Even today, it is possible to be completely debt-free. Living without creditors blowing up your phone and bills piling up on your doorstep is indeed the modern American dream. However, is living completely debt-free is a good thing? Is it a smart decision to absolve oneself of all debts? Only a handful few earn enough or save enough to make all-cash payments for the necessary purchases in life – a home, car, and college tuition. Nonetheless, is it wise to make cash payments instead of taking out traditional loans?
It is where the concept of good debt and bad debt comes in. While a good debt is akin to an investment in the long-term that has the potential to grow in value, bad debt is one that is high in interest and does not increase in value in the long run.
What is a good debt?
A mortgage loan for buying a house can be a good debt. Traditional home mortgage loans have a low-interest rate, and they are tax deductible. Most people take long-term mortgage loans for buying homes, and these can go up to 25 to 30 years. The low-interest rates ensure that the debtor has enough money left per month to make other payments, save up for emergencies and engage in new investments. Even automobile loans and student loans are examples of good debt. In the case of automobile loans, people try to pay off as much as possible in interest and principal in the first few months, since the car or van begins to lose value after 4-5 years of purchase.
According to a 2017 survey by PricewaterhouseCoopers (PWC), the average American household has an outstanding debt burden of $134,643. Their home mortgage loan constitutes a majority of their debt burden. As per reports from the National Association of Realtors, American citizens buying homes for the first time have fewer resources available to them. The average market value of their first homes is around $182,500. They are most likely to make 5% down payment on their first house, and their average monthly payment looks similar to the following –
- Around $840 per month at 4.1% for 30 years
- About $1230 per month at 3.43% for 15 years
Approximately 20% of the first-time home buyers make down payments of more than 20%, and their cash-flow roughly improves by $700 per month (for those with 30-year repayment terms) and $1042 (for those with 15-year repayment terms).
What is a bad debt?
It easy to tell bad debts from the good ones. A bad debt is when you borrow money or credit to buy something that quickly loses its value. Another way to discern a bad debt is by its high-interest rate. Most credit card debts are bad debts. For example – you see a pair of Louboutin heels for $500, and you decide to ring it up on your credit card. If you do not manage to pay the balance for years, the shoes will cost you over $600 in a little more than a year, but they will be quite outdated by then. That is not an investment, but a poor spending choice that will end up being a bad debt.
Can good debts become difficult to pay off as well?
Most of us understand the categorization of good debt and bad debt, but we struggle to maintain the balance. Since it is impossible to avoid the bad debts and incur only the good ones, one must learn how to balance them to create cash-flow. To keep your good debts from spinning out of control, you need to keep an eye on your debt-to-income ratio.
Here’s an easy way to calculate that –
Add up the debt payments you make every month. Then, divide them by the monthly income. It should yield your monthly debt-to-income ratio. For example – you pay around $1000 towards the home mortgage, $200 towards the auto loan, and about $300 towards other bills including credit cards and payday loans. Therefore, your total monthly debt is about $1500, which is quite comfortable compared to the average American standards. With a gross monthly income of $4000, your debt-to-income ratio should be 37%. That is an excellent debt-to-income ratio, which can improve your credit scores and open up new avenues for low-interest loans.
However, if your monthly earnings go down to $3000, with the same total debt, your debt-to-income ratio becomes 50%. Any rate above 43% is worrisome for the debtor, and it also makes receiving new low-interest loans difficult in the future. A high debt-to-income ratio drives people to debt consolidation and new loans. Visit Nationaldebtrelief.com to find out all about your debt-to-income ratio.
How can debt consolidation help restore your debt-to-income ratio?
When your monthly debt-to-income ratios are incredibly high, and you are struggling to make ends meet, it is time to consider debt consolidation. Debt consolidation usually works for all types of outstanding debts including revolving lines of credit. Debt consolidation refers to the processing of replacing all outstanding debts into one large loan. It is a method of refinancing the existing lines of credit and outstanding loans. People usually consolidate their outstanding credit card balances, payday loans and small personal loans to make monthly payments hassle-free.
However, if you are struggling to pay off your good debts, you can refinance them as well. Since debt consolidation does not have any effect on the FICO score, it gives each to simplify their finances by replacing multiple monthly payments towards mortgages, car loans, personal loans, and credit card companies with one fixed amount towards the consolidation loan company. The new amounts are typically lower than the summation of the multiple payments you were making towards your creditors. Lowering the gross monthly payment can help decrease your debt-to-income ratio and free up cash for other investments.
What are the unsecured loans for debt consolidation?
When you have a number of good debts in your profile, it is likely that you will have a good or excellent credit score. In such cases, you might qualify for an unsecured consolidation loan. Like other unsecured loans, the unsecured consolidation loan does not require collateral. If you don't have an excellent credit score, you might need a co-signer or receive a high-interest rate for access to an unsecured consolidation loan.
Unsecured loans for the consolidation of debt has become rare these days. Nonetheless, you might be able to pay off your consolidated debts using the following loans –
- Personal loans
These are the most popular loan types for the payment of consolidated debts. Unsecured personal loans typically require the borrower to have excellent credit scores, or the lender to charge sky-high interest rates on the principal amount. You might find it tricky to get one from the banks, but you can try negotiating with the credit unions and personal lenders for the same.
- Balance transfer
Credit cards might be the bane of financial freedom, but some credit cards offer 0% transfer fee or 0% interest during their promotional periods. You should seize this opportunity to transfer the remaining balance from high-interest credit cards to the zero-interest rate credit card. Always ensure that you are paying less in the long run.
- Line of credit
Opening a new line of credit without collateral is quite difficult in the modern financial scenario. However, if you have an excellent FICO score and a considerably high income, you might be able to apply for a new line of credit at the bank. Always remember to approach the financial institution, where you have an account, for receiving a new line of credit. You can use the money from this source to pay off outstanding loans and make monthly payments to the new line of credit.
- Peer-to-peer loans
Peer-to-peer loans not only work for those with high credit scores, but also for the ones struggling to make ends meet. These lenders have a high-risk appetite, and that makes qualifying for these new-age loans much easier for those looking to consolidate their loans. Another advantage of applying for peer-to-peer loans is quick access to cash. In fact, most online lenders claim that the borrower gains access to money within the next 24-hours.
What are the secured debt consolidation loans?
Secured debt consolidation loans require collateral. According to the top financial institutions in the US, you can leverage almost any guaranteed source of income and significant asset as collateral for a new loan.
Here are the most common secured debt consolidation loans –
- Home equity loan
This type of loan uses your home as collateral. Therefore, non-payment can lead to the foreclosure of your home. However, lenders typically provide up to 85% of the home's equity value to the borrower depending upon his or her credit record.
A home equity line of credit (HELOC) is similar to a home equity loan, except the borrower does not get access to a lump sum. He or she receives a revolving line of credit with their home equity as the collateral. The interest rate depends on the economy and the amount he or she has borrowed from the HELOC.
Most finance and accounting experts advise against it, but you can access your retirement funds to borrow money. You can use the amount to pay off your outstanding lines of credit. Then, you can gradually make up for the used-up amount by paying small monthly installments. However, some 401(k) plans prevent the users from contributing to the retirement fund, unless they settle the funds in principal and interest.
Depending on your debt-to-income ratio, and your FICO score, you can access any of the secured or unsecured consolidation loans. Unsecured loans bear lower risks as compared to secured loans. Therefore, if you have a high credit score, you should not think twice to access your unsecured consolidation loan options.