The Double Edged Sword of Credit

Managing debt is an integral part of financial literacy. It can be used to help reach your goals, or it can be a hindrance, depending on how you use it. While in general, the less debt you have, the better. Knowing what types of debt to take on and how to keep it in control can be part of your full financial picture.

Borrowing money to pay for any goods or services requires credit. The better credit you have, the better the interest rates and your ability to borrow will be. It’s a way for potential lenders to see how “worthy” of their trust you are, based on your track record of paying off debt. Anytime you request approval for a credit card, auto loan, mortgage, or a new utility contract, the lender will pull your credit report. That credit report provides a snapshot of your credit history and may influence their decision to extend you the loan.

Types of Debt. There are two types of debt, and they can reflect on your credit differently. They also often come with different interest rates.

A secured loan is when you give a lender some asset or property in exchange for borrowing money as a way to “secure” the loan and minimize their risk. Mortgages, home equity loans, and auto loans are all secured loans. They’re easier to get because if you don’t pay, the lender has collateral they can take to fulfill the loan.
An unsecured loan is when a lender loans you money based solely on your creditworthiness, not collateral. Credit cards, personal loans, and student loans are all unsecured loans. These are riskier, harder to obtain, and have higher interest rates.

Comparing interest rates. A good rule of thumb to follow is to pay off any debt that’s charging you a higher interest rate than what your investments are earning. For example, suppose you know you have an investment account earning an average return of 8%. You have a credit card balance that you’re paying an interest rate of 17%. In this case, it’s a better decision to pay off the debt. Doing so not only lessens the amount of money you pay back in interest but also is beneficial to your credit score.

Overall credit health. Regularly review your credit report to assess your current financial standing. Immediately deal with any past-due debts or those sent to collection agencies, as those are the most urgent and detrimental. The longer these sit, the longer they can affect your credit. Be sure to work with the lender or a third party to get them settled as quickly as possible.

Any debt you can’t afford can affect your long-term financial goals. Credit cards are no exception. The less you overextend yourself in debt, the better your financial picture is. If you need help to determine how to manage debt, please reach out. We can take a look at your whole financial picture and help you build a plan to reach your long-term goals.