Whether it’s student loans, a mortgage, or credit cards, debt is a reality for most of us. In fact, never borrowing money can negatively impact your financial health by lowering your credit score. At the same time, leverage can be a great tool when used strategically. With inflation and interest rates front and center, there’s never been a better time to review the basics of smart debt.
Different types of debt
In general, there are two types of debt: secured and unsecured. Secured debt is when the money you borrow is linked to an asset of some kind. A mortgage is secured by the house, for instance. Other examples of secured debt include an auto loan, a home equity loan, or a secured credit card. It’s also possible to use an investment portfolio to secure loans—known as securities-backed lending.
If you aren’t familiar with securities-backed lending, the terms for this type of debt are similar to a home equity line of credit but can vary based on market conditions and personal considerations. At Quorum, we tend to use securities-backed loans strategically to avoid selling assets or to solve a liquidity need.
Unsecured debt is not linked to an asset. The most common example is, of course, credit cards. Because there is no easy way to recoup missed payments on unsecured debt, it often carries a higher interest rate than secured debt. Still, credit cards may offer a number of perks to the cardholder. The key is to pay them off each month to avoid incurring any high-interest debt.
Interest rates: What you need to know
You’re likely familiar with the basics on fixed versus variable rate debt. A fixed rate stays the same for the duration of the loan whereas variable rates are subject to change and generally pegged to market rates.
Credit cards generally come with variable interest rates, meaning you’ll likely see higher interest payments on any credit card debt in a rising rate environment. But while this tends to get a lot of attention, there tends to be less discussion around home equity lines of credit and even securities-backed loans, both of which tend to feature variable rates.
It’s a good idea to keep tabs on which loans or lines of credit you have with variable rates; this way you can stay on top of things should rates change in either direction. At Quorum, this is something we can help with.
Finally, it’s important to remember there’s a difference between the pure interest rate listed on a loan and the amount you pay. Usually, the actual rate you pay is known by its acronym, APR, which stands for Annual Percentage Rate.
(As you know, we’re fans of financial education at Quorum Private Wealth, and this is a great lesson to go over with older children.)
Often, loans come with fees or other associated costs. The APR is the total amount you’ll pay each year with those additional costs included. Lenders are required to list the APR as well as the interest rate on any mortgage or loan product. When you’re comparing different terms, be sure to focus on APR since it’s a more accurate reflection of what you’ll pay.
How debt fits in overall
Debt isn’t necessarily good or bad in and of itself. How debt might impact your finances depends on a wide array of things. It’s often a highly personal decision. We sometimes see clients who can comfortably take on leverage with very little risk but prefer not to.
The general guidance is often something like: If you have an extra $1,000 and the potential return from investing your money is higher than the interest on your debt, it makes more sense to direct the money toward investments versus debt. The reality is often far more complex than basic articles about consumer debt suggest. There are times when leverage can be a helpful short-term tool as part of a broader goal. And there are times when the terms of a long-term loan need to be analyzed in greater detail.
Our goal at Quorum is to highlight how any decision, including those tied to debt, fits in with your broader goals and objectives. The goal is to use debt in a way that furthers your financial plan, versus interfering with it.
If you have any questions about debt (or anything else), we’re happy to discuss in our next meeting.
