Credit card companies are making more money off your debt than Warren Buffet makes in the stock market.
Household debt has been rising steadily for the past 5 years. Americans collectively owe $13.54 trillion in debt.
- $9.1 trillion in mortgage debt
- $410 billion in home equity loans
- $1.5 trillion in student loan debt
- $1.3 trillion in car loans
- $870 billion in credit card debt
However, debt is not inherently evil. While some debt is completely toxic, other types of debt (if used responsibly) can be used to improve our finances and our lives.
If you have debt, that simply means you borrowed money because you did not have enough cash to pay for something upfront.
Debt may not be a bad thing if that debt was used to fuel investment, such as buying a house, starting a business or getting an education.
Debt is bad when it is used to fund a lifestyle you cannot afford. Financing your trip to Hawaii with your credit card is stupid.
Ranking Types of debt from Worst to Best
The Worst type of debt: Payday Loans
I hate payday loans. They are marketed towards the poorest people in society and often trap them in a cycle of dependency.
The idea of a payday loan is just as it sounds. If you run out of cash and can’t pay your bills until your next payday, you take out a short-term loan with the intention of paying it back on payday.
Odds are if you don’t have enough money to pay rent this month, you won’t have enough money to pay rent next month (especially when you add on your new loan payment). That is why 80% of payday loan borrowers are repeat customers. One report found that the average payday loan borrower pays $793 in interest on a $325 loan.
Payday loans are the worst type of debt and should be avoided at all costs.
The Second Worst type of debt: Credit Cards
Unlike payday loans, credit cards are not inherently evil. If used responsibly, credit cards can help us build credit and collect reward points.
The problem is that many people do not use credit cards responsibly and as a result, the average American owes $6,400 in credit card debt.
The average interest rate on new credit cards is 19.24% while some of the highest interest rates on credit cards are pushing 30%. These are absurd interest rates. Credit card companies are making more money off your debt than Warren Buffet makes in the stock market. The inverse is also true; you are losing more money on credit card debt than Warren Buffet makes in the stock market.
The Third Worst type of debt: Personal Loans
Unsecured personal loans and lines of credit can get people into hot water. The interest rates on this type of debt are not as high as credit cards but tend to be much higher than mortgage rates.
The interest rate you receive on these loans depends largely on your credit score.
Personal loans can be good when they are used to consolidate higher interest credit card into a single payment with a lower interest rate.
They can also be bad when they are used to buy a new TV at an 8% interest rate.
The Fourth Worst type of debt: Car Loans
Taking out a loan to buy a depreciating asset is not a good financial move. Think about it, you are paying interest to buy something that is expensive and will eventually be worthless.
Sadly, this is one of the largest growing types of debt in America, totaling $1.3 trillion. The average car payment is now $551 per month.
If you can make a $551 car payment, why not by a used car with a $300 payment and save $251 per month so that you can buy your next car in cash and never have a car payment again.
The Fifth Worst type of debt: Student Loans
- 7 out of 10 college students graduate with student loan debt
- The average student loan balance is more than $37,000
- Total student debt is more than $1.5 Trillion
- The delinquency rate (meaning 90 days late on payments) is at 11%
This is a tricky one. The cost of tuition and the student debt load has been increasing for decades. But college-educated workers make significantly more income during their lifetime than non-college-educated workers.
Education is an investment in yourself, and I believe it is worth the cost. There are some steps you can take to reduce your student debt load.
- Consider a state school
- Apply for every scholarship possible
- Take AP & CLEP exams and earn college credits while in high school
The Sixth Worst type of debt: Mortgages (for your home)
In most circumstances, owning your home is a great long-term decision. There is lots of research that make it clear that homeowners are wealthier than renters.
However, you need to be smart about when and how you purchase your home.
If you purchase a home before you are financially prepared will cause you to become “house poor”, a term used to describe people who spend most of their take-home pay on their housing costs.
Even if you are prepared to be a homeowner, that does not mean you are ready to buy a 3,000 square foot house. One of the reasons housing costs have increased so much is that people are demanding larger homes.
I never understood the concept of “growing into a home”. The larger the house, the larger the mortgage, utility bills and property taxes. Why take on more debt to have that 4th bedroom you never use?
The Seventh Worst type of debt: Mortgages (for your Rental Property)
A mortgage attached to a rental property is the best type of debt. Why? Because someone else (your tenant) is making the mortgage payments for you!
The best type of loan is one you never need to make a payment on.
That is assuming that your rental property is cash-flow positive, meaning you are making more in rent than it costs to maintain the property. If you overextend yourself or the market goes in the tank you could end up on the hook for those mortgage payments yourself.
So, there it is the 7 Types of debt, ranked from worst to best. Do you agree with my ranking? Are there other types of debt I should have included? Let me know in the comments.
Want to Handle your debt? Check out this video on Debt Repayment Strategies
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.