Managing Debt
What is "good debt" and "bad debt"?
Good debt is debt that is invested in an appreciating asset, an asset that actually increases in value or has the potential to. A good example of "good debt" is mortgage, because, hopefully, your house is going to increase in value. Another example of "good debt" would be your education. You take out student loans, but what that does is increase your earning power over your lifetime. An example of "bad debt" is a depreciating asset, such as a car loan, for example. The car loses value as soon as you drive it off the lot. You might take out a loan for it, but you don't want to get in too much over your head, becuase it's not really great debt. Credit card debt is another prime example of "bad debt," because you're buying things that very likely you're going to use up very quickly. So, you may owe money on things that you've already eaten, or worn, or used.
What is the difference between "deferment" and "forbearance"?
Forbearance and deferment are both terms that you're going to hear associated with student loans. Deferment means that it's something that you're legally entitled to. You're actually allowed to defer repaying your loans in certain circumstances. For example, if you go back to school or you're unemployed. So if you're in those situations you should definitely take advantage of the deferment. Forbearance covers situations that aren't covered by deferment. It's not legally written into the law that you can suspend payments on your loan temporarily, but if you hit a rough patch, you get in touch with your lender you ask for forbearance. You throw yourself on the mercy of your lender and say "Hey can I have six months until I'm on my feet again?", and usually the lender will grant you forbearance. But if you hit more than one rough spot you have go back to the lender each time and ask for help.
What is the secret to managing a student loan?
The secret to managing a student loan is to find a way that you can pay it off. If you have a number of student loans what you can do sometimes is consolidate them into a single loan to make your payment easy. Sometimes you can even lower the rate on that loan. But even if you don't, just the convenience of having a single payment can be very helpful. You also want to make sure that it fits into your budget. Sometimes there are ways that you can re-negotiate your student loan so that you start out with lower payments, especially if you have a lower paying job, and then increase your payment as your income increases. Also, there are jobs that you can get that wherein you might actually have some of your student loans forgiven. If you are teaching or working in a low income school district, for example, that may be something that would qualify for loan forgiveness. So you need to look into all these alternatives and see which one fits the best in your budget.
How much debt is too much?
There are a couple of ratios that you can use to figure out how much debt is too much. If you've got a mortgage, the ratio that lenders usually use is wanting your mortgage loan along with, for example, the insurance and other things that you have to pay on that mortgage to be no more than 28 percent of your total gross income, and they don't want your total debt including all your other debts to be more than 36 percent of your gross income. So, that is one benchmark that you can use to decide how much debt is too much. If you don't have a mortgage and you're just starting out, another kind of quick debt benchmark is that your installment and revolving credit shouldn't be more than 2 percent of your take-home pay. So, those are two things that you can use to see if you're in over your head debt-wise.
What interest payments are tax deductible?
For an individual, the interest payments that are tax deductible would be the mortgage interest payments that you make, interest payments on a home equity loan, and also a certain amount of student loan interest, up to $2500, a year, is also tax deductible, assuming that you meet certain income limits. Those would be the main personal situations in which interest would be deductible.
How can I figure out my "after tax" interest rate on tax deductible debt?
There's actually a handy-dandy little formula that lets you do that. The formula is this: it's 1 minus your tax bracket, times the interest rate. So a little illustration here. Let's say you have a 6% mortgage, and let's say you're in the 25% tax bracket. You would take 1 minus .25, which is your tax bracket, that gives you .75. You multiply that times 6%, the interest rate, and your after-tax interest rate is actually 4.5%.
What is "refinancing"?
Refinancing means you renegotiate the terms of the loan, usually because you can get a loan at a lower interest rate. So you take out the loan at the lower interest rate, you pay off the old loan at the higher rate, and then you begin new payments on the new loan at the lower rate.
