According to the New York Times, young adults who are facing debt are now facing an economic crisis.
But, what exactly is debt? If you don’t have adequate knowledge of the cause of the debt, then chances are high that you’ll fall deeper into an unending financial hole of debt.
In this article, we’ll explain the basic features of a loan and those debts you need to be wary of. This article will also help you know the benefits of applying for debt and the pitfalls attached to it. You may also be interested in ways to get out of debt, using such tools as a debt payoff planner.
1) What is Debt?
Loan and debt are essentially the same, as such, don’t get confused when we use them interchangeably. But for those who like semantics, a loan is basically the amount of money borrowed from an entity, while debt is the sum of loans owed. For example, Samuel has two loans of $7,500 each; this means that his debt is $15,000.
2) An intrinsic concept for understanding debt is that it is highly intertwined with risk measurement.
Let’s assume your sister Alex took a loan of $500 to meet-up with a payment deadline on an apartment because she was recently promoted by her employer, and she was asked to manage the new office in another city. Your brother Steve will also like to borrow the same amount of money to meet-up with the monthly mortgage payment, but he already owes different creditors about $5,000 and doesn’t have a stable source of income.
Without any doubt, if you want to get your money back, then you’ll prefer to borrow Alex.
In the same vein, let’s assume you’re a bank and you’re approached by both Alex and Steven, will you charge both of them the same interest rate? Definitely not, as Steven is a high-risk fellow, and the chances are high that he won’t pay up when due.
But why is interest so important to credit firms and banks? This is the fee banks and creditors charge for borrowing people money, and this fee is calculated as a percentage of the loan.
3) Features of Debt
Unsecured vs. Secured Debt
Now that you have a basic understanding of the risk let’s get back to Steve. Let’s assume that he offered to drop his vehicle as collateral due to the dire importance of the money; it means that the loan is now guaranteed by something that is worth the value of the loan, which reduces your chances of not recovering the money. You can agree to such terms. As a matter of fact, due to the reduction in risk level, the chances are high that you’ll lend him the money at a much lesser interest rate. In the example given, the vehicle is collateral, and the debt is termed as a “secured loan” as the loan is now guaranteed with a valuable asset. “Often secured loans have lower interest rates because the creditor can take something if the loan is not paid”, stated Ben Tejes, co-founder and CEO of Ascend Finance.
You can get more information on Unsecured and Secured loans by navigating through our website.
Secured loans are in numerous types: Auto loans use your vehicle as collateral, home mortgages use your house as collateral, and title loans use the title on an asset as the collateral.
Generally, secured loans have a lesser risk than unsecured loans. Thus, if you’re applying for a secured loan, you will be issued a loan at a relatively lower rate than when you apply for an unsecured loan—this is because the only “collateral” on an unsecured loan is the credit score which means a bad decision will likely make the creditor lose money.
Variable vs. Fixed Interest Rate
When you get a loan from a bank, the interest rate will be fixed (unchanging during the course of the loan), or they can adjust with market value and regulators policies. Most lenders prefer a fixed interest rate as it allows them to estimate what they would be obligated to pay in advance; however, variable rates can also be appealing as the rates are relatively lower.
The majority of lenders will make a payment schedule for the lender. The lender will be mandated to pay a portion of the loan and the interest fee monthly. These monthly payments are known as “Minimum Payment” for credit cards and “mortgage payments” for home loans. You should take note of the payment duration, as credit card companies are notorious for fixing a minimum payment that will ensure that you pay for a very long time. The worst-case scenario is if a lender charges only interest on a loan, then the debtor will have to pay the loan till the day he/she dies.
Each lender will give you only up to what they think you can handle in total; they do this by considering your salary, your debt, and your monthly expenditure.
If you get an approval for a loan, it will always have a credit limit that you can’t borrow above. This is most common with credit cards; the credit limit is the maximum amount where you can’t withdraw beyond. The moment you reach a credit card limit, any further transaction will be declined.
4) Types of Debt
Since you know some basic characteristics of debt, let’s broaden your horizon by telling you about the most common types of debts. The list below is arranged from one with the lowest interest rate to the highest interest rate.
Interest rate: Very low
Type of loan: Secured loan (house as collateral)
Variable vs. Fixed: Both are available
Thoughts: Ensure that you have enough funds to afford a hike in interest rate when prices rise.
Interest rate: Low
Type of Loan: Secured loan (The car is the collateral)
Fixed vs. Variable: Often fixed
Thoughts: It is quite common to see vehicle dealers that offer a low-interest rate, or even 0% interest rate in holiday periods. Some dealerships still offer financing options for those willing to purchase used vehicles. However, this is on rare occasions as you’ll likely have to approach a bank for a loan. Since banks are not under any pressure to meet a sales quota, their rates will be much higher.
Bank Line of Credit
Interest rates: Low
Type of Loan: Unsecured or Secured (Your home is the collateral)
Variable vs. Fixed: Variable
Thoughts: Before getting a line of credit, you have to first approach the bank for approval. It’s quite common for banks to request for collateral before issuing an approval. Once you get an approval, you can use your funds in the same way you’ll use a credit card, but if you differ in loan payment, then the bank will come for your house. Before requesting any high-interest loan, or any other type of loan, ensure you try out other options first.
Type of loan: It varies
Interest rate: It varies
Variable vs. Fixed: It varies
Thoughts: Loans from friends and family can offer a way out, and the terms may look juicy, but the collateral here will be your relationship with the lender. Ensure that you don’t misuse the opportunity of having a friend or family loan you money.
Interest rates: Very high
Type of loan: Unsecured
Variable vs. Fixed: Variable
Thoughts: Credit card loans are the greatest source of unending debt as it’s easy to get overboard with. It is also one of the greatest sources of income for banks due to the high-interest rates and fees. As a personal finance expert, it’s best to use any of the previous loans before using the credit card debt. The only exception here are individuals who have a high credit score and can get a 0% interest rate as an introductory offer. Even with that, you’ll be required to pay off the debt within a stipulated period, after which the interest rate will kick in.
Title & Payday Loans
Interest rates: Extremely high
Variable vs. Fixed: Fixed
Loan Type: Secured and Unsecured
Thoughts: It will be an understatement if we describe this as extortion. The extortion is so appalling that it’s now illegal in most states of the United States of America. Before taking this money, you might want to consider selling a kidney first. Pursuing payday loans may result in an individual having to check Chapter 7 means test to estimate Chapter 7 qualification or a Chapter 13 repayment plan calculator to estimate Chapter 13 payment plan.