We’ve all heard stories of personal debt levels getting out of control. It’s simple enough to do: unexpected expenses arise, and credit card companies and lending institutions make it easy to obtain large amounts of credit. The difficult part is having the discipline to use the credit wisely, and paying it off as soon as it’s due.
But not all debt is bad. A healthy household budget can certainly accommodate some debt to attain things now that would otherwise take years of saving. Mortgages—to use a very common example—are seen as a prudent way to use debt to purchase property that typically increases over time.
The big issue in debt is the interest rate—the cost of borrowing the money. The higher the interest rate, the quicker it can accumulate, and the tougher it is to pay it off.
Generally speaking, credit cards have some of the highest interest rates, while mortgages offer some of the lowest. Recently, mortgage rates have been uncharacteristically low as central banks try to stimulate the economy after the recession. On the other hand, credit card interest rates continue to be high and can lead to thousands of dollars in borrowing costs for small, less valuable purchases.
We address mortgages in the next chapter, but let’s take a minute to better understand credit cards and lines of credit.
Credit cards can come from financial institutions or major brands such as department stores or gas stations. They often offer some form of benefit for using the cards, such as points toward merchandise or flights.
However, the interest rates (often 9%–20%) make those ‘rewards’ less attractive if you don’t pay off the full balance before each due date. When paid off quickly and before interest accrues, credit cards can be a viable option for smaller, day to day purchases. But their high interest rates and lower credit limits make them a poor choice for larger purchases such as renovations.
|CREDIT LIMIT||Varying credit limits||Based on the value of your home|
|INTEREST RATE||9% – 20%||Usually prime plus 0.5%|
|INTEREST RATE VARIABILITY||Fixed||Variable (linked to prime rate)|
|MINIMUM PAYMENT||Usually 3% of the balance owing||Usually interest only|
Let’s say you needed $250,000 to renovate your home. A typical HELOC currently has an interest rate of 3.2% If you chose a 20-year amortization period, your monthly payment would be $1,412.
At the end of the 20 years, you would have paid $338,798, or nearly $89,000 in interest.
One alternative to high interest credit cards is a loan known as a line of credit. A line of credit (LOC) essentially provides you with access to a set amount of money from a financial institution. Lines of credit can be secured against the value of your home, and are often referred to as a home equity line of credit (HELOC) allowing you to borrow for a variety of things. Most commonly secured HELOCs are used to consolidate other debt such as car loans and credit cards at a lower interest rate. Secured HELOCs can also be used for home renovations, vacations, new cars and education. Interest rates associated with HELOCs are generally a half a percentage point above prime, far lower than credit cards or unsecured lines of credit.
HELOCs can be used to access large amounts of money—up to 65% of the value of your home.
As with a mortgage, secured HELOCs need to be carefully considered as even a low interest rate adds up over time. This is particularly a concern if you only pay the minimum interest payment instead of a larger sum toward the principal amount that was borrowed.
Interest rates on HELOCs are linked to the prime lending rate, which means they can change over time. Because of that variability, they contain the risk of rates going up, making payments difficult to meet.
Another risk is the potential to become too dependent on the HELOC. For instance, you may have a HELOC for $200,000 to complete some home renovations. As you pay down the principal to say, $150,000, it can be tempting to use the remaining $50,000 that is available to purchase cars, vacations or other things. This can lead to a lengthy and costly period of borrowing that you hadn’t planned on initially.
Each person’s situation regarding debt is unique, and depends on credit history, income and the type of loan you are pursuing. The important thing to remember is that all borrowed money comes with a cost. It’s wise to weigh those costs against the overall value of the purchase to be sure it’s the right choice.
Investment returns are not guaranteed. Results are for illustration purposes only.