Chapter 1

Eliminating Debt: The Basics

IN THIS CHAPTER

Examining different kinds of debt

Erasing debt with different methods

Steering clear of accumulating more debt

Everyone hates having debt, but think about it: 99 percent of the population just can’t feasibly make a significant purchase or tackle a crisis without taking on some kind of debt, like student loans, auto loans, and credit cards. However, that doesn’t mean you can’t do anything about it.

This chapter looks at the different types of debt to help you create a budget for paying it off. You find out how to rank the importance of each debt so you can create a payoff plan that works with your budget, and you get tips anyone can use to keep themselves from accumulating more debt. It’s all fun and games when you come home with something shiny until you have to pay it back.

The illusion that you’re a terrible person if you have debt is a common misconception. In fact, many personal finance gurus even suggest that if you have debt, you shouldn’t enjoy your life until you pay that debt off in full. Ignore them. Debt happens to everyone at one time or another, and you don’t deserve a lower quality of life than the person down the street.

Looking at the Different Types of Debt

You acquire debt when you borrow a certain amount of money intending to pay it back. People can take on debt, but so can companies, corporations, and even countries. Heck, as of this writing, the United States is more than $33.7 trillion in the hole, according to U.S. Debt Clock.org.

Different types of debt affect your credit score in different ways, as you find out in Part 2. You want different types of debt paid off in full on your credit report so lenders can see that you’re a trustworthy applicant capable of paying off more than one type of loan. You do not want too many open or any delinquent accounts. The following sections review the different types of debt so you can get organized and pay these monsters off.

You often see people refer to debt as being “good” debt or “bad” debt:

• Good debt typically provides a return on your investment. Student loans are considered good debt because you’re using them to secure a college degree, which helps increase your earning potential. Another example of good debt is a home loan because your home can appreciate in value over time, allowing you to sell for a profit.
• Bad debt is anything you’ve borrowed that doesn’t further your finances; you can think of bad debt as anything that decreases your net worth over time, usually with depreciating assets. This type of debt includes auto loans (because cars lose their value) and credit cards.

Student loans

Student loan debt is money you borrow for costs associated with higher education, such as tuition, textbooks, laptops, and living expenses. If you attend a trade school or vocational school, additional expenses can apply. For example, you may need specific tools if you go into automotive repair or a stethoscope if you’re a medical assistant.

These types of debts are considered unsecured installment loans. When a debt is unsecured, you aren’t providing any collateral to the financial institution (or lender). An installment loan means that you’ll pay back the loan at regular intervals, but the payment amount may change based on the type of interest rate you have (that is, a fixed rate versus an adjustable rate).

Student loan debt can be recalculated depending on the type of loan and repayment plan. The interest rates on a student loan can be fixed or graduated (the rate increases as income increases). The lender determines the frequency of payments, which can vary but usually occur once a month over several years. Repayment starts six months after graduation, a span known as a grace period.

You can receive either a federal loan from the U.S Department of Education or a private loan through a bank or alternative lender. Private loans are much harder for a younger student to obtain because these loans are typically based on your credit score and credit history. Federal loans, on the other hand, require you to complete the Free Application for Federal Student Aid (FAFSA). Each of these types of loans has different requirements as well as pros and cons, such as income-based repayment options or the ability to refinance at a lower rate.

Everyone who hasn’t started their higher ed journey yet should at least fill out the FAFSA. A lot of schools award grants and scholarships based on the information you provide. You can find the online application at https://studentaid.gov.

Credit cards

Credit card debt is money you borrow from a financial institution or company through a line of credit. A line of credit is a preselected amount of money you can access at any time as long as you don’t exceed the available credit limit. The length of time to pay back the money is typically a month. After the month is over, the funds you borrowed acquire interest, which means you have to pay back more than what you had initially borrowed in the first place.

Credit cards, like student loans (see the preceding section), may be unsecured. If a credit card is secured, the lender wants you to put some skin in the game by providing some collateral such as paying a hefty fee or providing a cash deposit when you open the account. The lender doesn’t keep the collateral forever — usually a year, sort of like a deposit. After you’ve established a history of making your payments on time, it refunds your collateral and moves you to an unsecured line of credit.

Along with being unsecured or secured, credit cards are also known as revolving debt. Revolving debt allows you to borrow money and pay it back, only to repeat the cycle again and again with no end date. Credit cards can also come with perks such as free travel, cash back, and discounts meant to keep you using your credit card again and again. When you use credit cards responsibly, you can take advantage of these perks without spending additional money if you pay your card off in full every month. Many travel bloggers haven’t paid for a room or flight in years!

Home and auto loans

Unlike the student loan and credit card debt in the preceding sections, which can slowly creep up on you, purchasing a home or automobile can cause you to acquire a large amount of debt at one time. New cars can start at $20,000 and go up from there. Homes typically go for hundreds of thousands of dollars and, depending on the location, sometimes even more! We don’t have that type of cash lying around, and you probably don’t either.

Home loans

Mortgages, like student loans, are considered installment debt. When you’re approved for a mortgage, the bank that has approved your financing sets up an arrangement with you to pay back the loan over time — usually 15 or 30 years. Still, the exact arrangement depends on your lender and other factors, such as what type of loan you’re approved for, interest rates, and whether you have a down payment.

Mortgages are considered secured debt. A lender knows it’s getting its money back no matter what when helping you finance a home. So if you end up short one month and can’t pay your mortgage, no sweat — to the lender, not you. You’ll have to pay when it shows up on your credit report. However, after you’re 120 days late, the lender will start the foreclosure process and take the house back. Sure, it would’ve made more money if you had fulfilled the loan’s terms, but it’s still getting something out of the deal.

You find out how to prioritize your debt within your budget later in this chapter, but please pay your mortgage. You don’t want a foreclosure on your credit report! Foreclosures can prevent you from finding a new place to live, even when you’re just looking to rent. This costly mistake can cost you thousands of dollars for years to come.

Auto loans

If you don’t have enough cash to purchase a vehicle outright, you need a bank or credit union to finance you with an auto loan. Suppose you’re buying a car through a dealership. In that case, its finance department reviews options with you based on your credit history and whether you’re providing a down payment or a trade-in. Dealerships usually have preferred lenders they work with. You can choose to finance with them or look at your bank for finance options.

Auto loans are secured loans you pay off in installments. Because it’s an installment loan, you make monthly payments over a timeline, usually no more than six years. Six-year loans are more common when you’re purchasing a brand-new car versus an older model because the loan amount tends to be more significant. Auto loans also come with collateral, which is why they’re secured. If you don’t make your payments, the lender can take the vehicle in a process called repossession. It finds someone else to buy your car and then sticks you with the difference of what’s still left on your loan. This process happens in a much shorter time frame than a home foreclosure (see the preceding section), but can you imagine? You’re...