What you need to know about the 5 most common types of debt
We’ve been talking about debt a lot lately - what it is, how to manage it, and how to even leverage it for your gain. In this article, we are going to break down 5 of the most common types of debt that people take to get into in the first place. What they are, and key factors that are important for you to consider.
Let’s dive in.
#1. Credit Cards (a.k.a the most poisonous type of debt)
Credit cards generally demand the highest interest rate of all of the different types of debts you can get into. This is a consumer-based product. It’s meant to help boost your purchasing power. It also provides an accessible way to build (or destroy) your credit.
With a credit card, you can expect an average interest rate of around 22%. If you get lucky, you might be able to find credit cards that offer an interest rate as low as 11% - but that’s probably as low as you will ever get with a credit card.
Here’s a quick review of the two rules of thumb that was covered in our last article:
1. When trying to manage your debt, focus on eliminating the debts with the highest interest rate first.
2. Consistency is everything when it comes to making payments to resolve your debt (the amount, and the timing).
Now, let’s move onto more good-to-knows about credit cards that we didn’t get to cover, in our previous two articles about debt.
Taking out a cash advance on your credit card almost never makes sense.
Why? Because you still have your normal interest rate and a cash advance fee on top of the interest rate. Which, by the way you have to pay immediately.
For example, if you took out a $20,000 cash advance with a typical 10% cash advance fee, you would have to pay back $2000 right away, plus the interest accrued on the $20,000 - for simply just doing the cash advance. Now, this just doesn’t make sense for anybody. It’s better in this kind of situation to instead get a personal loan, in order to avoid the additional fee.
#2. Personal loans
Personal loans are typically large lump sums that you would borrow from financial institutions or individuals. When they are from individuals, the interest rate can range anywhere based on what the agreement is between you and the lender. When you take out a personal loan from a bank, the interest rate tends to range around 8-18%
When you work with a bank to get a personal loan, they use your credit score and history to determine your creditworthiness. Basically, assessing your credit to see how much they can trust you to pay them back. There are also secured and unsecured personal loans. You can read more about the difference between secured and unsecured loans here.
Personal loans are a way for you to access liquid cash. We covered some of the reasons why cash is king, also in the same article as mentioned above. So you can get more of the juicy details there if you want to learn how to apply some of these strategies.
But just quickly, a few advantages of the cash that you can get from a personal loan includes the fact that:
It can be used to leveraged debt
It can pay for bills in hard times (rent & utilities can’t be paid on credit card)
It generally has a lower interest rate than a credit card
One of the important things to keep in mind is that, as soon as you take out the loan, you are in debt immediately to the full amount of your loan. With a credit card, you don’t go into debt until you actually use the money.
That being said, you’ll need to start paying interest fees usually after the 1st month. After that, fees are is charged monthly.
If you want to have cash available but don’t want to take out a personal loan, you can also take out a line of credit. We’re not going to go into depth about that option in this article, but a simple Google search should yield you plenty of information about this type of loan.
The most common reason why people take out personal loans besides to pay bills, is to pay off their credit cards. Basically using debt to pay off debt. This can be a useful strategy in the short term, especially if the interest rate on the personal loan is lower than the one of the credit card.
BUT! Take caution - in some cases, this can lead to an unhealthy never ending cycle of debt.
# 3. Student loans
Student loans are easily the most forgiving of all of the different types of loans. We have already shared some information about student loans in previous articles, so we recommend you go back and check that out. And there’s an e-book titled “Student Loan Secrets” coming soon as well! So stay tuned for that.
For now, here are some basics:
There are 2 different types of student loans: federal and private.
Here’s a quick run-down of each type.
Federal Student Loans
These are loans given from the government. Generally through Sallie Mae, a banking institution that provides education loans.
The interest rate is much lower than consumer or personal loans, and is usually fixed typically around 6%.
With student loans you tend to have less flexible payment options. It’s not based on your credit, and you can get them deferred or through forbearance. Which means you’re not required to make payments until you graduate.
5 Most Common Options for Student Loans
1) Standard loan (10 year re-payment program)
Generally costs the most per month (if making less than 6 figures)
Usually pays the loan off the quickest
2) Extended plan (25 year repayment program)
Generally costs the least per month
Usually pays it off the slowest
Extended plans are our preferred way of paying back student loans, and here’s why:
If you have a standard loan plan, it forces you to pay the higher amount of money per month, no matter what. With the extended plan, you can still pay the higher amount if you want (by putting extra on it), but it gives you the flexibility that you may need (in case anything happens, e.g. lose job, COVID-19, etc).
You could plan to pay it off on the same timeline as a standard loan, it just gives you more options and flexibility as a safety
You will usually pay the most in interest with this option, even with a federal loan. Extended loan interest rates usually land at 7% unlike 6% as with most standard loans. And generally, if you take longer to pay it off, it means you’re paying more interest, because math.
3) IBR Income Based Repayment program
This option could potentially be the most affordable or the most pricey, depending on your income
The speed of paying it off will depend on how much money you make - the more money you make, the faster it will be paid off.
With IBRs your payment amounts are determined by your income.The government takes a look at your income tax returns for the previous year, and they determine how much you will pay in student loans per month for the following year - generally 10% of your income.
So as an example, say in 2019 you make $100,000 more than likely in 2020, that person’s student loan payments will be very close to $10,000 for the year
A word of CAUTION: This plan is dangerous if you know that your income will be increasing over the years. Your payment minimums will change every year - if you make more you will need to pay more. It's hard to plan for consistency over the years.
This is an amazing plan if you know you’re going back to school for a Masters or PhD - and you just want to put a small dent in your loans between the time you go back to school. This is the best plan for you if you are wanting to continue your education.
4) PSLF Public Service Loan Forgiveness
This is a 10 year student loan forgiveness program, with very specific eligibility criteria. This program becomes available to you if you have been on the Income Based Plan for 10 years (Again, this plan may not be a better option for you if you’re making a lot of money out of school. e.g. $150K +)
To qualify you also need to be employed by the government (federal or state job - e.g. working at a state hospital or VA). And you need to be working full time. So, it's kind of like an government employee benefit, in a sense.
5) Private Loans
Private loans generally come into play when students need more money beyond what their federal loans are able to provide.
It’s actually very similar to a personal loan (see above in the personal loan section). Think about it as basically a personal loan for students - where the money can only go toward education.
So just like a personal loan, these loans are based on your creditworthiness (credit score, credit history) - unlike federal loans. It is easier to qualify for than a regular personal loan. (they understand that as students you are still building credit)
Some other things to keep in mind:
Generally there are less options to defer payments (unlike federal loans)
It comes with variable interest rates (they can change) I see frequently with clients a range of 3-13% interest rates. Again, depends on their credit.
You have more options for payment plans - they tend to be more flexible, and easier to personalize.
# 4. Auto loans
Auto loans exist exclusively for the sake of purchasing a vehicle. They come in completely variable interest rates, 100% based on your credit. So the better your credit score, the smaller the interest rate.
Something you may not know, the higher the value of the car - generally they can have a longer term on the vehicle ($10,000 likely 4 year loan, $100,000 8-9 year loan). Shorter the term, the lower the interest rate.
Something you may not know is that late or missed payments on auto loans negatively affect your credit more than almost anything else. If you don’t make payments, the bank has permission to repossess the car - usually after 3-6 months. But it depends on your fine print in your contract)
When shopping for a car loan, you are able to get your credit run without it affecting your credit score for the next 30 days after your first scan (the first time it will be affected but not for the subsequent inquiries for the period of 30 days).
A mortgage is a loan used to acquire real estate property.
It generally has the lowest interest rate, highest monthly payments, and tends to be the highest value loan compared to any other debt. Mainly because houses are usually more expensive than other things.
Most people pay their mortgage off in 15-30 years - which tends to be the most common length of term for mortgages.
Mortgage payments are generally payments to your escrow balance - what does this mean? Your mortgage payments are not just your house loan, it is generally comprised of
House loan payment
Home insurance/mortgage insurance
Sometimes also HOA fees
So in actuality, you are likely putting in less money toward your actual house than the payment would suggest - only a portion goes toward the house. The rest go to cover the other fees.
If you want to make a payment to the principal of the mortgage above your normal payments, make sure to specify when you submit your additional payments that you want it to go toward the PRINCIPLE of the home loan.
Remember that in the first few years, your money goes toward your interest (not your principle)
Well there you have it. The 5 most common types of loans!
I hope that was helpful. When it comes to debt, there are so many layers of information and knowledge that people are missing. So if you are looking for more information, I welcome you to contact us.
If something in this article spoke to you and you would like help sorting out the situation with your own loans, please don’t hesitate to reach out to us to book your complimentary appointment.