In economics, personal debt is the total amount owed by non-homeowners. It includes outstanding debts on purchase of consumable goods and/or don’t appreciate as fast as house prices. In financial terms, it’s a debt that is used primarily to finance consumption rather than long-term investment. Personal debt has many forms such as: credit cards, medical bills, auto loans, overdrafts, personal loans, store cards, back taxes and more.
By definition, personal debt is any debt that a consumer owing someone else. Usually, this means credit card balances. The trend is expected to continue for the next few years, with consumers owing more in personal debt than on house equity. The question becomes how much debt should you tackle? How much debt can you pay off in your own lifetimes without running into financial trouble?
This depends on several factors such as current interest rates, duration of past due accounts and balance to maturity dates of each account. For example, a credit card balance that sits at 20% of the credit card balance owed will have a lower interest rate than the same balance due today. Likewise, the longer it takes to pay off the old debt, the higher the interest rates on the new debt. Many financial experts advise planning to pay off the most high-interest debt first (such as store card debt) to reduce the financial strain in the next years.
Another important factor is the consumer leverage ratio, or the debt to income ratio. This tells us how much debt we can handle. The ratio is calculated by dividing the debt owed by the annual income of the household. It’s better to owe less debt, but the higher the consumer leverage ratio, the greater financial risk of handling high debt loads. For example, if a couple has a combined total of ten thousand dollars in credit card debt, their annual income might be just above five thousand dollars, which would qualify them for a high-leverage debt ratio.
The length of time to pay off debts also affects the interest rates. The longer it takes to repay a particular account, the higher the interest rate. Credit cards with the lowest interest rates are often the best choice for consumers with plenty of consumer debt. High-rate credit card balances tend to attract more interest fees and penalties because they are harder to pay off in a shorter period of time. A plan to repay all outstanding accounts within ten years is recommended to keep the total debt to income in control.
Another factor affecting debt payments is whether the accounts are secured or unsecured. Unsecured debt like store cards carry variable interest rates because the lender cannot collect a loan until the account is paid in full. The advantage of this type of debt is that interest charges can be avoided by simply paying off the account in full each month. However, a consumer needs to realize that the longer it takes to pay off unsecured consumer debt, the higher the interest rates will be on future purchases.
One area where it makes sense to consolidate student loans and other consumer debt is when the repayment timeline is near the end of its grace period. A good rule of thumb is to pay about fifteen percent of the outstanding balance each month. In order to avoid accumulating too much interest, it makes sense to put as much money toward the principal as possible. Once the grace period is complete, borrowers can begin making monthly payments toward reducing consumer debt.
One of the best ways to pay down a student loan debt faster is to transfer balances onto a consolidation plan that offers a one-time, low-interest rate payment. Ideally, the new interest rate should be about two percent lower than the current average balance. By paying down the most important accounts first, borrowers can get rid of a lot of debt in a relatively short amount of time. Paying off student loan debt makes long-term financial sense. As a note, graduates planning to go into the corporate world should make sure they pay their credit cards off at the end of every year.