Types of Debt We Fall Into

I've been writing a lot about wanting to pay off my mortgage as soon as possible because I'm very debt averse. Today, Mr Credit Card (who himself is very debt adverse) going to go back to the basics and list down the types of debt we fall into. And in the meantime, he shares some thoughts on how we can change our mindset to avoid them

Most adults have some form of debt. Today, I am going to look at some common form of debt and discuss whether it is necessary and how we can reduce the debt we take.

Student Loans - The first type of debt that many folks are likely to incur is from their student loans - prevalent in the US!. With inflation rates of colleges at about the 7% area, it appears that college costs will simply keep rising. It seems like the number ranges from $40,000 to $200,000 if you go to an expensive private college. Unlike other types of loans, student loans cannot be wiped out in bankruptcy.

There is actually nothing wrong with taking on a student loan if you get a job that pays you enough to pay off your loans. Doctors for example have lots of student loans. But when they graduate from medical school, they are likely to have a stable high paying (at least high paying in later years) career. Or if you manage to get into consulting or a Wall Street job after your MBA, your student loans are pretty much taken care of.

However, there are folks who graduate with an degrees with "less earning potential" and with big student loans are the ones who will have trouble with debt overhanging them for a long time.

For folks whose parents have saved for their college education, that is a blessing. But I think future college students (and indeed parents) have to make more informed choices as to their choice of college, the price of admission and their choice of studies. If someone is going to study liberal arts and of a subject that may not have great earnings potential, then it would be quite foolish to go to an expensive college.

Credit Card Debt - After student loans, the next type of debt very likely to happen is credit card debt. Sometimes, it happens in college when a student first applies for a college student credit card. If used responsibly (ie PAY IN FULL), it actually helps a young adult build a credit history. Abuse it like an ATM machine, and you will be saddled with more debt. Of all the types of debt we talk are going to talk about, this one is the easiest to say NO to. Unlike student loans (where you could possibly make a case to say it's "good debt", credit card debt can never be justified). The real answer to preventing credit card debt is to understand that when you only pay minimum on your balances, it could take many years to pay off and you end up paying double the amount (due to interest!).

Credit cards are best used as a tool of convenience, and its balance paid in FULL every month. Done this way, a cardholder is free to take advantage of cash back credit cards or gas credit cards to earn rewards and rebates (ie save money).

Car Loans - Car loans is another area many folks take a loan. Again, like credit card debt, this one is easy to avoid Simply save up for a car. If you cannot afford the one you want, get a cheaper model or a second hand car. It simply makes no sense to take on car debt because new cars depreciate when driving out of the dealers lot and even second hand cars depreciate.

Mortgage - Today's society accept that taking on a mortgage is "good debt". It is regarded as a form of "savings" as you build up "equity". It is always assume house prices can "only go up" in "the long run"! (tell that to folks who bought in 2005 and 2006)!

I tend to take a different view on this.I believe that if you really wanted to, you could actually save for a significant portion of the value of the house. The conventional wisdom is to save 20% for a downpayment and take on a 30 year mortgage. In more recent years, folks took on no money down adjustable rate mortgages and are paying for it right now.

While having a mortgage seems to be an accepted today, it was not the case in the 1800s and early 1900s. And having a mortgage normally means having a debt hanging over your head for 30 years! It also means you always have to make sure your income is steady throughout your career, not an easy feat in today's economy.

A lot of posts on this blog is about paying off the mortgage. My challenge to you is to consider saving much more than the 20% downpayment - target 50%. Having a smaller mortgage and have a shorter mortgage. Consider getting one with on 10 years or 15 years.

Home Equity Line Of Credit - In the 2000s, many folks took out home equity lines of credit. Many used them for home renovations - the train of thought being that it "increases the value of the home". It is still debt though! Some "abused" it and took out HELOC to take vacations!

Like credit card debt and auto loans, this is one debt where you can really say NO to. Taking on debt simply to do a house renovation is not necessary. Simply save up for it and you do have to take on more credit. Taking a HELOC is simply criminal.

Business Loans - Having business loans for working capital purposes is very common among business owners. The trick to getting a business loan is to make sure you are not personally liable for it. This is easier said than done. For you to get a non-recourse business loan, your business must have established a credit history and you probably have to pay a slightly higher rate for the loan than a recourse loan.

Medical Debt - A lot of bankruptcies are filed because of medical debt. Medical debt is many times an unforeseen event. Having insurance is very important. And now with the Health Care bill, it should make it easier for those with pre-existing conditions. Regardless, having adequate coverage in health insurance is a must to avoid this nasty surprise.

Summary - There are many ways in which we can get into debt. The easiest to avoid are credit card debt, auto loans, home equity line of credit. Student loans are a little trickier. I think before you take on a massive student loan, both the parent and student have to consider whether their future earnings potential justify taking on the amount of student debt. The mortgage is probably going to be the biggest form of debt for most folks. Rather than sticking with the conventional 20% down and taking on a 30 year mortgage, I encourage you to be more ambition and save for a higher downpayment and take on a shorter mortgage so you can pay it off sooner.

While it may be impossible to be totally debt free for some, by taking some intelligent steps with regards to your college education and mortgage and avoiding debt you should avoid, you should have a smaller debt load. This would make it easier to pay off earlier in your life and be debt free.