Let's Talk About Debt
As the economy continues to reopen, we have started hearing headlines about consumers taking on more and more credit card debt to fund their lifestyles…especially to get out of the house, now that things are opening up a bit more. With more families staying home last year and with all of the government intervention, American consumers actually saw a reduction of overall debt in 2020 (the largest drop since 1999!). Now that the economy is starting to normalize, folks want to get out! Although we are monitoring the reopening with the Delta variant, the economy continues to show significant strength. We thought this would be a good time to discuss some of the different types of debt and how not all types are created equally.
A lot of folks that we work with and speak to every day have a healthy fear of debt. This fear comes from the fact that a lot of families struggle with out-of-control revolving debt (like credit cards). A lot of us have also seen our families and friends try to recover from thousands of dollars of typically unhealthy amounts of credit card debt. That being said, taken responsibly, debt is not something that we need to be scared of if used properly.
Credit cards are a perfectly good tool that can bring nice rewards and protections, just use them responsibly
Credit cards are one type of debt that first comes to mind. Their ease of use, high interest rates, and fees make them very dangerous for those families that need quick access to capital or may spend beyond their means. On the other hand, for families that are able to pay off their balance every month and keep their spending in control, credit cards can provide protection against fraud, provide easy access to capital without carrying around cash, and potentially provide cash or point bonuses. The important part is to make sure you are using cards similar to how you would use a debit card or cash. If you need some pointers here, let us know!
On the other end of the spectrum and with rates continuing to be so low, we have different types of debt that involve our primary residencies. Over the last 18 months, we recommended and assisted with a lot of our clients purchasing a new home or refinancing their existing mortgages. Rates have been at historic lows, and a lot of folks have saved a significant amount in monthly payments. These savings typically equate to thousands of dollars over the lifetime of the loan. Although the 30-year fixed mortgage is the most common, there are a lot of other options out there depending on a client’s plan. For folks who haven’t looked at a refi and think they may have missed their opportunity, rates have come down again due to our decreased inflation expectations (see prior Notables Articles for more info here!).
We also get a lot of questions around Home Equity Loans and Home Equity Lines of Credit (HELOCs). Both of them, if used responsibly and correctly, can provide homeowners access to cash to assist them in short-term goals. Let’s talk briefly about the differences. As we know, for a lot of folks, their home represents one of their largest assets. Both of these options give a homeowner access to the amount of equity that they have built up in their home. In a Home Equity Loan (also referred to as a second mortgage), a homeowner takes up to the amount of equity available in their primary residence and starts paying interest on the amount taken immediately. The interest rate is typically fixed and the bank offering the loan will fix the amount of time that the loan is paid back. These loans are pretty inflexible and look a lot like a standard mortgage, just at a little higher interest rate.
What the heck is a HELOC??
A Home Equity Line of Credit (or HELOC) is similar, but the bank offering the loan opens up an account that equals some of the amount of equity the homeowner has available in their home without giving them any actual cash immediately. Although the amount available is different depending on the program, it is usually equal a maximum of about 80% of the amount of equity available. The homeowner can then take out some cash from the account (also known as a Credit Line) whenever they’d like to as long as the account is still open. Once the homeowner draws from the account, the bank will start charging interest. The interest that the bank charges is typically variable and fixed to the Prime Rate. The borrower will start making payments back to the bank once they access the line or until the loan is paid off. If the borrower would like to take out any additional money up to the full line amount, they can. Also, once the loan is paid back, the HELOC remains open and the process could start again.
HELOCs offer a lot more flexibility, but one can see that for folks that have trouble controlling their spending, they can be dangerous. For a lot of clients, we like HELOCs as they provide access to capital that may help expand their emergency savings without having to actually take any money out if they don’t need it. They also allow for a flexible way to access a short-term loan with a relatively low interest rate. We just need to make sure they are used responsibly and that the homeowner is aware of any fees associated with the account.
Not all debt is bad, it just needs to be utilized properly and responsibly!
Similar to other types of investment philosophies, the bottom line is that different folks have different appetites for debt. As we discussed above, if used in a responsible way, debt can offer us better returns without being responsible for all of the risk. On the other hand, if things turn negatively, financial outcomes can be a lot worse. If you have any questions about how different types of debt discussed above would have an effect on your financial plan, let us know!
Does any of this bring up any additional questions? Things you hadn’t considered? Consider it an opportunity to reach out as we're here to help!
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