Many adults have some form of debt by the time they reach 21. This may be a credit card, a car loan or perhaps student loans. As we grow older and enter different stages in our lives, our debt changes and evolves with us.
Paying attention and managing your debt ‘portfolio’ is as important as your investment portfolio. There are various types of debt each with their own purpose and they each have an impact on your financial health.
There are four main types of personal debt available to most adults:
Secured debt – This type of debt is secured with an asset to be used as collateral. A car loan is an example of this type of debt – the lender who provides money for the purchase claims ownership on the title of the vehicle. This type of debt typically has a reasonable interest rate based on the creditworthiness of the borrower.
Unsecured debt – This type of debt is based wholly on the borrower’s credit and is offered based on their ability to repay the funds. Credit cards are a good example of this type of debt. There is a contractual agreement to repay the funds, but with no collateral on the line, default or non-repayment has more risk and potential cost to the lender. This means there are typically higher interest rates with this type of debt.
Revolving debt – This debt is like a credit card in that there is a limit to the credit (debt level) available. A revolving debt offers a borrower access to a certain amount of funds on an as needed or revolving basis. An example of this type of debt is a line of credit (unsecured), or home equity line of credit (secured).
Mortgage – This debt is most common and usually the largest and longest debt someone typically has. A mortgage is a secured debt with the home (or property) as collateral. Mortgages typically have the lowest interest rate available, although still tied to the borrower’s creditworthiness, and average between 15-to-30-year terms. During that time, the mortgage is re-negotiated on a regular basis.
Each of these types of debt serves a purpose in helping us through life’s stages and needs. Plus, they each come with their own ‘cost’ or interest rate. Some of these debts are indeed a form of investment. Think mortgages, as typically the value of property increases over time. Loans for improvement to enhance your property will also increase its overall value and is often considered an investment.
There are also investment loans available. While ‘collateral’ takes on a slightly different meaning in this situation, they can be a great way to utilize borrowed funds. Often loans for investment purposes can be at a lower interest rate than the return on the investment the money would gain. Many people take out annual investment loans to purchase RRSPs and then use the increased tax return to immediately pay off the loan. Yet other options allow for longer terms usually with collateral. Interest rates and repayment terms are tied to creditworthiness, so it is important to consider your specific situation with your lender and financial advisor to make sure an investment loan is a good option for you.
Maintaining some type and amount of debt is helpful in your life. However, unsecured debt, without an appreciating asset, can be damaging and should be entered into with intention and purpose. Unsecured debt in the form of consumer loans, like credit cards, can be very tempting to use in the moment without considering what the re-payment plan may be.
Many of us have found ourselves in a position where our debt has gotten the better of us. Develop a plan to pay down your debt as part of your financial plan, if you find yourself in a situation where you are uncomfortable with the level of unsecured debt you are carrying. Paying down one side of your financial statement is as important as investing in the other and takes intention and commitment.
There are two primary ways to pay down unsecured debt. Both methods require you to compile all the information available about your current debt including current balances and the interest rates for each source of debt. Here are more details about the two ways to pay off unsecured debt:
Snowball method – In this approach, you line up your debt and make the minimum payment on each one, except the smallest. For the smallest debt, pay the minimum, plus any additional funds you can afford until that debt is paid off. Once that debt is paid off, you turn to the next smallest and add the money you were using for the smallest debt to that payment until the balance is zero. The name comes from the process of continuing to build on the payment being focused on each one grows as the number of creditors decreases.
Debt-stacking method – This approach tackles the debt with the highest interest first. Since unsecured debt tends to have the highest interest levels this will also help you focus more on the that type of debt. In this method, line up your debt from highest interest to lowest and begin at the top. Similar to the snowball method, make minimum payments to all sources of debt only this time add any additional money to the debt with the largest interest rate. Once the highest interest debt is paid off, roll your payment into the next highest and so on.
Both repayment options are effective. Debt-stacking is technically better from a mathematical perspective; however, from a quick-win, psychological perspective, the snowball method may be better for some. Be sure to choose the method that will work best for you. Committing to debt repayment also requires you to stop accumulating unsecured debt as much as possible.
To talk to an advisor about your debt as it relates to your investments and overall financial plan, connect with us today. Our professional advisors are happy to talk through your options.