Types of Debt

There are two types of consumer debt, installment and revolving.

Installment Debt

Installment debt has a finite term, interest rate, and set amount. All the funds are delivered at the time of inception (when the loan begins).

Installment debt has three components:

  • Fixed term
  • Interest rate
  • Principal balance
 
The funds for installment debt are “front loaded” which mean you get the entire funds transferred to you once the transaction closes. Whereas, revolving debt you only borrow what you need when you need it. Assuming the loan is not an interest only mortgage, you would make both principal and interest payments every month until you either refinance the note or pay the note off in its entirety.
 

Examples of installment debt:

  • Mortgage
  • Home equity loan
  • Car loan
  • Student loan

*NOTE: Always ask the loan officer to confirm if there are any pre-payment or principal payment reduction penalties. Pre-payment penalties are not always disclosed upfront and you won’t find out until you try to pay off the loan early or refinance it.

 

Revolving Debt

Revolving Debt has an interest rate and maximum limit amount. You may pay the minimum payment the bank requires, pay the minimum payment plus more if you can, or you may pay the full balance. You always want to confirm if there is an annual fee for a credit card.  Also, be aware of introductory offers;  some banks will initially offer very low interest rates for a specified amount of time and then the rate increases; this means you’ll be paying more that you were initially.  You will want to know the terms of the rate adjustments so you are prepared for the rate increase.

Revolving debt includes:

  • Credit cards
  • Home equity lines of credit
  • Some fitness memberships
  • Technology devices


Typically, you need to make the minimum payment which is the interest on the outstanding balance. Wise savers pay their balances in there entirety monthly. Also, down the road when you are applying for a mortgage you may not be able to pay off revolving debt to qualify whereas you can payoff installment debt to qualify.

 

Debt Preparation and Monthly Payments

Reference your budget, particularly the payments you make monthly, such as credit cards, membership fees, organizations, car payments, student loans, etc. Create a spreadsheet with a line item for each one, and include the lender, starting balance, monthly payment, outstanding balance, and interest rate.  Whichever lender has the highest interest rate is one to target for paying extra each month; this is your additional money/earnings that should go towards principal payment reduction, which will lower the total  interest you may owe over time.  Keep this spreadsheet updated monthly. 


Here’s an example of the power of principal payment reduction: If you make one extra principal and interest payment per year on a 30 year mortgage, you eliminate almost 8 years of interest over the life of the loan! Huge savings.   My advice to those who are on commission or in heavily bonused positions is to take the longest term available on installment debt, assuming you have the discipline to prepay the debt and there are no prepayment penalties.  This keeps your payments low during times you’re not receiving commissions or bonuses, yet allows you to pay more when the commission or bonus check arrives.  Ditto with college loans.  Extend the term for the longest time as more debt/expenses may occur during this phase of life.  Cash is king in this period.  Car payments, rent or mortgages, and family planning are all very typical while you’re still paying off college loans.  I’ve seen doctors take out short term student loans to pay for medical school which ultimately disqualified them from buying a home because their monthly school loan obligation was too high to qualify for a mortgage! 


Essentially, I can’t overemphasize the importance of proper financial planning as a strategy to attain your goals and maintain a lifestyle that is best fit to your financial means. Note: My advice about extending loan terms may not pertain to everyone, but when starting out of college, building savings will help you more than paying down debt. Savings will give you options for larger purchases such as a home or car, or pay down unnecessarily high credit card debt.  Make no mistake,  debt will enter your life. Just be prepared to successfully manage those payments with the options you can create for yourself with savings.

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