The ABCs of Debt: How To Be Smarter With Your Finances
Debt gets a bad rap, but borrowing built the modern world. If people couldn’t borrow money, they wouldn’t be able to buy cars, houses, businesses, or college educations until they saved enough cash to pay for it on the spot, which most people never would. The global economy would come to a screeching halt without debt, and if you want to avoid debt altogether, you’d better be planning to live way, way off the grid.
A better strategy would be to brush up on your knowledge, make sure you understand key terminology, and position yourself to leverage the incredible power of borrowing to your advantage so that you — and not the bank — come out on top.
Learn the Basics — and the Lingo
Debt is when a borrower takes on an obligation to return something that was loaned to them by a creditor. Unless that creditor is a close pal, your lender will expect not only the money that was loaned, but a little extra in the form of interest. When you take on debt, the following terms will become some of the most important words in your financial life.
Terms to know:
- APR: Annual percentage rate is the yearly cost of a loan. Since it includes all fees and expenses, it — unlike the advertised interest rate — is what you’ll actually pay.
- Interest: This is the fee you pay your creditor for the service of lending you money. The lower the interest rate, the cheaper the loan.
- Payments: Most loans are paid back not in one lump sum, but in periodic — usually monthly — payments. As you’ll learn further down the page, the number of payments and the length of time they’re spread out will have a lot to do with how much your loan ends up costing.
- Principal: This is the amount of money you borrowed. Debtors are obligated to pay back the principal as well as fees and interest.
Convince Lenders That You’re a Low-Risk Borrower
Lenders charge more to high-risk borrowers than they do to those who are likely to pay back the loan on time as agreed. The single best thing you can do to get the lowest interest rates and the cheapest loans is to stay in good financial health and keep your credit in good shape.
Terms to know:
- Credit bureaus: Your lenders report your debt, payment history, and other critical information to the three credit bureaus: Experian, TransUnion, and Equifax.
- Credit report: The credit bureaus compile your information into a credit report that prospective creditors will examine when making a decision on whether to loan you money and what interest rate to charge. You should check your credit report periodically, too, to see what lenders see, to find out where you have room to improve, and to make sure it doesn’t contain any errors.
- Credit score: The bureaus assign every prospective borrower a credit score based on the information in their credit reports. Ranging from 350-850 with higher being better, your credit score represents your risk. The single most important thing you can do to maintain a high score is to pay all your bills on time every time — a single missed payment can crash your score. It’s also important to keep your credit utilization ratio low, which you will when you use less than 30% of your open credit. Your credit mix, credit age, and the number of creditors requesting “hard pulls” on your report also play a role.
Don’t String Out Loans to Buy Things You Can’t Afford
Mortgages are often paid back over 15 or 30 years. Those who opt for 15 years will pay much less interest over the life of the loan. The tradeoff is that their monthly payments will be higher. If the only way you can afford the car you have your eye on is to finance it over 84 months, then you can’t afford the car — you’ll wind up paying for several cars in the process. The same logic applies to making only the minimum payments on a credit card purchase that you couldn’t really afford to charge.
Terms to know:
- Amortization schedule: A table that details your payments and breaks down how much is going to your principal and how much is going to interest.
- Compound interest: The power of compounding works in your favor when you invest and works against you when you borrow. When interest is added to the principal sum, you pay interest on that interest, which continues to compound — daily in the case of credit cards — over time. That’s what makes revolving debt and long-term loans so dangerous.
Not All Debt is Bad, But Plenty is — Steer Clear
Low-interest car loans, mortgages, and business loans are critical elements of healthy finances that many people use to get ahead — but debt can also be toxic and destructive.
Terms to know:
- Cash advance: Think hard before you use your credit card at an ATM machine. Cash advances almost always come with higher APRs and usually end the 0% interest introductory period applied to any balances you transferred.
- Payday loan: Perhaps the most dangerous kind of loan there is, payday loans are the closest thing to loan sharking allowed by law. The institutions that offer them are infamous for preying on low-income people with high-interest short-term loans designed to trap borrowers in endless cycles of debt.
- Revolving debt: Credit cards are the most common type of revolving debt — loans that aren’t extended for a fixed period of time. The single best way to dodge the danger is to pay your statement balance in full every month — never charge what you don’t have the cash to cover — and avoid paying finance charges.
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