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Managing Your Debt, Part 1
If you’re like most Americans, then you’re carrying more personal debt than you ever have before - to the tune of about $38,000, according to an article on a national news service. That’s $1,000 more debt than most Americans were holding a year ago. The average income in the U.S. is about $46,000 a year, according to another article on a national news service, which means the average person owes almost a year’s salary in debt.
Understandably, the thought of paying off that much debt feels overwhelming to most people. Really, how can you even wrap your head around owing that much money to anyone? The good news is it’s possible to get out from under your debt with the right strategies. In this ebook, we cover not only what debt is, but also how you got so deeply into debt, and finally, how to get out of it.
1. Defining Credit and Debt
Tackling debt and learning how to manage your credit count as some of the most important financial skills to have. Without this knowledge, you’re likely to find yourself in over your head in debt. So, in this section, we’ll talk a bit about debt and credit.
What is the definition of debt?
Debt is money that you have borrowed from a creditor that you have not paid back yet. A creditor can be a credit card company, your car, a home mortgage loan company, or a bank or lending institution where you’ve gotten a loan from. You can also owe a debt to the U.S. government for student loans.
Additionally, there are categories of debt called “secured debt” and “unsecured debt” A secured debt is one that’s backed by some sort of security or collateral. Car and home loans are debts that fit into this category.
Unsecured debt is a debt that has no physical collateral backing it. People who qualify for unsecured debt typically have a very good credit score. That means that their signature equals their collateral because their credit score is good enough to merit it. People who can get a signature loan or credit cards typically have a history of paying back the money they owe to their creditors in a timely manner.
Finally, it’s also important to note that not all debt means you have credit. If your bank gives you money to buy a car, then the money you get is to be used specifically for that purpose. Once you use the loan to pay for the car, you have no more credit on that particular line of credit. This means that it’s possible to have debt and no credit at the same time.
What is the definition of credit?
Credit represents your potential to borrow money: Most often, your ability to borrow is tied to your credit score. For example, you can borrow money from your bank if you have good enough credit. If the bank agrees that you are credit-worthy, then the bank will give you a loan for a specified amount. You’ll eventually have to pay that money back with interest.
Interest is the fee that your creditors charge you for using their money. It’s usually based on a percentage. For example, if you borrow $1,000 to be paid back over a year and you have a 6.8% percentage rate, then you’ll pay $37.16 in interest.
2. Understanding Debt: How to Get a Handle on It
If you haven’t learned how to take care of your debt, then it’s likely that you’ll remain in debt for an indefinite period of time. This lack of understanding leads to cycles of debt that can be difficult to break out of.
However, understanding your debt, at least the mechanics of it, is a pretty simple deal. It boils down to you knowing the answers to the following questions:
1. Who are your creditors? In other words, who do you owe money to? This could be your credit card companies, payday or title loan companies, your mortgage company, the bank or credit union that holds your car loan, and others.
2. Once you know who you owe money to you then need to determine how much you owe them. How much do you still owe on your remaining balance?
3. How much are your monthly, bi-weekly, or weekly payments and when they are due? There may be other types of payments, like balloon payments, (which is covered below).
4. What is the interest rate on each of your credit cards, payday loans, mortgage and car loans, etc.? Do be aware of the fact that some types of debts carry more interest with them, particularly if you are considered a high-risk borrower.
5. Are there penalty fees for being late? How much are they? Do you owe any fees? You should include overdraft fees that your bank charges you if you bounce a check in your list of penalties as well as the fees that a payday or title loan company will charge you to refinance your loan.
6. Does the creditor charge prepayment penalties? This is where you get charged extra for paying a loan off early: Very often, this is a home loan, though it can be any other type of loan, too. A prepay penalty gives the mortgage company/creditor a financial buffer to recoup the losses that the financial institution would incur if the loan were to be paid off early
7. Is your loan a balloon payment loan? This type of loan allows you, the borrower, to have low monthly payments but with a catch: There is one gigantic payment due at the very end of the loan terms to make up for the low payments. For example, you might get a $200,000 mortgage on your home and have $1,000 mortgage payments each month for five to seven years. At the end of the “normal” pay period, you would then be expected to make a payment of $175,000 or more to make up for the low payments. Many borrowers in this predicament try to refinance the loan or sell off the asset before the balloon payment comes due.
Final Thoughts for Part 1
As you can see, there are myriad types of debt and credit that you can qualify for. Each type of debt comes with interest, though how much the interest will be depends on the type of creditor you borrow from as well as what type of credit risk you pose to a borrower. Additionally, certain types of debt can come with fees or penalties, which can take a big bite out of your budget.
Finally, there are some types of credit, like balloon payments, which pose an enormous financial risk to the borrower. As we will discuss in later sections of this ebook, avoiding certain types of high-risk credit is an important step to take in order to get a handle on your debt.
Go to part 2 to learn more about how certain types of debt work, how much debt you owe, and how debt can affect your financial situation.
