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Pay It Down!: From Debt to Wealth on $10 a Day

Debt-Proof Living: The Complete Guide to Living Financially Free

You owe it to yourself.

Getting out of debt is never easy. But it’s essential for building a strong financial future, and it’s a means to a happier, less stressful life. This guide will show you the basics of getting out of debt, including:

The difference between good debt and bad debt
Foolproof approaches to reducing and eliminating debt
Ways to avoid more debt and build wealth once you’re in the clear

Understanding Debt

The first step toward getting out of debt is having basic knowledge of what debt is and how it works.

Debt Basics

Debt is money that you owe to one or more creditors, the banks or other financial institutions that lent you money. When you take out a loan, you owe the creditor the amount of the loan plus interest. Interest is charged at a particular interest rate, or annual percentage rate (APR), which is a percentage of the original amount of the loan or of the existing loan balance. Many loans also have a term, a fixed time frame in which you must repay the principal (the original loan amount) in full. For example, a $1,000 loan with a 5% APR and a five-year term requires you to pay the creditor $50 in interest annually for a period of five years.

Nonconsumer Debt vs. Consumer Debt

Most debts fit into one of two types: nonconsumer debt and consumer debt. These debts differ in four main ways: collateral, tax treatment, APRs, and terms.

Nonconsumer Debts

Nonconsumer debts are debts backed (guaranteed) by an asset that tends to appreciate in value, such as a home or other real estate property. The most common types of nonconsumer debt are mortgages and home equity loans.

Collateral: In nonconsumer debts, the asset serves as collateral. The lender can seize and sell the asset if you fail to pay back the loan.
Tax treatment: The interest on most nonconsumer debts is fully tax deductible, meaning you can deduct the amount of interest you’ve paid on nonconsumer debt from your taxable income each year.
APRs: Nonconsumer loans are much less risky for lenders than consumer debts—loans not backed by appreciating assets—because lenders can always seize and resell the asset if you fail to repay the loan. Since the APRs that lenders charge tend to correlate with the lender’s risk, nonconsumer-debt APRs are generally much lower than consumer-debt APRs. Currently, interest rates on nonconsumer debt are in the 6–8% range, but actual rates change constantly.
Term: Most nonconsumer debts have a specific term that can last anywhere from less than a year to 30 years or more. Having a fixed term is beneficial to borrowers because it ensures that they’ll pay off their debt by a certain date.

Consumer Debts

Consumer debts are most often incurred from everyday spending on goods and services, such as purchases made with credit cards. Auto loans and personal loans—loans made for general purposes, such as the purchase of a major appliance—are other common types of consumer debt.

Collateral: Though some consumer debts can be backed by collateral, consumer-debt collateral tends to lose value and therefore doesn’t constitute a guaranteed repayment of the loan. Say you use a car as collateral on a $5,000 auto loan. As the car ages, it will likely become worth less than the amount you still owe on the loan.
Tax treatment: The interest on consumer debt is typically not tax deductible.
APRs: Consumer-debt APRs are generally much higher than nonconsumer-debt APRs. Currently, consumer-debt APRs are in the 8–20% range, though some APRs are as high as 30%. These rates also change constantly.
Term: Most consumer debts have no specific term. This can be a boon for lenders but a bane for borrowers, who sometimes end up paying high interest rates on consumer debts forever.

Good Debt vs. Bad Debt

Nonconsumer debts are often described as good debt because of their low interest rates, tax advantages, and collateral that tends to appreciate in value. In contrast, consumer debts are considered bad debt because they have high interest rates, no tax advantages, and use no collateral to secure the loan.

This guide focuses on approaches to getting out of bad debt, though several of the debt-management strategies covered here can also help you eliminate certain types of good debt.

Why Credit Card Debt Is a Bad Deal

By far the most common type of bad debt is credit card debt, a type of debt that many debtors don’t entirely understand. Credit cards require you to make a minimum monthly payment equal to about 2–3% of your balance in order to keep using your card: you don’t need to pay off the balance in full each month. For instance, if your current credit card balance is $2,500, you’ll likely be required to pay only $50 or so at the end of the month.

Many credit card holders consider this a “good deal” because it allows them to spend money without having to pay for the goods or services they buy right away. In reality, it’s the cause of most major debt problems. The ability to spend without paying for what you buy right away misleads you into thinking you can spend more than you earn or can afford and get away with it. In truth, because of the high APRs on bad debt, not paying for what you buy right away makes every item on your credit card bill cost much more.

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