What are the different types of unfavorable loans?

debt

Studies indicate that the typical American owes over $90,000, but is this always a bad thing?

If you can't repay any of it, then it becomes a significant issue. However, some debts can enhance your financial portfolio and create new opportunities when handled responsibly.

But what about the unfavorable loans? These bad debts complicate budgeting and can start a vicious cycle, making it hard to keep up with payments.

What distinguishes the two primarily are the interest rates charged and how you manage the debt.

Here's how to steer clear of bad debts and consider better alternatives.

Understanding Bad Debts

What Are Bad Debts?

Bad debts are those you can't repay, don't add to your net worth, or lose value over time. They can damage your credit score, especially if they push your debt-to-credit ratio too high by using too much available credit. Examples include payday loans with high-interest rates, high-interest credit cards, uncontrollable expenses, personal loans for non-essential items, and risky loan shark deals. We'll also explore 'good' loans that can help you buy significant items that might otherwise be unaffordable.

Categories of Bad Debt

Bad loans can quickly become overwhelming if not managed properly, leading to a cycle of increasing debt. It's best to avoid these types of loans altogether and focus on borrowing that supports your financial well-being. To steer clear of bad loans, it's advisable to avoid the following:

Payday Loans

Payday loans can be tempting for quick cash when traditional loans are slow to process, but they should be a last resort. These loans are notorious for their extremely high interest rates, which can range from 391% to 521%. This means you could pay $15-$30 for every $100 borrowed. Some payday lenders charge even higher rates, exacerbating bad debt. Additionally, there may be extra service and late fees aimed at pressuring you to repay the loan quickly.

Loan Sharks

Loan sharks are even more dangerous than payday lenders. They target vulnerable individuals by offering loans without background checks or credit score requirements. Similar to payday loans, loan sharks charge exorbitant interest rates and demand swift repayment. However, unlike payday lenders, loan sharks may resort to threats or violence if payments are not made on time. Borrowing from a loan shark can severely worsen your financial situation.

High-Interest Credit Card Debt

High-interest credit cards can make it challenging to manage monthly payments. Like any other loan, missing payments can harm your credit score. If you have high-interest credit card debt, it's best to pay off the full balance each month or consider consolidating it into a lower-interest loan.

Credit cards are often used for purchases that don't add to your net worth or that depreciate in value, such as vacations, toys, baby strollers, and other everyday items.

Auto Loans

Purchasing a car might seem like a good investment, but cars lose value quickly, beginning as soon as you drive off the lot and continuing to depreciate at a slower rate over time. This depreciation is influenced by factors such as mileage, warranty length, fuel economy, condition, and service history.

If you're considering buying a car, you might want to opt for a used vehicle, which depreciates more gradually. Alternatively, leasing a car instead of buying a new one could be a better option. Keep in mind that auto loans often come with high interest rates, which can increase further if your credit score is low.

How to Steer Clear of Bad Debt

Breaking free from bad debt can be tough and stressful. To improve your financial situation and prevent falling into similar debt problems in the future, focus on managing your current bad debts and follow these steps:

Consolidate your debts

If you’re having trouble managing several loans or debts, consider taking out a low-interest personal loan to consolidate them. This approach can lower your overall interest payments and simplify your financial management by reducing the number of payments you need to make. With fewer, more manageable payments, you’re less likely to fall behind.

Create an emergency fund

Setting aside money for unexpected situations is always wise. Aim to save enough to cover 1-3 months of expenses in case you lose your primary income. Having an emergency fund ensures you’re prepared for unforeseen expenses and can handle financial surprises without resorting to debt.

Invest in your future

Prioritize obtaining credit that benefits your long-term financial health. Rather than falling for short-term cash solutions that may be costly over time, explore alternatives to bad debt such as long-term loans, low-interest personal loans, and home equity options. These can help manage expenses while avoiding high fees and interest rates.

Alternatives to bad debt

Fortunately, there are several alternatives to bad debt that can provide the funds you need without leading to a cycle of late payments and fees.

If you require money for significant expenses, consider the following options:

Personal loan

A low-interest personal loan is a viable alternative to bad debt. Unlike high-interest loans, a personal loan typically offers more manageable rates and can be used for point-of-sale purchases while improving your credit through regular payments. Personal loans usually range from $1,000 to $8,000, making them suitable for everyday expenses rather than large purchases. Additionally, if you have multiple high-interest loans, you might use a personal loan to consolidate them, which can reduce your overall interest payments.

HELOC
A home equity line of credit (HELOC) provides a revolving credit source similar to a credit card. It can be used for significant expenses like home improvements or education costs. To qualify for a HELOC, you'll need a strong credit score and sufficient home equity. The main benefit of a HELOC is its flexibility, allowing you to withdraw funds as needed, making it suitable for covering ongoing or unpredictable costs.

Cash-out refinance
A cash-out refinance involves taking out a new mortgage that exceeds your current loan balance, with the extra funds provided to you in cash. This process enables you to access the equity you’ve accumulated in your home. Typically, the new mortgage comes with a lower interest rate compared to your existing loan.