Since you now know how to balance your budget, it might be challenging to even think about going into debt. But remember: there is "good debt" and there is "bad debt". What is the difference? Using your credit card to finance a vacation or fancy meal, that is "bad debt". It might have been fun at the time, but how do those drinks and desserts taste when you are still paying for them several months later? Probably a little bitter.
In general, if you are financing something that will grow in value (and still be there when the bill is due), then it is considered to be "good debt". For example, carefully financing your education (one that will lead to a career at the end!) is "good debt".
Keep in mind, that whatever money you borrow, you will need to repay, with interest. So only borrow as much as you will likely be able to repay. For education, you can use one of two guides:
- Borrow only up to about 80% of the anticipated starting salary for your career field.
- Borrow at a rate that will keep your standard repayment at 10 to 15% of your starting monthly gross salary (gross salary is your total salary before any deductions are taken out of it).
For example: if the starting monthly salary for your career is about $35,000, then you would want to limit all of your educational debt to about $28,000 (or about 80% of your starting salary).
That means if you are going for a Bachelor's degree, you should borrow no more than $5600 per year (assuming you are in college for 5 years). If you are getting a Master's Degree, you should limit your average borrowing to $4000 per year (assuming it takes about 7 years total to complete both degrees).
For other types of debt, consider the following guidelines:
- When you work, 25% to 30% of your gross monthly income will go to taxes (income taxes, Social Security, Medicare, Unemployment, etc.)
- You will want to be able to save about 10% to 15% of your income each month
- If you buy a home, your total monthly housing expenses (principle, interest, taxes and insurance) should stay below 28% to 35% of your gross monthly income
To stay within these guidelines, all other spending, including debt repayment, needs to stay under 25% of your income.
Types of Debt
What are the different types of debt? There are basically two different types of debt, secured debt (debt that is secured by a good or money) and unsecured debt (debt that is given based on an agreement between the lender and the borrower). Both types of debt usually carry interest, but unsecured debt usually carries a higher interest rate.
Types of Secured Debt
A home mortgage is a loan for your house and property.
Home Equity Line of Credit
A home equity line of credit is also called a "second mortgage" - a loan on the equity built from raising property values and/or the amount you still owe on the original mortgage.
A car loan is secured by the vehicle you purchase.
Secured debt is usually less risky to the lender, because if you default on your loan your items may be foreclosed on or repossessed. This usually means lower interest rates for the borrower, and in the case of a mortgage or home equity line of credit, the interest you do pay is usually tax deductible.
Types of Unsecured Debt
Credit cards generally are a form of revolving debt, which means the balance can go up and down within the limit, and you are obligated to pay only the minimum payment, which could take years and end up costing you a lot more money. Most credit cards eventually carry high interest rates, with the national average around 15%.
A payday loan is usually for a smaller amount (up to a percentage of the value of your paycheck), and carries an incredibly high interest rate, which kicks in as soon as the loan is due (usually within a few days or weeks from the time you borrowed it). If you get behind on a payday loan, you'll likely have a difficult time paying it off because of the very high interest rate. For that reason you should avoid these loans.
Personal loans are installment loans, meaning you borrow a set amount and repay that amount in specified installments over a specified amount of time.
Most unsecured debt includes higher fees and/or interest rates, because there is greater risk to the lender. To get the best deal, it is wise to shop around for credit cards or personal loans. Having a good credit score will also increase your chances of getting a better rate on most unsecured debt.
What about student loans?
Student Loans, another type of installment loan, are loans to help students meet the growing cost of education and are also unsecured debt. Because they are guaranteed by the federal government, student loans differ from other types of unsecured debt because the guarantee by the federal government offers the lender less risk.
The interest rate on a student loan is generally lower than other types of loans or debt options, and there are many options for borrowers who have entered the repayment period on their loans. Keep in mind though, whatever you borrow you will have to repay, with interest. There is virtually no discharge for student loans, meaning your loans are not subject to bankruptcy protection. That means all student loans are required to be repaid with interest: there is generally few options for eliminating this debt (except for repayment).
3 Main Considerations Before You Borrow Money
Good use of money?
Is this a good use of money?
Thinking back to good debt vs. not so good debt, will your purchase increase in value? Or will it be worth less than you paid because it is not lasting (i.e., a coffee drink, an expensive pair of sunglasses, or 6 tanning sessions?)
What is the interest rate?
What is the interest rate on the loan or credit card?
If you use a credit card to buy an $80 concert ticket, for example, you may pay up to 24% interest on that purchase, making the actual ticket cost $99.92 if you pay it back in one month. If you don't, interest continues to accrue, and the ticket could end up costing double the original amount!
How long will it take to pay back?
Can you pay it back, and how long will it take?
It is tempting to tell yourself "I'll worry about how to pay it back later." But you can create thousands of dollars of not-so-good debt over time with small purchases, and at some point you will have lots of debt and nothing to show for it. Before borrowing money, consider the interest rate, monthly payments and how long it will take you to pay it back. Then stick to your payment schedule. You can use a credit card debt calculator to see how much you will pay and how long it will take to pay off the money you borrow.
Did you know...
If you are borrowing money to buy something that will decrease in value and/or that you cannot repay easily, you should seriously consider paying for it in cash. Examples: clothing, coffee drinks and concert tickets, or borrowing money to pay your rent. These add up quickly!