- Household debt is money people borrow to handle expenses, some necessary, some not.
- Most adults in the U.S. have some debt, and use it without major problems.
- Household debt comes in two main forms: installment loans and revolving credit.
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Borrowing money is a normal part of managing a household. It can help you afford things you want and need, and can even be a tool for building wealth over time. But debt can also create problems if mishandled. A key to using household debt effectively is to understand how it works.
What is household debt?
Household debt is money consumers borrow to cover expenses.
Household debt comes in two main forms: installment loans and revolving credit. Understanding the difference between the two can help you pick the one that best meets your needs.
An installment loan is money you borrow with repayment terms that are set in advance. You borrow an agreed-upon amount up front, on a predetermined schedule for paying it off.
Most installment loans have a fixed interest rate. The monthly payments will be the same for the life of the loan and are laid out when you sign up for the loan.
The fixed interest rates and monthly payments on most installment loans make planning easier. You know from the start how much of a payment you’ll have to come up with every month, and how long you’ll be making payments.
While installment loans have the advantage of being predictable, they aren’t very flexible. Once you’ve borrowed the money, you’d have to apply for a new loan if you need more. You also don’t have any choice over how much you’ll have to pay each month.
Revolving credit allows you to borrow, repay, and borrow more as needed. The most common type of revolving credit is credit card debt, though other lines of credit such as a HELOC can be used in a similar way.
A nice thing about revolving credit is that it’s on-demand. You don’t have to apply for a new loan every time you use it. You can dip into your account whenever you need it.
You also have some flexibility in how much you pay back each month, so long as you meet the minimum. The minimum monthly payment on credit cards is usually fairly small. When you have more money available, you can make a bigger payment to pay the balance down faster. If money’s tight, you can stay up to date with just a small payment.
In reality, that flexibility can be tough to manage. It’s easy to spend a lot and only pay back a little. Credit card debt is a trap many people fall into. If you keep borrowing, making only a small payment can mean the balance you owe grows over time. This generally results in paying a lot of money in interest.
Why is it important to understand household debt?
Understanding household debt helps you use it successfully. This means being able to pay it off on time, and also choosing the best type of debt, or even no debt at all, for each situation.
When trying to understand any kind of household debt, ask these three questions:
1. How much money will I have to come up with each month?
For installment loans, unlike with revolving credit, the monthly amount you owe should be laid out on a schedule you can review before you borrow. That gives you a chance to figure out in advance how those payments will fit into your budget.
2. Can the monthly payment vary?
Find out whether your monthly payment is subject to change. For example, credit card minimum payments vary with your balance. Even some installment loans, like adjustable-rate mortgages, can have fluctuating payments. Changing payments can make the debt harder to afford.
3. How much will this debt cost me in the long run?
Affordable monthly payments are only part of the equation. You should also look at how much the debt will cost overall and whether it’s worth it to you to pay that much for whatever it is you’re buying. For example, the interest on a 30-year mortgage at 5.5% could be more than the purchase price of the home. Most of us take on the extra expense willingly. But would you want to pay double or triple the purchase price for a pair of shoes or a cup of coffee? It’s a consideration if you’re carrying credit card debt for unnecessary expenses.
Common types of household debt
Here are some types of household debt you’re likely to encounter at some point:
Student loan. This is often a person’s first experience with debt and can help a young adult establish credit.
Credit card debt. This is a type of revolving credit that is easy to use but can get expensive if you routinely carry a credit card balance.
Auto loan. The average new car loan takes nearly six years to pay off.
Mortgage loan. A mortgage is a loan for (and guaranteed by) a home or other real estate.
Personal loan. Personal loans tend to cost more than loans tied to collateral, like mortgages and auto loans.
Why household debt can be a problem for families
Debt isn’t always easy to handle. Here are three reasons why people can run into problems with debt:
Household debt often represents a long commitment. Debt can last a long time.
Debts can overlap. People often end up with more than one form of debt at once. For example, you may still be paying off a student loan by the time you get a car loan and a mortgage. This means juggling multiple payments and due dates, and a bigger budget.
Life is unpredictable. A lot can happen in the time it takes to pay off a debt. You might borrow money at a time when you can easily meet the scheduled payments. But then a job loss or a new expense may make those payments harder to afford.
Strategies for managing debt and achieving financial stability
Here are some tips for using debt successfully:
Plan before you borrow. Being able to pay oft your debt is what’s important. Know what payments you’re going to have to make and how you’re going to come up with that money.
Focus on what’s comfortable for your budget, not what someone else says you can afford to pay. Lenders will tell you what payment they think you can afford, but it might be a number that strains your budget. Remember to compare the payment amount with the actual money you have to spend.
Leave room for future needs. Debt is usually a multi-year commitment. In the time it takes to pay off your debt, you might also have kids, buy a car or a home, or move. You should also be setting aside money for retirement. Consider the effect of the debt on your other financial priorities.
Choose the right type of debt for the situation. Credit card debt is more convenient than installment loans, but generally more expensive. The best time to use a credit card is when you can pay it off quickly.
Compare offers. Whatever form of debt you choose, interest rates and other terms can differ a great deal. Do a little homework before you choose.
Update your plan regularly. A lot can happen between the time you take out a loan and when you pay it off. Update your budget regularly to keep your budget on track.
How do you calculate household debt?
One way to calculate household debt is to add up all the debt a household owes. Here’s an example:
Mortgage balance: $210,000
Car loan: $18,000
Credit card balances: $4,800
Student loan: $12,000
Total household debt: $244,800
How long does it take to pay off debt?
If you attack your debts aggressively (not including the mortgage) it’s possible to pay them off in 2-5 years.
If you are paying an installment loan as agreed, the payoff time depends on the loan’s term. A 30-year mortgage takes 30 years to pay off.
How much debt is too much?
An important sign that you have too much debt is if you struggle to make your payments from month to month.
Another red flag is if you usually carry a credit card balance. Even if you’re keeping up with your payments, carrying a credit card balance dramatically increases the cost of everything you buy with the card. Look at your total year-to-date interest charges on your next credit card statement and ask yourself if you’d rather have that money in the bank. If the answer is yes, you might have too much credit card debt.