Types of Debt - Everything You Should Know

Hey, what's up everyone and welcome to the School of Personal Finance. In this week's video, we're going to talk about the different types of personal credit and how they all work. So we're going to start with credit cards and we're going to talk about personal lines of credit that you could get at a bank. Then we're going to talk about home equity lines of credit. And then finally, we'll talk about regular amortized fixed rate loans like a mortgage or a car loan or any fixed rate in term loan that you may be able to get. All right, let's get to it. All right, so let's start by talking about credit cards. Now, I'm sure that all of you know what a credit card is, but let's throw some terms out there that maybe you're familiar with, maybe you are not. So the first one is revolving line of credit. So a credit card is a revolving line. And what that means is that you get a credit limit that's available. Let's say you have a $10,000 limit on your credit card. You can use it, then pay it down, then use it again and pay it down. You just cannot go above that limit. So if you max out your credit card and you owe 10 grand on it, you can no longer use it. You have to pay some of it down before you could use it again. And credit cards have variable interest rates. So what that means is that the interest rate is subject to change at any time, depending on the credit card issuer. And they might have different tiers of interest rates. Like for example, it might be one interest rate for purchases that you make on the card. Then it might be a higher interest rate for cash advances that you take against the card. They might also have promotional rates that are at 0% or at a lower rate for a shorter period of time. Another term is uncollateralized. And what that means is that there's no collateral. You're not putting anything up in order to get access to that credit card money. And this makes it a higher risk for the bank because they don't have anything to take if you don't pay them back. And now with any loan or line of credit, the higher the risk, the higher the interest rate that they are going to charge you. That goes with anything. If I was going to lend you money, I would want to do underwriting on you and see what your income is, what your assets are, what your credit score is. If I could deem that you're a very low risk, then I will give you a lower interest rate. But if I come to the conclusion that you are a higher risk, then I'm going to charge you a higher rate of interest to compensate for the additional risk that I might not get paid back. Now, I'm also sure that I don't have to sit here and tell you how dangerous credit cards can be. People ruin their entire lives using credit cards. They're so easy to swipe. You don't have to have any money available. You just go, you buy something, you swipe, and it feels like you didn't even spend any money. And before you know it, you've racked up these large balances on credit cards. But here are a few important points that you need to know when it comes to credit cards. The first one is that when used responsibly, it could be like an interest-free loan. So when you use a credit card, let's say that you get a shiny new credit card, you owe no money on it, you haven't made any purchases yet. And you go out and you start buying things around town. You go grocery shopping, you go out to dinner, and let's say that you spend a thousand dollars on your credit card. As long as you pay off that entire balance by the due date that you get on your monthly statement, then you will owe zero interest. So it's almost like an interest-free loan for that amount of time until your payment is due. And now most credit cards, they have what's called a grace period. So you use the credit card for a month, you get your statement, and then you will have a grace period, let's say 21 days before your actual payment is due. So you might have 50 days or so of getting an interest-free loan from the credit card company. And then as long as you pay off that statement balance in full every month, they will not charge you any interest. So you never want to carry a balance from month to month on your credit card. Because if you do, then you no longer have that grace period. Now you are going to be charged interest on that previous balance, plus on any purchases you make on the day that you make them. So there's no longer that grace period. So if you carry a balance, even if it's only $100, from one billing cycle to the next, and then you decide to go out and buy something for a thousand bucks, you will start paying interest on it on the day of that purchase. Now there could be other fees and charges associated with credit cards. Like for example, if you take a cash advance, not only does the interest start day one when you take the cash advance, but they will also charge you a fee, maybe a 3% fee of whatever cash advance you're taking. Or if you use one of those nice checks that they send you, or do a balance transfer. Even on the promotional rates, a lot of times with the balance transfers, there is a 3% fee on the amount that you transfer over. And then on top of that, depending on the card, it might also have an annual fee attached to it as well. Now most credit cards will have like a minimum payment due every month that is much lower than what you actually owe on it. So if you only make the minimum payment, then you're going to be paying interest. You're going to be carrying a balance from month to month, and it will take you a very long time to get out of that credit card debt if you continuously only make the minimum monthly payment. And on credit card statements, they actually show how long it will take if you only make the minimum payment each and every month. All right, now let's move on to the second product, which is called a personal line of credit. Now you could go into a bank and you could apply for a personal line of credit. And it is very similar to a credit card. It's going to be unsecured. There's not going to be any collateral. You have to go through underwriting or you have to apply. They're going to want to know, you know, what your income. There'll be a short application. They're going to look at how much money you have in the bank in order to get approved, what your credit score is, all of those types of factors to see how big of a line of credit that you would get approved for. Now with a personal line of credit, it's typically attached to a checking account. So there's no card that comes with a personal line of credit. But what you could do is you could just move money online from the line of credit into your checking account and use it. And it's similar with a credit card. Let's say that you have a $10,000 personal line of credit. You're able to go and you can move the whole $10,000 into your checking account and use it however you wish. They might have some limitations on what you could use it for, but for the most part, you could use it on whatever you like. So now one nice thing about a line of credit, it is revolving and you don't pay any interest on it unless you actually use the money. And then you will only pay interest on the amount that you use. So if you have a $10,000 line of credit that's available to you and you say, you know what, I need a thousand bucks to tide me over until something happens. Then you can take a thousand bucks. You can move it into your checking account and you will only owe interest on that $1,000. And then you'll still have the $9,000 that is available to you. Now interest on these, it accumulates right when you borrow the money and it is charged on a daily basis. So every day they will look at how much you owe on that line of credit, multiply it by the interest charge that they are charging you, divide it by 365 days. And that is your interest charge for that day. And they will add up all the interest charges throughout the month and come up with the monthly amount of interest that you owe on that card. Now, because these lines of credit are unsecured, the interest rate is going to be higher than like a mortgage or a home equity line of credit because those have collateral. So these are a higher risk to the bank because there's no collateral with it. And now the payments are going to be interest only. So you will have what's called a draw period, which is a period of time where it's revolving, where you could use it, pay it down, use it, pay it down. And the bill, the amount that you owe every month will only be the interest payment. You can pay above and beyond that whenever you want to, to reduce the amount that you owe so that you pay less interest, but they are going to bill you for the interest amount each month. That will be the minimum payment. Now, personal lines of credit, people use them to have as a backup to their checking account in case they accidentally overdraw their checking account, or people will use it maybe to pay off higher interest rate credit card debt. But the rates on these are not great either. So it's not a great place to carry debt for the long term in these personal lines of credit because they typically have a pretty high rate on them. All right. Now the third product is a home equity line of credit. Now this works very similarly to a personal line of credit. The big difference is that your house is collateral. So when you apply for one of these, you're going to go through underwriting. They're going to check your credit, your income, your assets, all of that stuff. But they're also going to appraise your house and see how much equity you have available in the house to see how much you would actually qualify for in a home equity line of credit. And then once you have the line of credit available, you don't have to use it, right? So this home equity line, you could just sit it there as an emergency fund, or just if you're going to have a project that's going to come up in the future, you could have this line of credit sitting there and it won't cost you anything. I mean, some might have an annual fee or some kind of administrative fee, but for the most part, there's no costs associated with setting up a home equity line of credit. Now they're going to have a variable rate. It's going to be lower than a personal line of credit because the home is collateral. So like the prime rate right now is 3.25. That's what the banks base these lines of credit on is the prime rate. So if you could get a HELOC, a home equity line of credit at prime plus a half, say, then your rate will always be half a point higher than what the prime rate is. And it's variable. If the Fed decides to raise interest rates, then the prime rate will go up, let's say a quarter of a point. So your home equity line of credit will also go up by that quarter of a point. Now, just like a personal line of credit, HELOCs are going to be interest-only payments. So they're going to calculate how much interest, how much money you have outstanding each and every day to come up with your monthly interest payment. And then it's also going to have a draw period and a repayment period. So like a typical one might be where you have a 10-year draw period. And then at the end of 10 years, it's no longer revolving line of credit, but then they give you an additional 10 years to pay off any balance that you owe on the home equity line of credit. And you have to be careful because there's definitely verbiage in these contracts. They can definitely be very complicated where they might have clauses in there that they could call the home equity line of credit, depending on circumstances that are well beyond our control. Like I remember in 2008, 2009, banks were calling home equity lines of credit, or they were just freezing the home equity line of credit where people no longer had access to them. So if you were using that as an emergency fund, or you're depending on it for some project in the future, the banks just froze it and that was it. You didn't have access to it anymore. All right. So now let's talk about the last type, which is just a fixed rate amortized loan. Now, there are other products out there like adjustable rate mortgages that I'm not going to talk about in this video. So for a fixed rate amortized loan, you borrow a specific amount of money. It's not a line of credit, right? So when you take out this loan, you're getting the lump sum. So let's say, for example, a car loan, right? You need to borrow $20,000 to buy a car. So you get $20,000. You give it to the car dealer to purchase the car. And now you owe 20 grand and you're going to start paying principal and interest back right away, right from month number one. So you could choose a term. Let's say it's a five-year term. So over 60 months, you're going to pay back that $20,000 plus interest. Let's say that it's a 5% interest rate. Now, the easiest way for me to show you is to look at a calculator. So this calculator online, it's actually a mortgage calculator, but we're just going to make the assumption that we're doing a car loan. So let's take a look. We're doing a $20,000 loan over five years, 5% interest. So the monthly payment would be $377.42. And now this loan is amortized. So what that means is that they run a calculation to figure out exactly how much you would have to pay each month so that it's zero at the end of the term. So the payment is going to stay the same no matter what. Even if you decide that you want to pay extra towards the principal one month, you could do that, but your monthly payment is going to stay the same. What will happen is it will then knock years off the back of the loan. So let's look. We could actually look at an amortization schedule here and look at all the payments. So like in this first month, making $377.42 is the payment of that $294.09 would go to principal, and then $83.33 would be the interest. And now it's very easy to calculate what the interest is each and every month. All you would have to do is if we take a calculator and we say during that first month, $20,000 times 5% interest, that would be $1,000. And then we divide that by 12, and that would be $83.33. So that's where we get this interest for the first month. If we jump down, let's say to month 12, we have $16,388.96. That would be the outstanding balance. We multiply that by 5% and we would get $819.44. And then we divide that by 12, and that would be the monthly interest payment, which would be $68.29 as we see right here for month 13. That's what would be due in interest based on the ending balance from month 12. So it's easy to calculate the monthly interest payment at any point during a loan. It's just a simple mathematical formula. And so the same concept applies to a mortgage. If you have a 30-year mortgage and you want to pay it off faster and you're going to throw some extra money at it each and every month, it's not going to change your monthly payment. It doesn't improve your cash flow month to month, but what it will do is it will reduce the amount of interest that you're paying over the life of the loan because now you owe less money on the mortgage. And it will knock years off the back end. So if you make a lump sum, then you might, instead of having a 30-year mortgage, you might be done in 26 years depending on how much money you throw at it. I know I went over a lot of stuff today, but I hope that you found this one helpful. Please make sure to hit that like button if you enjoyed this video. Hit that subscribe button if you are not subscribed to the channel already. And I will see you again next week. Thanks.