Could borrowing let you meet your goals?

Find out the basics before taking out a loan or using a credit card.

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Key takeaways

  • Mortgages let you invest in a home; student loans, in yourself.
  • Home and student loans may offer tax breaks.
  • When shopping for a car loan, beware of looking only at the payment.
  • Credit cards can be convenient, but beware of high rates and fees.

Debt is a double-edged sword. Borrow wisely and you may create the opportunity to build equity—for instance, in a home, or maybe even in yourself, with an education. But rack up too much debt, and financial distress could be around the corner.

Many Americans who own a home were able to do so thanks to a mortgage. Many college grads got their degree thanks to student loans.

The flip side is less rosy. Too much debt can lead to foreclosure on your home or repossession of your car, and you might wind up saddled with a low credit score. That can lead to high interest rates and difficulty borrowing in the future.

For a quick guide to specific kinds of borrowing, click on the links below. But first consider some important borrowing basics.

How much debt is too much?

Even if you can handle your debt, having too much may simply eat up your paycheck and cost a lot in the long run. To avoid becoming bogged down by debt, know the details of your income and expenses before borrowing. Think carefully about how much debt your monthly budget can reasonably accommodate.

Housing is the biggest monthly expense for many people. A good rule of thumb is to only spend about 30% of your income on housing costs. This includes mortgage or rent payments, real estate taxes, and homeowners or renters insurance.

Keeping housing costs under about a third of your income should leave plenty of money to cover other necessities like food, transportation, child care, and insurance. Fidelity believes that essential expenses, combined with housing, should account for no more than 50% of your take-home pay.

Education costs can be a significant outlay as well. For both students and parents, it’s important to consider how borrowing for college and beyond could affect future plans. Parents must consider funding their own retirement, while students have to think about the reality of graduating with some debt.

Choice of school and field of study can factor into the equation when you try to figure out how much education debt is too much.

You may have more control over how much you borrow for a car or on a credit card than you would with a mortgage or student loan. While you may very well need a car, the amount you borrow for a car—or don't—is discretionary. Keep our 50/15/5 rule of thumb in mind here—your car costs are included in the 50% bucket, along with housing and other necessities; Fidelity believes at least 15% of your pretax income, including employer contributions, should go to retirement savings; and 5% of your monthly income should go to short-term savings.

Credit cards can be convenient, and may even reward you for simply using the card. But credit card rewards are only a bonus if you are disciplined about paying the balance in full every month. Otherwise, interest charges could cost you money and outweigh any rewards that come with the card. Use credit cards wisely so they don’t end up using you.

2 types of debt

There are 2 basic forms of debt repayment: installment debt, like a home mortgage, car loan, or a student loan, which you pay back over a set period of time, and revolving debt, like credit cards, which you potentially can carry forever. Often, installment debt is preferable, because it offers potential tax deductions and typically does not adversely affect your credit score the way revolving debt can. The amount of credit card debt you carry relative to the amount of credit available to you, called credit utilization, is a big part of your credit score. Balances on installment loans aren't considered in that calculation. "Revolving debt is usually considered 'worse' debt, because it lacks these advantages and is frequently used when cash reserves are unavailable," says Ann Dowd, CFP®, a vice president at Fidelity.

But there are exceptions; even "good" debt, like a mortgage, can take a turn for the worse. We all remember what happened during the housing crisis: millions of defaults and foreclosures, and many people losing their homes.

The real difference between "good" and "bad" debt isn't so much the form of debt you take on, but how you use it. Any debt can be bad, regardless of the form, if it's too big compared to your ability to repay it. Here we lay out the pros and cons of 4 common types of debt, plus some pitfalls to avoid. Says Dowd, "No matter what form the borrowing takes, the worst kind of debt is the kind you can't pay back."

 

Mortgage debt

Basics

Houses are generally the most expensive purchase most people will make. In order to swing it, most people take out a mortgage. There are a few different types to consider.

FHA loans: For first-time homebuyers with little savings, the Federal Housing Administration, or FHA, has a loan guarantee program that allows first-time homebuyers to buy a home with as little as 3% down. However, borrowers have to pay extra to have the loan guaranteed by the FHA.

VA loans: Similarly, the Veterans Administration (VA) guarantees loans to service members and eligible surviving spouses. Loans backed by the VA might not require a down payment if the sales price is equal to or less than the appraised value. No private mortgage insurance (PMI) is required, as the VA insures the loan. PMI is an insurance policy designed to protect the lender in case you can't pay your mortgage and default on the loan. Even if you have less-than-perfect credit, you may be able to get a loan at competitive interest rates.

Conventional loans: Unlike FHA and VA mortgages, a conventional home loan is not insured by the government. Down payments of at least 20% of the purchase price are ideal, as down payments lower than this typically require private mortgage insurance, or PMI, which can be a significant, ongoing annual expense. Once your loan-to-value ratio hits 80%, PMI is no longer required.

FHA, VA, and conventional mortgages come with fixed or adjustable interest rates. Most mortgages last for 15- or 30-year terms.

Interest-only loans: For people with good credit and the ability to make the loan payments, there are also interest-only loans. Borrowers pay the interest on the mortgage for a fixed term, typically for 5 to 10 years. After the term is over, many will refinance their home, or move. That's because the monthly payments increase after the interest-only term is up. The new monthly payment amount will be based on the loan balance and interest over the remaining years of the life of the loan. There are fixed-rate and adjustable-rate mortgages with the interest-only option.

Home equity loans and lines of credit. You can also take money out of your house through a home equity line of credit (HELOC) or a home equity loan. The process of applying for a HELOC or home equity loan is similar to taking out a mortgage. An appraisal may be required, and the lender will evaluate your ability to repay. The home equity loan will be given to you in a lump sum, while the HELOC allows you to borrow against your home equity, up to the limit set by the lender.

Starting in 2018, the interest paid on a home equity loan or HELOC will only be deductible if they are used to buy, build, or improve the home securing the loan.

Pitfalls to avoid

Don't take on too much mortgage debt. To decide how much money you can borrow, lenders look at your debt-to-income ratio. To get that number, add up your monthly debt payments and divide by your monthly income. The sweet spot for many lenders is between 36% and 42%—including your mortgage. This figure comes from information you'd get from your credit report and focuses only on debt payments relative to income. But just because a lender will let you borrow a certain amount of money doesn’t always mean it will be affordable.

A good rule of thumb: Keep housing costs around 30% of your monthly income. That means your mortgage payment, property taxes, homeowner's insurance, and PMI if you have it. It's just a rough gauge to make sure you have enough money for all the other necessities and to save for the future—with some left over for fun stuff.

Borrow wisely: Defaulting on a mortgage, home equity loan, or HELOC comes with the risk of losing your home. 

Student loans

Basics

There are 2 types of lenders for student loans: federal and private.

Federal loans are guaranteed by the government. They come with some perks that may not be offered by private lenders, including income-driven repayment options, loan forgiveness programs, and fixed interest rates. Plus, some federal loans are subsidized, which means the government will foot the bill for the interest on the loan while the student is in school.

Once the repayment period begins, you may be able to refinance your loan at a lower interest rate, if you have good credit—or consolidate if you have multiple loans.

Private loans come from banks, credit unions, or schools. In some cases nonprofit agencies provide a guarantee for student loans, or lenders may self-insure. A private loan may have a variable interest rate, which means that the interest rate you pay can change. Just like the federal student loans, you may be able to refinance or consolidate once the repayment period begins.

If you're having trouble making the payments on private student loans, your lender may be willing to set up a graduated repayment plan or extend the life of your loan in order to reduce monthly payments. Both of these options increase the amount of interest you’ll pay on the loan over time.2

Pitfalls to avoid

Not understanding your college ROI: Those evaluating college financing should consider education debt within the context of potential return on the education investment. Some fields pay more and offer more opportunities than others.

To estimate how much it could cost to repay the loan—and the salary required to make those payments—try the Repayment estimator at Studentloans.gov. If you're already making payments on student loans, check out Fidelity's Student Debt Tool to see your current loan picture and the other repayment options that may be available.

 

Car loans

Basics

Many people need a car; it's a fact of life for most Americans. But cars are a depreciating asset. Unlike a mortgage or a student loan, you're not building any equity or making an investment in yourself.

Car loans can be found at banks, credit unions, and at car dealerships. Loan terms generally range from 24 to 84 months. The average new car loan term was 69 months at the end of 2017.5

For borrowers with great credit (between 781 and 850 on the Vantage Score model), the average new car loan rate was 3.17% at the end of 2017. On the other end, borrowers with the worst credit scores (between 300 and 500) got an average new car loan rate of 13.76%, according to Experian.6

Besides the interest rate, be sure to check whether there are any penalties for early repayment. One thing to look for is whether the loan is calculated as simple interest, which lets you avoid paying interest if you’re able to pay the loan off early.

Alternatively, the interest could be precomputed, which adds the interest to your balance. If you pay the loan off early, you owe the interest you would have paid over the life of the loan. Or, the lender may charge a fee called a prepayment penalty, to let you out of the loan ahead of time.7

Pitfalls to avoid

The false allure of low monthly payments: Unless you love repaying debt, avoid shopping for a car loan based on the monthly payment. Unless you're putting down a significant amount of money up front, low monthly payments typically come with long repayment plans—which add up to more interest paid over the life of the loan.

Car loan terms have been stretching in recent years to accommodate higher car prices and consumer preferences. In the fourth quarter of 2017, more than 17.9% of used cars and nearly 30% of new cars were financed for 73 to 84 months.8 That's 7 years.

Long loan terms may also hinder your ability to sell the car before the loan is paid off if the amount owed is more than the resale value of the car.

Avoid buying a more expensive car than you can afford simply because you're able to finance it.

Do shop around for a car loan before taking the loan offered by the dealership. Banks or local credit unions could give you a better rate. 

Credit cards

Basics

Credit cards can be great tools. They're convenient and easy to use, and may even throw some dollars your way if your card offers cash back as a reward.

After you apply for a card, credit card issuers review your credit report and decide whether they want to give you a line of credit. Depending on your income and credit history, lenders choose how much you are allowed to borrow and the rate of interest they will charge.

Most credit cards come with variable interest rates that are tied to the prime rate. The prime rate moves up or down with interest rates set by the Federal Reserve. When the Fed raises interest rates, the rate on your credit card will more than likely move up as well.

Credit card issuers have many options for borrowers. Some cards offer balance transfers, some have great rewards, and some may be best for students or for those who are rebuilding their credit. Store-branded cards and gas cards may give you a break on purchases made at the store or gas station, but these cards sometimes carry higher-than-average annual percentage rates.

Another way of categorizing credit cards: Is it secured or unsecured? Unsecured cards are regular credit cards. Secured cards are typically aimed at people with no credit or low credit scores, and require a deposit before you can start spending.

Pitfalls to avoid

Late payments can lead to more than fees. Making a payment late may trigger a higher annual percentage rate. Reading the fine print attached to your card is important. Card holders should be aware of what they agreed to when they signed up for the card.

That being said, there are all kinds of credit cards—even ones designed for people who have missed a payment here and there.

The best way to take advantage of credit cards is by not carrying a balance. That way you get to reap all the rewards, with none of the costs.

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1. In order to take advantage of the mortgage interest tax deduction, taxpayers must itemize their taxes in place of taking the standard deduction of $12,000 for singles and $24,000 for married couples for 2018.
2. Consumer Financial Protection Bureau, Repay student debt.
3. Federal Reserve Bank of San Francisco, Does College Matter?
4. The deduction for interest paid on student loans is phased out based on the borrower's modified adjusted gross income (MAGI). For 2018 for singles, the threshold starts at $65,000, and the cutoff is $80,000. For married couples, the phaseout begins at household incomes of $135,000, and cuts off at $165,000.
5. Experian, State of the Automotive Finance Market Q4 2017.
6. See endnote #5.
7. Federal Trade Commission, Financing a car? Ask about prepayment penalties.
8. See endnote #5.
9. Federal Trade Commission, Lost or Stolen Credit, ATM, and Debit Cards.
10. Board of Governors of the Federal Reserve System, G.19—Consumer Credit, March 2018, May 7, 2018.

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Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917

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