An important part of personal finance is how you manage your debt. Ideally, you would not have any debt, but in practice, most families do. It is not likely that most persons would be able to buy a car, a house, an education, or even major appliances without having to incur some debt. Sometimes, debt may actually be desirable, especially if you could borrow money at a low interest rate to make a high-interest investment.
Debt makes everything cost more. If you saw a sign in a store window advertising "Sale—Everything 25% Off," you might be tempted to rush in and buy, buy, buy. But what if the sign said "Sale—Everything 25% More Than Marked"? That is just what happens when you pay for goods and services using debt. Moreover, you may be using debt without even realizing it.
Debt means paying for things with other people's money. Whenever you use a credit card, buy on convenient time payments, or take a loan, you are using other people's money to make a purchase. In return for the privilege, the other people are entitled to payment (interest) for the money they lend to you. Do not be fooled by 0% interest. There is no such thing. Sometimes the interest is paid up front, hidden in a higher price for such a purchase (when you see such a deal, ask how much discount you can get if you pay cash up front). If there is no discount, read the terms very carefully. You may wind up paying all the interest after the term expires.
Debt is not bad, but you must use it wisely. To use it wisely, you need to understand it.
Personal debt comes in many forms. There is long-term debt, such as a mortgage on a home that may take 10, 15, or more years to repay. Intermediate-term loans such as a home equity loan or auto loan may be repaid in five years. Short-term loans such as credit card debt or personal loans are usually paid in three years or less.
Generally, the longer the term of the loan, the lower the interest rate (%) will be. But the longer it takes to pay off the loan, the more dollars you will pay for the loan. For example, if you borrow $1,000 and pay it back monthly over 24 months at 15% APR (annual percentage rate) compounded monthly, you will pay $164 in interest, while the same loan amount paid back monthly over 120 months at only 5% APR would result in your paying $273 in interest. So, a lower rate does not necessarily mean it will cost you less. Revolving credit, such as an unpaid credit card balance, can be even more insidious. If you pay only the minimum amount due each month, it may take years to get the balance reduced to zero. This is because credit card companies only require that you pay a very small fraction (2–3%) of the unpaid balance each month while charging you a high APR on the unpaid balance. For example, the same $1,000 purchase made on a credit card with minimum monthly payments at only 10% APR would have cost you over $277 in interest after 5 years, and you would still have over $275 in an unpaid balance.
All of this is not to suggest that you shouldn't use credit; it just means use it wisely.
Even the best-intentioned folks run into financial difficulty. As a solution, there is always bankruptcy, but that is a last resort. Negotiate with your creditors for terms you can live with. If you cannot resolve credit and debt problems on your own, seek out professional help, such as a reputable consumer credit counseling agency—check with the Better Business Bureau in your area.
This article provided by The Educated Investor and powered by CalcXML.
© 2000-2014 Precision Information LLC. All rights reserved.