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 homeowner’s or renter’s insurance. Read Viewpoints: “Are you ready to own a home?” and “Should you buy a home or keep renting?”
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. All these essential expenses, combined with housing, should account for no more than 50% of your take-home pay. Read Viewpoints: “50/15/5: a saving and spending rule of thumb.”
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. Read Viewpoints: “How much college can you really afford?”
Car loans and credit cards represent different types of borrowing than a mortgage or student loan. While you may very well need a car, the amount you borrow—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; 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 negate rewards and cost you money. Use credit cards wisely so they don’t end up using you. Read Viewpoints: “Seven credit card tips.”
Two types of debt
There are two basic forms of debt repayment: installment debt, like a home mortgage 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. “Revolving debt is usually considered ‘worse’ debt, because it lacks these advantages and is frequently used when cash reserves are unavailable,” says John Colantino, CFP®, a vice president in Fidelity’s Strategic Advisers, Inc.
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. Here we lay out the pros and cons of four common types of debt, plus some pitfalls to avoid. Says Colantino, “No matter what form the borrowing takes, the worst kind of debt is the kind you can’t pay back.”
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. Borrowers do 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 is required, as the VA insures the loan. Even if you have less-than-perfect credit, you can 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 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: If you have 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 five to ten years. After the term is over, many will refinance their home, or move.
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.
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%.
Borrow wisely: Defaulting on a mortgage, home equity loan, or HELOC comes with the risk of losing your home.
A good rule of thumb: Keep housing costs around 30% of your monthly income.
There are two 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-based 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.
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. 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.
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: College students should avoid taking on massive education debt without a promising return on their investment.
To figure out the debt level that is appropriate for you or your college student, investigate salaries in your chosen field. 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 student loan calculator at FinAid.org.
- Read Viewpoints: “How to reduce student debt.”
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 25 to 84 months. The average new car loan term was 67 months at the end of 2015.5
For borrowers with great credit (between 781 and 850 on the Vantage Score model), the average new car loan rate was 2.69% at the end of 2015. On the other end, borrowers with the worst credit scores (between 300 and 500) got an average new car loan rate of 13.29%, 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
Thinking about leasing rather than buying? The Consumer Financial Protection Bureau may be able help you decide.
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 2015, more than 16% of used cars and nearly 28% of new cars were financed for 73 to 84 months.8 That’s seven years. At the end of 2015, the number of borrowers going for new car loan terms between 61 and 72 months was up 5% from the previous year, while the number of people financing new cars for 73 to 84 months was up 12%.
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.
- Want to lease a car instead of buy? Watch this video: “Split decisions with Jean Chatzky—Buy a car or lease it.”
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.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917