The Impact of Bank Loans on Your Financial Health
Written by
Chris Ozarowski
Edited by
Jairo Rodriguez
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Do you currently have any form of debt you’re trying to pay off, such as a personal loan, student loan or mortgage? If so, you’re not alone. According to data from credit agency Experian, the average American currently has over $104,000 in total debt. This includes an average of $19,402 in personal loans, $23,792 in auto loans and $38,787 in student loans.
While a certain threshold of debt is commonplace in the American economy and is required for most people who want to own a home, mismanaging loans can have a profound negative effect on your long-term financial health.
The Different Types of Bank Loans
Here are a few of the most common types of loans people may get during their lifetime.
Personal Loans
Personal loans are unsecured loans, which means they don’t require giving the bank some sort of collateral. People may use these loans for consolidating debt, doing home renovations or covering unexpected expenses.
Personal loans can be harder to get than secured loans, such as a car loan, since it’s usually harder for the bank to get its money back if you stop paying. Whether the bank decides to give you a personal loan will usually depend on your credit. As with all loans, missing payments can immediately tank your credit score and make it more difficult to get a good deal on an auto loan or mortgage in the future.
Mortgages
Mortgages are secured loans, with the property you purchased as the collateral. This means if you don’t make payments, the bank can legally repossess your home and sell it at auction to get its money back. Terms typically extend for 15 to 30 years with interest rates that can be fixed or variable.
A fixed-rate mortgage means that the current rate at the time you get the loan will be the interest rate for the rest of your loan’s duration. If you get your loan during a time with relatively low rates, this can be a great deal, since compound interest can build up significantly over 30 years. If you have a variable rate mortgage and rates go up, you will find that your monthly payments increase.
Auto Loans
Auto loans are secured with the purchased vehicle as collateral. They usually have terms from two to seven years. Interest rates depend on the lender, the buyer’s credit score and the down payment.
An expensive car loan can end up being a bad idea. A high-interest loan can be difficult to pay off, and your car starts losing value the minute you drive it off the lot. You can end up owing more than the car is worth if you aren’t careful.
Student Loans
These can be federal or private, with federal loans generally offering more favorable terms and repayment options. Federal loans often come with fixed interest rates and multiple repayment plans, while private loans — from banks, credit unions, etc. — may have variable rates and fewer repayment options.
It’s important to try to balance the size of your student loan with your expected income after earning a degree. If you pay a lot for your schooling by, for example, choosing a more expensive out-of-state college, you may end up making payments for much longer during your career.
Mortgages vs. Renting
It can be hard to save for a down payment or qualify for a mortgage. However, if you manage to do so, buying a home instead of renting can have a long-term positive effect on your financial health.
Building equity is a key financial advantage of buying a home versus renting. When you buy a home, each mortgage payment you make partially goes toward paying down the principal amount of the loan, which increases your ownership stake in the property. Over time, as you continue to reduce the amount owed, you build equity — the difference between the property’s market value and the remaining loan balance.
When your home is paid off, you could recover all that equity by selling the house. That means a good chunk of the money you pay every month in mortgage payments isn’t lost. It still belongs to you. If your house increased in value while you were making payments, your home might be worth more now than the total you paid.
Renting offers no such benefit. Monthly rent payments go entirely to the landlord and, in many cases, may actually be paying for their mortgage on the house. As home prices go up, those who are locked out of the housing market due to the high upfront cost of a down payment end up losing out in the long run.
Loans and Your Credit
When it comes to your credit score, loans can be a double-edged sword. If you want to build your credit, you will likely need to actively take out and repay some form of debt, such as a credit card. However, mismanaging your loans can tank your credit score quickly.
Consistently making loan payments on time is the most significant way loans can boost your credit score. According to Experian, payment history accounts for 35% of your credit score calculation. Unfortunately, this means that a payment that is 30 days late might lower your credit score by as much as 100 points. The impact of late payments diminishes over time, but in some cases, the record can stay on your credit report for up to seven years.
Taking out and repaying loans adds to your credit history, demonstrating to lenders that you can manage debt responsibly. This can be especially beneficial for younger individuals or those new to credit. Credit scores also improve when you have a more varied mix of credit types with both credit cards and installment loans, like auto loans or mortgages.
Using a large portion of your available credit, especially on revolving accounts such as credit cards, can harm your credit score. High utilization signals potential financial distress and risk to lenders. Also, every time you apply for a loan, a hard inquiry is made on your credit report, which can lower your score temporarily.
Risks of High-Interest Loans
One risk of loans with higher interest is that if you don’t pay enough monthly, the total loan amount may grow faster than you can pay it.
Interest is calculated as a percentage of the principal amount of the loan — the initial sum borrowed. The rate can be fixed, remaining constant throughout the term of the loan, or variable, going up and down based on current government interest rates. Interest may be compounded at different intervals — annually, monthly or daily — meaning that the interest is added to the principal and also earns interest. This compounding effect can cause a debt spiral if regular payments aren’t made to cover at least the interest due.
For example, imagine you have a credit card with an APR of 20%, compounded monthly, and a principal balance of $5,000. If you make only the minimum payment, which often barely covers the interest, the principal will remain nearly intact. Each month, interest is calculated not just on the original $5,000 but also on the accumulated interest from previous months. Over time, what started as a manageable amount can grow exponentially.
Psychological Effects of Debt
Loans can have a serious effect not just on your financial health but your physical and mental health as well.
Studies have found a strong correlation between high debt levels and increased mental health issues and high blood pressure. Individuals with higher consumer debts have reported higher levels of anxiety and depression.
This type of stress, often referred to as “debt stress,” can exacerbate feelings of helplessness and lack of control, further entrenching feelings of anxiety and depression. The psychological burden of carrying debt may also affect everyday decision-making processes, leading to poor or short-sighted financial decisions that can perpetuate the debt cycle.
Life is unpredictable, and in many situations, debt is unavoidable. However, it’s important to be aware of the potential consequences of bank loans. Try to save where you can. For example, buying a reliable old car in decent condition instead of taking out a high-interest car loan may save you a chunk of money and stress in the long run.
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