Debt gets a bad rap, but borrowing has built the modern world. If people couldn’t borrow money, they couldn’t buy cars, houses, businesses, or college studies until they saved enough money to pay for them on the spot. that most people would never do. The world economy would come to a screeching halt without debt, and if you want to avoid debt altogether, you had better plan to live away from the grid.
A better strategy would be to brush up on your knowledge, make sure you understand key terminology, and position yourself to leverage the incredible lending power to your advantage so that you – not the bank – are ahead.
Read: 10 ways to bounce back from a month of heavy spending on your credit card
See: What not to do when trying to get out of debt
Learn the basics – and the lingo
Debt is when a borrower agrees to return something that has been loaned to him by a creditor. Unless that creditor is a close friend, your lender will not only be waiting for the money that was loaned, but a little extra in the form of interest. When you take on debt, the following terms will become some of the most important words in your financial life.
Terms to know:
APR: The annual percentage rate is the annual cost of a loan. Since it includes all fees and expenses, unlike the advertised interest rate, this is what you will actually pay.
The interest: These are the fees you pay your creditor for the service of lending you money. The lower the interest rate, the cheaper the loan.
Payments: Most loans are repaid not all at once, but in periodic installments, usually monthly. As you will see further down the page, the number of payments and the length of time they are spread will have a lot to do with the final cost of your loan.
Main: This is the amount you borrowed. Debtors are required to repay the principal as well as costs and interest.
Budgeting 101: How to Create a Budget You Can Live With
Convince lenders that you are a low risk borrower
Lenders charge higher risk borrowers more than those who are likely to repay the loan on time as agreed. The best thing you can do to get the lowest interest rates and the cheapest loans is to stay in good financial health and keep your credit in good shape.
Terms to know:
Credit bureaus: Your lenders report your debt, payment history, and other critical information to the three credit bureaus: Experian, TransUnion, and Equifax.
Credit report: Credit bureaus compile your information into a credit report that potential creditors will review when deciding whether to lend you money and what interest rate to charge. You should also check your credit report periodically to see what lenders are seeing, to find out where you can improve, and to make sure it’s free of errors.
Credit score: Bureaus assign each potential borrower a credit score based on the information in their credit reports. Ranging from 350 to 850, the higher the better, your credit score represents your risk. The most important thing you can do to maintain a high score is pay all of your bills on time every time – one missed payment can drop your score. It’s also important to keep your credit utilization rate low, which you will do when using less than 30% of your open credit. Your credit mix, your credit age, and the number of creditors requesting “large draws” on your report also play a role.
Getting started: easy-to-use budgeting templates
Don’t give out loans to buy things you can’t afford
Mortgages are often paid off over 15 or 30 years. Those who opt for 15 years will pay much less interest over the life of the loan. The trade-off is that their monthly payments will be higher. If the only way you can afford the car you’re considering is to finance it for 84 months, then you can’t afford the car – you’ll end up paying for multiple cars in the process. The same logic applies to only making the minimum payments on a credit card purchase that you couldn’t really afford to charge.
Terms to know:
Amortization schedule: A table that details your payments and details the amount of your principal and the amount of interest.
Compound interest: The power of compounding works in your favor when you invest and against you when you borrow. When interest is added to principal, you pay interest on that interest, which continues to accumulate – daily in the case of credit cards – over time. This is what makes revolving debt and long term loans so dangerous.
Not all debt is bad, but a lot is
Low-interest auto loans, mortgages, and business loans are essentials of a healthy financial situation that many people use to progress, but debt can also be toxic and destructive.
Terms to know:
Cash advance: Think carefully before using your credit card at an ATM. Cash advances almost always have higher APRs and usually end the introductory 0% interest period applied to any balances you have transferred.
Payday loan: Perhaps the most dangerous type of loan there is, payday loans are the closest thing to legally permitted loan sharking. The institutions that offer them are infamous for preying on low-income people with high-interest, short-term loans designed to trap borrowers in endless cycles of debt.
Revolving debt: Credit cards are the most common type of revolving debt, that is, loans that are not extended for a specified period. The best way to avoid the danger is to pay off your statement balance in full each month – never charge what you don’t have the money to cover – and avoid paying finance charges.
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Last updated: October 29, 2021
This article originally appeared on GOBankingRates.com: The ABCs of Debt: How To Be Smarter With Your Finances