Handling Debt

Debt creates anxiety for most people, but why is that? It’s because most people don’t have a clear understanding of how to approach debt. Debt isn’t inherently bad. The average American in 2021 had an average debt of $96,371. Without it, most people wouldn’t be able to own a home or get a college education but identifying when you should take on debt can be tricky.

What is it?

Debt is money borrowed by someone from another with the understanding that it will be paid back later with interest. The most common type of debt is a loan. Loans help us pay for large purchases like houses, cars, and education when we don’t have cash available to pay for it all at once. Understanding the terms of your loan can be tricky. Here are some definitions of common loan terms you should know:

Annual Percentage Rate (APR) – the total yearly cost of taking out a loan. This includes interest as well as any additional finance charges.

Collateral– an asset, like a house or a car, that you allow the lender to take if you don’t pay back the loan.

Credit Score – a number calculated on how good you are at repaying debt. The main factors in your credit score are payment history, amount owed, credit history, type of credit, and new credit. Having a high credit score will let you borrow money at a lower interest rate and will increase your likelihood for loan approval.

Default – not paying back the loan as promised. If you default on the loan, the lender may take any collateral you provided. The two main consequences of defaulting are potentially losing your ability to borrow money in the future and being at risk of a legal suit.  Defaulting on a loan will stay on your credit report for 7 years.

Co-signer – someone who agrees to be responsible for paying back the loan if you can’t. If you are a co-signer and the original borrower misses a payment or defaults on the loan, you will be responsible for paying back the loan.

Debt-to-income ratio (DTI) – the ratio of debt to your gross income (income before taxes). Your debt-to-income ratio is important because it can impact getting approved for new loans. Every lender is different, but most lenders will not approve a mortgage if your DTI is above 40%. Note: Your DTI is calculated based off your gross income. When you consider taking out a loan, make sure that you are looking at your net monthly income to know if you can afford it.

Prepayment penalty – a fee charged for paying off your loan earlier than agreed upon. Some lenders charge a fee if you pay off your loan early. This is because they will make less interest off of your loan. Always check your loan’s terms before paying your loan off early.

Why it matters to you.

Debt can help you make bigger purchases like a house or a car, but interest can add up quickly. To use debt wisely, avoid taking on debt that you can’t afford. Having a budget helps you know what your cost of living is and what you can afford. If you have a credit card, making your payments before the payment date can prevent you paying interest. If possible, avoid carrying credit card balances as high APRs can snowball quickly.

Paying off debt vs investing

Knowing when it makes sense to pay off debt rather than saving money is tricky. When you put your money into a savings account, your money earns interest for you. However, when you take on debt, you owe interest. From a mathematical perspective, comparing the expected return from saving your money to the interest that will accrue on your debt helps you understand if you should pay off debt or save money.

For example, let’s say you had a $100 and a debt of $100 with a 3% APR. If you paid off your debt assuming no early payment penalty, you would avoid paying $3 of interest. However, if you invested your $100 and got a return of 6%, you would have made $6. In this case, you would have received $3 more from investing rather than paying off your debt.

Investing is also risky. Even the experts don’t know what will happen next month. Paying off debt will give you a guaranteed return rather than a return that is tied to the stock market. Also, taking on debt can cost you more than dollars. It can also cause mental and emotional stress. Considering your tolerance for debt and risk is always important when you are making financial decisions.

Key Takeaways

Debt is not inherently bad. However, if you’re considering taking on debt, making sure that you can afford it will reduce your stress, and help you use debt wisely. When it comes to handling your debt, examine the actual cost of the debt and compare it to the return you could get by investing your money can provide a rough guideline of how to set yourself up for future success.

If you have any questions on how to best prepare for the future, one of our advisers would be happy to help!