I want to understand debt and loans a little better. I have some student loans, and the idea of debt is both very scary to me and very, very real! I want to pay off my loans as quickly as I can and live debt-free–but I also know that loans and debt can help people get rich. So what I’m hoping to do is learn a little more about how loans and debt actually work, so that I can do that savvy-people thing of turning loans into wealth, instead of doing that naïve-people thing of having debts mount up. What’s the difference? How do I get the most out of loans and debt without putting myself at risk?
Loans and debt are powerful–and dangerous–tools for building wealth and a secure financial future. As you’ve discovered already, having debt can be stressful. But you’ve also, of course, discovered that debt can help you acquire very valuable things–like your college education. In the long run, it’s quite likely that you’ll find yourself wealthier thanks to your decision to take out student loans. The education that your loans gave you access to will give you opportunities to earn a higher income, more than offsetting your loan payments. In a nutshell, this is the hallmark of what we call “good debt:” you’re using debt in a way that gives you an asset that, in turn, increases your wealth.
Before we get deeper into that, though, let’s talk about loans and debt in general. You probably know the basics: when a lender loans money, the loan stipulates a timeframe and rules for the borrower to pay the lender back. The amount being borrowed is the principal, while the extra amount the borrower pays back (in order to make the loan a worthwhile investment to the lender) is the interest. The interest rate is a key part of the loan: if it’s very high, as is the case with short-term debt, it makes it easy for the borrower to get trapped in a cycle of debt. Imagine only being able to pay off the interest, leaving the principal of the loan untouched–and therefore triggering more interest and penalties! That, unfortunately, is a daily reality for many Americans.
Lower interest rates are better, and interest rates tend to be lowest on “secured loans”–loans in which the borrower puts something up as collateral. If you don’t pay your car loan, for instance, the car will be repossessed, giving the lender something to sell off so that they can get some cash to offset their losses. Less risk for the lender means lower interest rates for the borrower.
There are all types of loans and debt: personal loans, business loans, mortgages, car loans, payday loans, credit cards, and more. The best way to decide which sorts of debt are healthiest is to ask yourself a few basic questions: is the loan giving you the power to acquire a wealth-building asset? Is the interest rate low or high? And what is the size of the loan?
The best kinds of debt give you access to wealth-building assets (like homes and educations), feature low interest rates, and are large enough to be necessary yet small enough to fit your budget. Any kind of loan can be toxic if you can’t afford it, and smaller loans can be bad for you if their interest rates are high or if you simply don’t need to take them out (why pay interest if you could simply budget a little better and buy what you want in cash?). Steer well clear of short-term debt, like credit card debt and payday loans.
Life is complicated, of course, and you should always review the terms of loans very carefully. But, generally speaking, the rules above make good guidelines for healthy borrowing. Take care of your financial future, and avoid bad debt!
“Financial freedom is available to those who learn about it and work for it.” — Robert Kiyosaki