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Consumer Loans: Consumer Debt Basics

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Consumer Loans: Consumer Debt BasicsConsumer loans and debt result from the purchase of goods on credit that are consumable and that tend to decrease in value over time.  Using consumer debt and loans unwisely can ruin your credit and cause you to pay thousands of dollars in interest.

Types of Consumer Loans and Consumer Debt

Consumer debt may include all of the following:

Credit Card Debt

A credit card is a card issued by a financial institution giving the holder the ability to borrow funds, generally at point of sale.  Credit card debt results when the funds are not repaid in a timely manner.

Auto Loans

Auto loans are secured by the vehicles that the loans are paying for.  Since they are secured consumer loans, interest rates are generally lower than some other types of consumer loans.

Student Loans

Interest rates on certain types of government student loans are subsidized by the government, and so they remain fairly low.  Additionally, payments on some types of loans may be deferred until after you graduate from college.  Interest rates on private student loans can be quite low for those with good credit.

Payday Loans

Payday loans are short term consumer loans that charge astronomical interest rates and that are secured with a post-dated check, which is then cashed on the appointed date.  Payday loans should generally be avoided.

Home Equity Loans

A home equity loan is secured with the equity in your home.  Since it is a secured loan, the interest rate is generally lower than many other types of consumer loans.  Additionally, the interest you pay on the loan may be tax-deductible.  Defaulting on a home equity loan could cause you to lose your home.

Characteristics of Consumer Loans

Consumer loans come in all shapes and sizes.  Below are some of the more common types of loans:

Secured Loans

Secured loans use assets as collateral in case of default.  Auto loans and home equity loans are common examples of secured loans.  Miss enough payments on this type of loan and you could lose your home or vehicle.  Secured loans generally have lower interest rates than unsecured loans since there is less risk to the lender.

Unsecured Loans

Unsecured loans are not secured by assets.  Unsecured loans tend to have higher interest rates than secured loans and are generally only available to people with good credit due to the risk to the lender.  A credit card is a type of unsecured loan.

Balloon Loans

Balloon loans are loans that are paid back with interest in one large sum at the end of the designated term.

Instalment Loans

Instalment loans are loans that are repaid at regular intervals over a specified period of time.  Both principal and interest are included in each payment.  Mortgages and auto loans are common examples of instalment loans.

Fixed Rate Loans

Fixed rate loans charge a fixed rate of interest over the term of the loan.  Since lenders bear the interest rate risk of a fixed rate loan (the risk of rates rising), interest rates are generally initially higher on a fixed rate loan than on a variable rate loan.

Variable Rate Loans

Variable rate loans have an interest rate that may increase and/or decrease over the term of the loan.  Since borrowers bear the interest rate risk on a variable rate loan, initial rates are generally lower than those of a comparable fixed rate loan.

Sources of Consumer Debt

The cheapest sources of consumer loans may be obtained from the following sources:  family and secured-loan lenders such as a mortgage lender.  The most expensive sources of funds may come from unsecured consumer debt such as payday lenders and credit card companies.  Other sources likely fall somewhere in between.

How to Reduce Consumer Debt Borrowing Costs

You can reduce overall borrowing costs by doing the following:

  • Maintain high FICO scores (most widely used credit score)
  • Obtain debt from inexpensive sources, such as a mortgage lender
  • Don’t borrow from payday lenders or carry a balance on your credit cards
  • Keep the term of your loan as short as you can afford
  • Make a large down payment (if applicable)
  • Take out loans that receive favourable tax treatment (i.e. home equity loan, etc)
  • Take out a variable rate loan instead of a fixed rate (reduces the initial interest rate since the borrower assumes the interest rate risk)
  • Shopping around for the best deal

However, make sure that what you do is appropriate for you.  For example, even though a variable rate loan may lower the initial interest rate, I can think of many scenarios when choosing a variable rate loan would not be the best decision.

Are All Consumer Loans Bad?

I personally don’t think that any type of debt is “good.”  However, certain types of debt are definitely more palatable, necessary, and less expensive than other types.

My personal opinion is that in most circumstances, debt should only be incurred to finance the purchase of the following:

  • A home
  • An education
  • A vehicle (if necessary for work or school)

There may also be valid business reasons to incur debt as well.

Mortgages and education loans are generally seen as more favorable than other consumer loans since interest rates are generally lower, they may receive favourable tax treatment, and the underlying assets will likely appreciate over time.  Most other purchases can wait until adequate funds are available.

By consumer debt, I am not referring to credit card use if you don’t carry a balance.  Personally I love credit cards as long as they are paid off in full each month.

Alternative to Consumer Loans

Most people would be much better off saving up for a purchase rather than using consumer loans to purchase things they can’t afford.

Put your savings in a safe, online savings account or money market account that pays a competitive interest rateOpen up a new account for each major savings goal so that you know exactly how much money you have saved and so that those funds don’t get spent on something else. 

Then, when you have the necessary funds make your well deserved purchase.  Let interest work for you, not against you.

Spending money you don’t have and paying exorbitant interest rates on consumer debt may prevent you from achieving more important financial goals, such as the following:

If you already have consumer debt, develop a plan to get out of debt

Final Thoughts on Consumer Loans

  • Before entering into any consumer loan contract or agreement, carefully read the contract and make sure you agree to the terms and conditions before signing.
  • Take steps to improve your credit before taking out a loan.
  • A budget can help you plan for and save for future purchases.

Additional Reading

For additional reading on consumer debt and consumer loans, take a look at the following books:

What are your thoughts on consumer loans?  When do you think consumer debt might be appropriate?  Leave a comment below!

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