Aug 21, 2019
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Understanding Loans and Debt

Personal finance can be stressful and confusing. We all know that you’re supposed to be saving money for retirement and paying your bills on time, but it isn’t always easy. When you’re working long hours and rushing around to care for yourself and your family, it’s easy to see why so few Americans have found the time or the money to save enough for retirement, and why so many would struggle to handle a sudden expense of hundreds or thousands of dollars.

Saving money is more than spending less than you earn. To effectively overcome economic setbacks and increase your long-term wealth, you need to understand the power of loans and debt.

Are loans good or bad?

There’s a student loan crisis. Debt is a stressful thing. Too much debt can ruin your credit. So loans and debt are bad, right?

Not always. High rates of home ownership are a sign of a healthy economy. Lots of wealthy people take out loans, and some people use loans to start businesses. So loans and debt are good, then, right?

The real truth about loans and debt is more complicated, of course. Debt is as good as whatever you’re doing with it, and that the type of debt (and the amount of it, and the interest rate) matter, too. To understand which types of debt are good and bad, we need to know more about debt.

Understanding interest and principal

Generally, we go into debt when we take out a loan of some kind. Sometimes, there’s a big official process, such as when we get a mortgage. Other times, our “loans” are just things that we bought on a credit card (on “credit,” of course — that’s why they call credit cards that). When we take out any kind of loan or buy anything on credit, we owe the money that we borrowed, which is the “principal.” But we also owe extra money (or might owe it, depending on how your credit card or loan works): the interest.

The interest is why anyone is willing to loan money to you. When they get their money back, they’ll get more of it. And the interest that you pay on any loan is the interest rate. This isn’t groundbreaking information, of course, but it’s important because the interest rate is what determines the quality of your loan and your debt. The higher the rate, the more you owe.

Secured loans and collateral

How high the interest rate is on the loans that you take out will depend on a lot of things, including your credit score. If you’re seen as likely to not pay the debt back, then your creditors will demand a higher interest rate. They’ll make more money as compensation for their perceived risk.

In some cases, you’ll be able to get a loan while putting up something valuable that you own as secured collateral (it’s sort of like the financial equivalent of going to a pawn shop). When you pay back the loan, you keep whatever you put up; if you don’t, your creditor can seize it. This is also how it works when you use a loan to buy something new. If you don’t pay your mortgage, the bank will take your house; if you don’t make your car payments, your car will be repossessed.

Secured loans are less risky for lenders, which is why the cheapest home loan rates are much better than the rates you’ll find on short-term, unsecured loans.

Using loans and debt wisely (and avoiding the cycle of debt)

The best kind of debt to take it out has a low interest rate and helps you build your long-term wealth. The best example of this is a mortgage.

The worst kind of debt to take out is short-term debt, like credit card debt. It’s usually not helping you achieve anything important, and it will have high interest rates.

Of course, you’ll have to make your own decisions based on your situation. Short-term loans make sense at times, especially to those with few other options (for instance, those with bad credit), the experts at Eastern Loans say. The key to using short-term debt wisely is to use it as a last resort to cover crucial expenses that might otherwise increase or destroy your credit. Then, work hard to pay off your short-term loans as quickly as possible. They should be your priorities because of their high interest rates.

If you’re diligent about paying off loans with high interest rates, you can avoid the cycle of debt. This dangerous situation keeps you paying interest and taking out new loans to cover old ones, all without really attacking the principal that is at the heart of your debt. To use debt wisely, avoid this cycle and build up your wealth slowly, then use large and healthy long-term loans such as mortgages to secure your financial future.

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