successes that increase motivation to settle the rest of the debt.
- Employ avalanche method. The avalanche approach suggests focusing on clearing off debt with the highest interest first. Once it is fully paid, shift attention to the next highest and continue the process until all listed debt are paid.
