The Financial Journey Begins – The Loan
Preface – Thank you so much to everyone who read the first installment of the personal financial miniseries for young adults. It was nice to hear what everyone thought of it, so thank you for the feedback! I hope that the last one did some good for others and I hope this one does as well. Thanks again and enjoy the blog!
If you missed the first installment, please click here to read “The Budget”
Let's Get Started - The Loan...
Great! You’ve implemented a budgeting strategy that allows you to live comfortably within your means and save for retirement. That means you’re ahead of a good portion of people starting their careers, good job! There’s just one thing though; the car you’ve had since high school looks a little sad, and you don’t have quite enough money to replace it yet. Looks like you’re going to have to drive it until the wheels fall off. Unless…. You get a loan and purchase a new one!!!
This blog will take you through everything you need to know about a loan: From understanding interest rates, the difference between good and bad debt, all the way over to debt repayment strategies. Once you’ve read through this article, you’ll understand more about debt and how to manage it!
Before we get into the meat and potatoes, there is one thing that should be understood; money is a tool and not a toy. The same thing goes for incurring debts. Debt allows you to purchase big assets that would otherwise be unobtainable with your current funds. The reason I point this out is because debt can be, and often is, misused.
Debt falls into two distinct categories: good and bad. Good debt is something that, when purchased, will raise your net worth, or greatly enhance your way of living. An example of good debt is purchasing a home which typically retains value and may even appreciate over the years. Another example would be the one seen in the introduction, purchasing a new car to replace your hazardous old one.
Bad debt is when the asset is consumed or devalued over time. An example would be clothing or food, which should be obtained using available funds from your budget. Using credit to purchase clothing and food, without paying the debt off within the statement period incurs interest charges and fees. Bad debt is usually an outcome of poor spending habits, lack of budget and not paying off debt. Now that you have a firm understanding of what debt is good and what debt is bad, we can move onto something that greatly affects debt payments, interest rates!
Interest rates are something you need to be cognizant of before purchasing anything with credit. Interest is how the loan generates revenue while also providing themselves with a level of security. The rate of interest you are charged can depend on a mixture of collateral, credit score, credit history and income. An example of how interest is assessed would be if you purchased a home for $200,000 and the interest on the loan was 3%. That 3% is tacked on to the balance that you carry. So, if you did not pay anything off after a year, the loan would increase to $206,000. If you paid off $20,000, then you would owe $185,400 at the year's end.
The final thing that we will cover is a strategy to repay debt. What you might find surprising is that it is better to chip away at your debt by paying the minimum amount every statement period. “How could that be? debt appreciates every year! I don’t want to owe more than I must!” True, but there is something else that can effectively appreciate much more than debt, the US stock market!
The S and P 500 has returned 10.5% over the last two decades, which makes it a great option for outpacing inflation as well as debt. If you use your cash to pay off your debt in access, that money is now useless to you. If instead, it is invested into your retirement, it will compound for years and become a great advantage to you in the future. It should be acknowledged that this is true if the interest rates being charged on your debt are not greater than interest being earned in investments. If your interest rate is about 5.25%, like the current federal funds rate, then it may be a good idea to pay it off quicker instead. The same is true if you have more debt than you can manage.
Now look at that! You’re truly a debt management pro now! You learned why debt is useful, the difference between good and bad debt, interest rates and a debt repayment strategy. Despite this, there is still a little bit more to learn to truly become a debt management wizard! The next installment will cover even more topics on debt like credit cards and credit scores, so stay tuned for next time!!!