Personal debt is often referred to as consumer debt and it simply refers to money we borrow to pay for goods or services we need or want. When a bank, credit union, or store provides money to borrow they are known as a creditor or lender. The consumer or individual agrees to pay back what is borrowed with specified terms. There are various forms of credit that can be extended to an individual, some of them are as follows:
- Unsecured credit cards — these are funds that you can borrow up to a certain limit or dollar amount without any asset (owned by you) to back the borrowed amount. The credit is revolving, meaning if the funds are not used up to the credit limit they are available to borrow at any time. Once the balance is paid off or down, borrowing may resume. Finance or interest rate charges accumulate each month based on the outstanding balance and the stated annual percentage rate set by the creditor.
- Secured credit cards — these funds can be borrowed as long as the borrower promises an asset as collateral in the event they cannot pay the funds back. Typically the asset is a cash deposit.
- Installment loans — loans that have terms associated with them such as a fixed borrowed amount, annual interest rate, and the length of time in which the loan must be repaid. Auto loans, student loans and mortgages are all types of installment loans.
- Lines of credit — can be secured or unsecured and offer a revolving credit amount. Lines of credit are often used to extend cash to a business or individual. The interest rates for a line of credit are typically much lower than that of a credit card cash advance or purchase. For individuals, a common line of credit is a home equity line of credit, which will use an individual's home as collateral.
Credit may be extended with either fixed or variable interest rates. Variable interest rates are pegged to something called LIBOR (London Interbank Offered Rate), which is a benchmark that the world’s major banks charge each other for short-term loans.
Most of us know debt is bad. Consumer debt can take over our excess income each month and keep us from becoming financially free. Student loans, mortgages, or business loans are not seen as bad debt, necessarily. Instead, they are seen as loans that can build our assets to create wealth. Debt used to finance a large asset will be paid down over long periods of time and as the loan is paid ownership or equity will increase. Long-term wealth is created when there is a focus on purchasing assets, financed with loans or not, that provide a passive source of income in the future.
In September 2017, U.S. consumer debt increased by 6.6% to reach $3.789 trillion, of which $2.8 trillion was fixed-term lending, with student loans making a significant contribution. Credit card debt totaled $1.005 trillion in September, increasing 7%, although credit card debt represents just 27% of total debt in 2017.
As you use credit for purchases, a credit score will be assigned to you and continually updated. This lets lenders know if you are a reliable consumer who has a track record of paying back loans or lines of credit. Understanding how to find the right type of loan and protect your credit score is essential if you want to be sure you have access to funds when you need them; particularly for the bigger purchases in life such as buying a home for your family. Here we take a closer look at various aspects of personal lending and highlight some ways you can ensure you maintain a spotless credit history and efficiently manage your repayments.
Saving and planning ahead of time for a car purchase is best, especially if you can pay cash for your entire purchase. Otherwise, personal finance experts suggest finding ways to pay off your auto loan early will be a benefit. Early repayment will reduce the interest you pay overall. You can do this by either making two payments each month rather than one or simply paying off more than the required monthly payment — both methods will reduce your principal balance faster.
Because the annual percentage rate, APR, on credit cards is usually much higher than interest charged on installment loans, it’s always in your best interest to pay off as much of the outstanding debt as quickly as possible. This is because compound interest is applied to credit cards, which will result in a balance that gets bigger over time if not managed efficiently. We will take a closer look at compound interest later on, but if you are trying to figure out how to whittle down your outstanding credit card balance, paying more than the minimum amount will get you there faster.
If you have accumulated debt across several loans and credit cards, you might feel a little overwhelmed as to how best pay everything off. The first thing to do in this situation is to create a practical repayment schedule that is realistic and works within your budget. There are two popular strategies to attack your debt balances: they both involve making the minimum payments on all of your accounts while aggressively paying down one account at a time. The difference between the two methods is in the way each chooses what accounts to prioritize in your repayment schedule.
This approach means that you pay off the balances with the highest rates of interest first. Paying off these balances first saves you money because it will keep interest that you are charged to a minimum. Also known as the debt avalanche method, this method prioritizes efficiently and is one of the cheapest and fastest ways for you to get out of debt.
As opposed to the high rate method, with the snowball method you pay off your smallest balances first to create momentum and keep you on the straight and narrow. This strategy allows you to stay on track by helping you stay motivated as you see the smallest debts disappear quickly. As a debt is paid, that payment will be applied to the next debt with the smallest balance; creating a payment snowball. The snowball method helps keep you from feeling overwhelmed by multiple payments, that is why many people prefer the goal of reducing the quantity of payments as quickly as possible.
It is critical for you to understand that a payday or short term loan is an emergency measure that shouldn’t be taken out unless there’s a genuine need. You are extended the loan until your next payday and if you’re not in a position to pay it back, the interest can become crippling very quickly. For this reason, you should never use payday loans to fund a leisure activity or unnecessary purchase. This is an expensive form of borrowing and requires discipline to prevent you from getting into financial difficulty.
- Instant Cash: Once you have been approved for a payday loan, the cash is often sent to your bank account immediately.
- You Can Apply Online: Something that makes payday loans popular is the fact that you can apply for them at any time of night or day and get an instant decision.
- High Interest Rate: One big downside to this kind of borrowing is that you get a relatively small loan at a high rate of interest. It’s always better to seek help from your bank where you will get a lower rate of interest if you need cash to meet an urgent expense.
- Additional Fees May Apply: If you do not pay the due balance when you get your paycheck, you risk being charged additional fees and interest. For that reason you have to be 100% confident that you can repay the entire loan and accrued interest on the day agreed with the lender before you make the commitment.
- May Affect your Credit Score: Most payday lenders are going to use a credit ratings bureau when making a decision whether to approve the loan or not. If you fail to make repayments according to the agreement, that too will end up on your credit report which can have a negative impact on your overall score.
Taking responsibility for someone’s borrowing by co-signing a loan is something that may seem like a good idea initially but can easily spiral out of control to become a significant problem. The main problem is that most people don’t realize that co-signing means that you are taking joint responsibility for someone else’s loan and more often than not, it is because they have poor credit that they’re required to have a guarantor.
A guarantor essentially guarantees the loan will be paid back. When you apply to co-sign debt, you will be assessed in the same way as if you were the principal borrower, with thorough credit checks. Most co-signed or guaranteed loans will still have higher-than-average interest rates no matter if you have the best credit rating possible. This makes them an expensive and risky business.
When someone applies for a loan and they have a low credit rating, they are seen as high risk by lenders. To mitigate this risk and make it possible for them to lend, they will typically request a family member to act as guarantor and sign on the lender’s behalf to secure the funding.
From a personal relationship point of view, co-signed loans can threaten the closest bonds among family or friends if not managed correctly; although there are obviously cases when the arrangement works very well. Much depends on the reasons why someone is not able to get credit on their own. Perhaps they have lost a job or suffered ill-health. There are numerous reasons people lose credibility with the agencies and it doesn’t necessarily indicate that they are a spendthrift.
There are pros and cons to co-signing loans:
Provided both signees are on the same page, there are some advantages that come with co-signing:
1. Overcomes the Approval Barrier
There are usually very good reasons an individual needs to borrow some money. Perhaps they need to get a new car for their job or pay for training to increase opportunities. Getting approval for vital funds is much easier to achieve with a co-signer or guarantor and allows them to meet the demands their lifestyle places on them.
2. Reduces Interest Rates
There is a significant difference between the interest rate applied to a loan to someone with a poor credit rating and someone with an exemplary track record. Getting someone with a good credit rating to underwrite a loan can make a big difference to how much the monthly repayments work out to. This can make borrowing much more affordable to someone who is struggling financially.
3. Can improve credit for both people
Naturally it depends on whether the terms of the loan are adhered to, but it is very possible for both parties co-signing a loan to achieve a better status with credit agencies. Establishing good payment habits and even paying off more than the repayments are ways of increasing your credit score and that is something that would apply to both parties. Obviously, the person with a lower credit rating will see a more significant hike than the one with a good track record.
Ignoring the risk is particularly perilous with co-signed loans because they usually involve two people in a close — usually family — relationship. Struggling to keep up with repayments or worse, falling behind, can place a huge strain on even the closest bonds. The disadvantages can be very damaging and include:
1. The Co-Signer Assumes Responsibility
The person with the better credit record automatically assumes full responsibility for the borrowed amount when they co-sign a loan. This is the principal reason they are required: for their friend or relative to meet the lending criteria and as a security on what would otherwise be a high risk case. A co-signer needs to consider their own financial commitments and make sure they can afford to bear the financial burden of repayments if the other party fails to meet their responsibility.
2. The Co-Signer Needs to Trust the Person They’re Signing For
Trust is extremely important when it comes to co-signing loans because the stakes are high in terms of the relationship of both individuals. If the person being signed for takes the arrangement for granted and becomes lax about making repayments, the other party will also suffer the consequences. The best way to avoid this situation is to make sure there is plenty of communication throughout the term of the loan so that if circumstances change, everyone is prepared.
3. Co-Signing Can Be Damaging To Relationships
One thing that is responsible for a considerable amount of the world’s stress is money. Relatives can think they are helping out their loved one by sharing their debt burden but in fact, it often fails to teach any lessons about money management. That said, if the relationship is strong enough, there is a very good opportunity for the person being co-signed for to elevate their credit status successfully through this method of lending.
Simple interest is the percentage rate applied to a loan and is charged as a percentage of the amount borrowed or ‘principal’. Simple interest is the price paid for borrowing and is the easiest method of calculating how much has to be repaid to the lender. The most common example of interest is a car loan, where interest is only payable on the original amount that was borrowed for its purchase.
The formula used to calculate simple interest is p x i x n or principal x interest rate x number of years.
For example: If you were to borrow $1,000 from your friend with an annual interest rate of 10% for 3 years, then you have to return $1,300 to your friend at the end of 3rd year calculated as follows:
$1,000 x 10% x 3 = simple interest of $300
Compound interest is slightly more difficult to calculate than simple interest and effectively means you are paying interest on principal and accumulated interest. When you take out a loan, its interest rate is calculated for the first agreed period of a month or a year and added to the original total. In other words, you see the interest amount for the first period on the total amount borrowed when you make the agreement. After that, interest for the next period is calculated based on the total figure from the first period – i.e. the principal and first period interest payment. It can be a very expensive way of borrowing because repayments can increase as time passes if they are not made regularly to reduce the amount of the principal.
The formula used to calculate compound interest including the principal is as follows:
M=P(1+i)^n or final amount payable (M) = principal x (1 + interest) raised to the number of years exponent.
Let's say you borrow $3,000 over a 3 years paying 10% annual interest on your debt but you have been unable to make regular repayments. In this case, the amount you will have to repay will look like this:
Year 1: $3,000 x 10% = $300
Year 2: ($3,000 + $300) x 10% = $330
Year 3: ($3000+ $300 + $330) x 10% = $363
After 3 years and including compound interest, the total repayment figure in this example is $3,993.
Naturally, if regular payments are made to reduce the loan amount, the total compound interest will decrease as the loan is paid off.