DEBT OVERVIEW

Debt is a part of life for almost all Americans. A very small percentage of Americans have no debt whatsoever. Most have some sort of debt it may be as small as $1,000 dollars on a credit card up to $800,000 for a mortgage and beyond. No matter where you fall on the spectrum it is important to understand what debt is and how to use it intelligently.

Debt is part of our society, it allows for overall growth in the economy which leads to more jobs and the opportunity for people to increase their income and better their lives. Businesses use debt when they see an opportunity to use the capital to earn a better return than that of which they pay to borrow. By doing this many businesses can grow exponentially and use the proceeds from their revenue to repay the loans and better the overall financial position of the firm.

This is exactly how individuals should use debt as well, the difference is if the borrowers of debt in a business do so in an irresponsible way they are fired and the business can fail. For an individual if they borrow too much they are not fired but in most cases just slowly start to get behind (or bled out due to interest), often resorting to borrowing more to meet obligations. This causes a big deficit and can trap many people for years and years. None of this is necessary, and can be avoided all together if you educate yourself on the different types of debt and how to use each as a tool.

The cost of borrowing (Interest Rate’s)

The interest rate is set by whoever is willing to loan money. For example, some people want instant gratification and will borrow to purchase an item today instead of waiting until they can pay in cash sometime in the future. This happens every day with one of the easiest ways to access credit, through a credit card. Most people with a decent credit score can get approved for at least a modest amount of money and will be able to make a purchase the very next day.

The only catch is that the issuer of the credit card sets the terms for how much it will cost to borrow this money based on the perceived risk of repayment by the borrower. If you have a low credit score the rate can be very high, however if you have a high credit score you are perceived as lower risk and therefore receive a lower rate or an overall lower cost of borrowing.

The same idea works if you are borrowing to purchase a home. Whoever you are getting a loan from looks at your information (credit score, income, other debt obligations) and decides on what rate you should pay to borrow…. or if you can borrow at all. When buying a home rates are generally much lower than credit cards. The reasoning being if needed the bank can sell your home and recoup part of their investment, also in a personal residence most people will do what they can to make sure and always pay on time to avoid foreclosure. Many in real estate try to use low rates to their advantage and borrow money to make a higher return from both renting and reselling down the road. All debt is not created equal and using it can be beneficial to meet investing goals, just use caution.

Your personal credit score and what you are borrowing money for will be the biggest factors in determining what interest rate you will receive.

In the past, you may have heard the term “risk free rate” this the baseline for perceived risk in our monetary system, if you buy a short-term treasury you expect the government will pay its obligations therefore there is “no risk”. This can be debated as many have argued it is possible for the government to default, but the point is the market uses the “risk free rate” to get their baseline for the price to charge the borrower. After the “risk free” rate the lender will add on various risk premiums based on the type of loan and what collateral the lender will have in case of default. For a more in-depth explanation on credit risk check out the Wikipedia link here.

The federal reserve attempts to lower or raise rates based off their overall view on the economy. They are either trying to encourage borrowing or discourage it based on economic factors. Based on their view they will buy treasury securities (those issued and backed by the US government) sending money into the system so there is a higher supply with the intentions of leading to a lower cost to borrow, and vice versa to raise rates.

Without this basic understanding how would you know if you are getting a good or bad deal on the money you borrow? It is important to grasp the basics of this context so you can make smart borrowing decisions throughout life.

Once you know what you will be charged to borrow you can analyze to see if it is worth it. Most people never make it to this point and will blindly borrow and get themselves in trouble. Make sure that the amount you will make from borrowing is large enough to justify borrowing in the first place. Many people fear debt and I would argue it is better to be paranoid then to not care. However, if you are intelligent about debt you can use it to make your life better and to earn more throughout your life. Just make sure you are doing it for the right reasons and that you have a plan to repay your debt with the proceeds you earn. A plan to borrow without repayment will quickly lead to negative results.

What Are Your Thoughts?

  1. Do you use debt to get ahead?
  2. Are you personally in debt?
  3. How good is your understanding of debt?

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