Debt: Types of debt, How to use it and pay it off

Updated: Jun 22, 2020

A man thinking hard watching a laptop.

Many people think that debt is evil. When you think of the millions of people who have declared bankruptcy and have spent the majority of their life living in debt, you can understand why people believe that debt is evil.

With one notable exception (more on that in a minute), debt is not evil. In fact, debt is not even bad. The problem is how most people use debt.

If you are struggling with debt, you are going to want to read this article in its entirety to learn the difference between good debt and bad debt, how people fall into debt, how to get out of debt, and the two scenarios where you should not pay off your credit card.

What is debt?

Debt is simply a financial tool that allows you to buy something if you don’t have enough money available to make the purchase using cash.

Debt is no more “evil” or “bad” than any other tool like a hammer. It is the misuse of this financial tool that causes pain and suffering to so many people.

  • If you use debt in the right way, it has the potential to increase your wealth and improve your life.

  • If you use debt in the wrong way, it will take you down the path to financial misery.

Let me be clear on what I mean when I say, “if you use debt the right or wrong way.” Four factors will determine if you are using debt properly.

  1. The type of debt you are using.

  2. The purpose of which you are using that debt.

  3. How much debt you take on.

  4. The interest rate and repayment terms of that debt.

Those four factors are what make the difference between good debt and bad debt.

Good debt vs. bad debt

To further clarify the difference between good debt and bad debt, let’s review the eight types of debt and rank them from worst to best.

1. Payday loans

Remember when I said debt is not “evil?” I might need to amend that statement because there is one type of debt that might actually be evil, and that is payday loans.

What are payday loans? Payday loans are a bridge loan to provide cash for people who have run out of money and need to pay bills before their next paycheck.

That sounds pretty harmless and, in fact, like it provides real value to the borrower. You might be wondering why payday loans are bad? The issue with payday loans is that they have the potential to hook borrowers into dependency and keep them coming back every month.

Think of it this way; if you can’t afford to pay your bills this month, there is a decent chance you won’t be able to pay your bills next month. This is especially true when you just added a new loan that needs to be paid off on top of your regular expenses.

Here are two stunning statistics about payday loans.

  1. 80% of payday loan borrowers are repeat customers.

  2. According to a report from the Centre for responsible investing, the typical Average Percent Rate (APR) on a payday loan ranges from 391% to 443%.

Payday loans can trap you in a vicious cycle of dependency on ultra high-interest debt. For that reason, payday loans are the worst type of debt and should be avoided.

2. Credit cards

In contrast to payday loans, credit cards are not “bad.” They are, however, the most mismanaged and abused type of debt in the world today. The average American owes $5,700 on their credit card. If that does not sound like a lot of money, consider the fact that the average APR for credit cards was over 16% in May 2020. It’s not uncommon for credit card rates to be as high as 20% or even 30%.

You can’t find an investment that can guarantee you a 16%-30% annual rate of return. It does not exist. If you carry a credit card balance, credit card companies are making more money off you than Warren Buffett or any investment manager could ever make in the stock market.

How to manage credit cards

Managing credit cards is simple. There is one golden rule to successfully managing credit cards; always pay off your outstanding balance immediately after making a purchase. If you do that, you will avoid all the pitfalls of credit cards and begin building up your credit score.

This means you only use your credit card to buy something that you could have purchased using cash. To make this easier, most credit card companies offer a grace period where no interest is charged. Typically this grace period is three weeks. If you pay your credit card balance within the grace period, you won’t be charged interest.

Credit card cash advances

It’s important to know that this three week grace period for credit cards does not apply to cash advances made on your card. A credit card cash advance is when you use your credit card at an ATM to withdraw cash.

There are three crucial facts you need to know about using your credit card to make a cash advance.

  1. Interest begins accruing immediately. There is no grace period; you start racking up interest the second the ATM spits the money out.

  2. Cash advance interest rates are higher than standard credit card rates. The average interest rate on cash advances is around 24%.

  3. You pay an additional administration fee. To rub salt in the wound, credit card companies often charge an administration fee in addition to the interest you pay on cash advance. These fees might be a flat rate like $5 or $10, or it could be a percentage of the amount of the cash advance you are making.

How to read a credit card statement

If you have never reviewed your monthly credit card statement, you should because it contains a lot of useful information.

Let’s review a sample credit card statement from an old credit card I had several years ago. Every month your credit card company should send you a statement that looks something like this.

Your monthly statement contains a lot of information and can feel intimidating. It’s not as complicated as it looks, and specifically, we will be looking for the following information on a credit card statement.

  • Name of the financial institution which gave me the credit card. If you have multiple credit cards with the same bank you could sort them by the type of card, for example, this card is what’s called an “Aventura Visa Infinite” card.

  • You’re also going to need to know the current balance on the card.

  • The interest rate you pay on any outstanding balance.

  • The minimum payment required.

  • The due date of that minimum payment.

  • Consequences of missing that minimum payment due date.

If we zoom in a little closer, we can easily find that information.

The first thing you’ll likely notice is what’s usually called a “summary of account activity” or as my bank called it “your account at a glance.”

Let’s go through this line by line to understand what we are reading.

  • Previous balance: Balance on the credit card last month.

  • Payments: Total amount of payments you have made since the last statement

  • Other credits: Total of any other transactions that reduce your credit card balance, for example, returning an item and having it refunded on your card.

  • Total credits= Payments + Other credits.

  • Purchases: Total cost of all the things you purchased with your credit card since the last statement.

  • Cash advances: Total of any cash you have borrowed from your credit card since the last statement.

  • Interest: Any interest you have been charged from carrying a balance on your credit card.

  • Fees: Any other fees charged to your account.

  • Total charges= Purchases + Cash advances + Interest + Fees.

  • New balance: This is how much you currently owe on your credit card and is equal to your Previous balance + total charges — total credits.

It’s crucial that you carefully read your credit card account statement every month. It has vital information that you will need to manage your credit card.

Credit card reward points

If you follow the golden rule of managing a credit card, you will put yourself in a position to take advantage of one of the major perks of owning a credit card; reward points.

There are many different types of credit card reward programs, but the two most common are travel and cashback rewards.

  1. Travel reward programs allow you to collect points for each purchase you make using that card. These points can typically be redeemed for flights, hotels, and vacation packages.

  2. Cashback reward programs provide a cash rebate for each purchase you make with that card. These rebates are typically around 1%-2% of the value of purchases made on the card. Many rebate programs provide different cashback rates for various purchases. For example, some cards give a higher percentage of cashback at grocery stores and gas stations.

In addition to points and cashback, credit card reward programs also provide additional perks to the cardholder. For example, my travel reward card gives me free insurance coverage on rental cars.

A word of caution about credit card reward programs: these reward programs incentivize you to spend money. The more money you spend, the more points you get. You should never spend money simply to collect credit card points.

That might sound obvious, but you would be amazed how many people justify purchases they don’t need to make because “I get points.” Credit card companies are not stupid. They know that people respond to incentives. Use the reward programs, but don’t let them use you.

Another word of caution on credit cards that offer a reward program; don’t get fooled into paying a high annual fee for the privilege of collecting points.

Often, credit cards that have a reward program offer two different versions of the same credit card.

  1. A version of the card with a less generous rewards system with a small or even no annual fee.

  2. A version of the card with a more generous rewards system with a higher annual fee.

Let me repeat it, credit card companies are not stupid. They know that many people will take the card with a high annual fee for the sole purpose of collecting more points.

Depending on how much money you spend per year, it is possible that the more generous rewards program could justify the higher annual fee, but for most people, it’s best to stay away for a straightforward reason. The high fee credit card incentivizes you to spend more money.

Think about two versions of a cashback rewards card.

  • Card 1: Offers 1% cashback and has no annual fee.

  • Card 2: Offers 2% cashback and has a $120 annual fee.

You would need to spend $12,000 per year or $1,000 per month just to break even on card 2. This provides an incentive to spend at least $1,000 per month to justify the choice to go with the high-fee credit card. You may not even be aware that this is happening, but somewhere in your subconscious is a voice telling you to get the points.

When in doubt, choose the credit card with no annual fee.

While credit cards themselves are not evil, mismanaging a credit card can have devastating consequences on your finances. As long as you always pay off your balance immediately and opt for a card with a low or no annual fee, a credit card can be a valuable financial tool.

3. Personal loans and lines of credit

Unsecured personal loans and lines of credit are other forms of debt that people often abuse.