The Complete Guide to Managing Consumer Debt

What is consumer debt? It may sound scary, but part of financial empowerment is getting comfortable with the idea that well-managed debt is not necessarily a bad thing! 

In the first part of our money series, Credit 101: The Ultimate Guide to Managing Credit, we made a deep dive into the world of credit. This time, we’re going to be exploring debt.

What’s the difference between good debt and bad debt? How can you make debt work for you? How do you recover from bad debts and develop a debt management plan? Can consumer debt counselors help you succeed?

Let’s find out with our deep dive into debt management!

What Is Consumer Debt?

Consumer debt refers to all personal debts that are owed as a result of purchasing goods or services used for individual or household consumption.

Types of consumer debt include:

• Credit card debt
• Personal loans
• Auto Loans
• Medical Loans
• Home Equity Loans / Home Equity Lines of Credit
• Payday Loans
• Mortgages
• Student Loans

Consumer debt is measured on a national level via the consumer leverage ratio (CLR), which is the ratio of household debt to disposable personal income.

Some economists argue that the rapid increase in this ratio in recent decades has been a net benefit due to its driving economic growth. Others argue that it’s increased overall risks in the American economy. 

On an individual level, many Americans struggle with debt due to the ease of obtaining credit and a misunderstanding of good debt versus bad debt.

Part of becoming financially empowered is educating yourself, though; you’re here to learn how to differentiate between types of debt, so you’re already on the right track!

Revolving vs. Non-Revolving Debt

A revolving loan is a loan that allows the borrower to access funds as needed up to a maximum amount determined in advance. As they pay back the amount they have borrowed, it becomes available to borrow again.

A home equity line of credit (HELOC) or credit card would be an example of a revolving loan. A non-revolving loan is a one-time loan, such as a mortgage or personal loan.

Revolving loans often have variable interest rates, while non-revolving loans can have either fixed or variable interest rates. 

Secured Debt vs. Unsecured Debt

A secured loan is a loan that is ‘secured’ by some form of collateral. This means that if the borrower doesn’t pay back the loan, the lender has legal right to recover its losses by seizing the collateral.

For example, a mortgage or home equity loan/line of credit is secured by the home; if the borrower doesn’t pay the loan back on time as agreed upon, the lender can foreclose upon the home and sell it to recoup the loan.

Since secured debt generally has a lower risk for the lender, interest rates are often lower as well. 

Types of secured debt include:

• Mortgages
• Home Equity Lines of Credit (HELOC)
• Home Equity Loans
• Auto Loans

An unsecured loan does not have any collateral attached as security. Defaulting on an unsecured loan can hurt your credit, but the lender can’t take away your home, car, or other property. 

Types of unsecured debt can include:

• Personal loans
• Credit cards
• Medical loans
• Payday loans
• Student loans

Good Debt and Bad Debt

It’s natural to think that being in debt is a bad thing. This thinking is ingrained in many Americans. But debt in and of itself isn’t a bad thing.

It’s about how you manage it and whether you’re using debt strategically as part of a well thought out plan. So, let’s look at some differentiators between good debt and bad debt.

Appreciating vs. Depreciating Assets

One of the fundamental differences between good debt and bad debt is the purpose for which you’re using it.

There are two types of assets. Appreciating assets generally gain value over time (although there are no guarantees and short-term fluctuations may occur). Depreciating assets generally lose value over time.

Going into debt for a loan secured by an appreciating asset can be a smart move. You’re betting that the amount you’ll pay over the life of the loan will be less than the gain you could make from the increasing value of the asset the loan is secured by (in the case of a mortgage for your primary residence, this includes the value of living in a home that you own instead of renting one).

Going into debt for a loan secured by a depreciating asset is different; you’re paying interest for something which is generally declining in value while you’re still paying for it. This is sometimes unavoidable; few Americans, for example, can pay cash for a new car.

However, going into debt for a loan secured by depreciating assets should be deliberated before making a commitment.

Good Debt (Mostly) 

Mortgages

A mortgage is the most obvious example of good debt. Some indicators of consumer debt specify mortgage debt separately from other consumer debt because real estate is, under most circumstances, an appreciating asset. 

Most experts consider real estate a stable and fruitful investment. Historically, housing prices have risen over time. When you take out a mortgage, you may gain equity in your home as you pay it down.

Equity is the difference between how much your home is worth and how much you owe on your mortgage. You can leverage this equity to access home equity loans and home equity lines of credit and these types of loans can often have more advantageous terms than unsecured loans. 

Housing is a necessity, and the vast majority of adults have to either buy or rent their home. In many cases, it’s considered a smarter long-term solution to take out a mortgage to own a home instead of renting.

When renting, the landlord is the one gaining the equity in the home, and you’re effectively paying for their investment. By taking out a mortgage, you are the one gaining any potential equity.

Tips for Getting a Mortgage

You’ll want to take several things into account when taking out a mortgage: 

• Closing and up-front costs: You’ll typically pay 3–5 percent of the purchase price in closing costs (title, appraisal, and other administrative costs). You may also need to pay a down payment up-front, depending on the type of loan and your individual circumstances. 
• Interest versus principal: When you make a mortgage payment, that payment is allocated first to the interest accumulated. The principal, or loan balance, is paid only after interest is satisfied. This means payments in the early years of a mortgage will go almost entirely towards the interest, with only a small portion paying down the principal. But as the principal balance goes down, so does the interest that it accumulates, so each month will have a little less interest accumulated and a little bigger bite taken from principal. 
• How long will you live there? Since it takes time to make progress in paying down your principal, and short-term fluctuations may occur, your primary home is a stronger investment if you plan to live there long-term. That means buying a home big enough that you won’t outgrow it, while at the same time not buying more house than you can afford. Renovating and adding on, when possible, can help your home grow with your family while improving your home’s value.

Real Estate Investment Debt

See, debt isn’t automatically a bad thing! For example, most people can’t pay cash for a new home, but going into debt for a new home may allow you to build equity, which may unlock the availability of home equity loans or lines of credit.

When moving to a new home, some homeowners choose to rent out their old home as an additional revenue stream, instead of selling it. It’s also possible to buy additional homes as an investment and rent them out.

While having a mortgage on multiple homes increases your debt, you’re earning any equity that may accrue in your rental properties, while profiting from any rental income that exceeds the mortgage. For some, this can become an additional or even a primary income stream.

Student Loans

Student loans, in some ways, are also an investment. Whereas a mortgage allows you to invest in a home or other real estate, a student loan is an investment in your future.

Education pays off. According to the U.S. Bureau of Labor Statistics, each increase in education level carries with it a substantial average annual salary increase. The unemployment rate also decreases with each level of education.

• No high school diploma: 5.4% unemployment rate, $30,784 annual salary
• High school diploma: 3.7% unemployment rate, $38,792 annual salary
• Associate Degree: 2.7% unemployment rate, $46,124 annual salary
• Bachelor’s Degree: 2.2% unemployment rate, $64,896 annual salary
• Master’s Degree: 2% unemployment rate, $77,844 annual salary
• Professional Degree: 1.6% unemployment rate, $96,772 annual salary
• Doctorate: 1.1% unemployment rate, $97,916 annual salary

While it’s preferable, of course, to pay in cash or get scholarships and grants to cover educational costs, student loans can be a smart investment in your future. This is because not only does a higher level of education generally mean a higher average salary; it also generally means greater employability.

It is important to consider all the factors when considering student loans. It’s important to have a plan for your education and career and a general idea of how your chosen field of study will suit you.

Also, historical data is not a guarantee of future trends. However, if you’ve done your research and have a plan, student loans can pay huge dividends for your future income potential.

Good Debt? Bad Debt? It Depends on How You Use It 

What is consumer debt? Consumer Debit can fall under several categories.

Auto Loans

Cars are a classic example of a depreciating asset. You’ve heard the saying, “The minute you drive a new car off the lot, it loses about 10 percent of its value.”

New cars typically lose about 15–20% of their value each year, with the sharpest drop coming in the first couple of years.

Depreciation varies based on everything from brand to model to condition to color. Some classic cars hold or increase their value, but they are exceedingly rare and usually already very expensive.

Additionally, changes in the economy may cause the rate of depreciation to fluctuate when it comes to cars.

However, a car is a necessity for many Americans, and cars are expensive enough that few people can afford to pay cash for one. So, while an auto loan may not be ‘good’ debt, it is often necessary debt.

Tips for Buying a Car

There are some smart moves consumers can make when buying an automobile:

• Buy used: Since the biggest loss of value comes in the first year, buying late-model used cars avoids the biggest depreciation hit. Many automakers offer certified pre-owned vehicles, where they carefully inspect and recondition late-model used vehicles and offer a manufacturer’s warranty on them.
• Do your research: Know the resale value of different cars, and since most dealerships negotiate prices, know their costs.
• Buy and keep: Being upside down on a car means you owe more than it’s worth because of its rapid depreciation. Dealers will let you trade-in a car that is upside down to get a new car, adding the amount you still owed on the old car to the purchase amount of the new car, but then you’re even more upside down on the new car. If you’re going to buy a new car, it’s best to hold on to it until you’ve paid the loan on your current car down enough to at least break even on resale value.
• Comparison shop: Many automakers offer promotional APRs for new or pre-owned certified used cars. It’s also a good idea to get a quote for an auto loan from your preferred bank or lender for comparison.

Don’t confuse an appreciating asset with a depreciating one. A house is a necessity but also an investment. Likewise, a car is just a necessity and generally not an investment in the asset. 

Avoid buying cars you can’t afford and prevent your auto debt from spiraling out of control by trading in too often.

Home Equity Loans and Home Equity Lines of Credit (HELOCs) 

Home equity loans and HELOCs are powerful financial tools, and access to them is one benefit of building equity in a home. They generally provide flexible access to funds at lower interest rates. But does using these types of loans create good debt or bad debt? That depends on what you’re using them for. 

A home equity loan is disbursed as a lump sum and paid back according to a set schedule. A HELOC is a revolving line of credit accessible for a set term, usually several years, followed by a payback period where you cannot use the revolving funds any longer and instead focus on repaying what you had previously borrowed.

Borrowers may use these types of loans for debt consolidation, home improvements and renovations, educational expenses, vacations, big-ticket consumer items, or many other options.

It’s best to carefully consider how you’re using the funds and have a strategy to pay them back. Most experts recommend keeping your personal level of consumer debt to 20% or less of your take-home pay (not counting mortgage, of course).

If you use a home equity loan product for home improvements, for example, that can increase the value of your home. If you have a cash shortage or an unexpected large expense, a HELOC can be a powerful tool in your hip pocket to handle it.

Using credit like this to live beyond your means, however, can be dangerous. It’s not automatically a bad thing to finance things like a big-screen TV or a vacation using revolving credit, but do so thoughtfully, with a plan on how long you’ll take to pay it off. 

Credit Cards

Credit cards, like HELOCs, are an excellent tool for flexible cash access, but as an unsecured loan they generally have higher interest rates than HELOCs or other secured loans.

However, they also generally have very flexible payback options, with most credit cards allowing you to make a minimum payment that covers the interest each month. This provides outstanding flexibility for consumers, and, like HELOCs, it’s important to use them responsibly.

Credit cards provide some benefits without even going into debt. ​​You don’t have interest charges if you pay off your balance in full each month. Credit cards offer anti-fraud protections and the ability to dispute charges if services aren’t rendered.

Some credit cards have rewards programs that allow you to receive cash back or travel benefits when you use them for everyday purchases.

Credit cards can also help you manage an unexpected expense, emergency or tide you over through a short-term cash shortage.

The important thing is to use them with consideration; going on a spending spree can leave you with debt that will limit your financial options in the future.

Personal Loans

Personal loans are a great tool for home improvements, debt consolidation, medical bills, or big purchases. But like other types of consumer finance loan products listed here, their status as good or bad debt depends on how you use it. 

Fortunately, most people take online loans out for a specific reason, and these are smart tools for financial empowerment.

Consumers can take out a loan of the amount they need for a particular purpose, with a set payment term and a reasonable interest rate.

So, using a personal loan to consolidate debt, handle large expenses, or make home improvements or other investments in your future just makes sense. 

Recovering From Bad Debt

Not everyone is starting from a place of perfect credit. Many Americans are struggling to pay off existing bad debt. And that’s ok; the important thing is that you’re working to become financially empowered.

You can climb your way out of debt and begin using debt as a tool instead of an anchor pulling you down! 

Create a Debt Management Plan

Believe it or not, creating a debt management plan isn’t as hard as it sounds! Just follow these easy steps, and you’ll be on the road to getting your debt under control.

1. Add up your debts: Create a list of all your debts. This includes credit cards, student loans, medical loans, personal loans, home equity loans, and HELOCs, etc. List the name of the lender, the total amount you owe on the loan, the minimum payment, and the interest rate.
2. Build your budget: Next, build a budget. Account for your income and monthly expenses, including the minimum payment for each loan. Commit as much as you can of the amount remaining after your expenses to paying down your debt.
   • Cut expenses: The more money you can put toward debt reduction, the faster you can pay your debts and the less interest you’ll pay in the long run. When budgeting, keep an eye out for ways to lower your expenses.
3. No more debt: Debt is not a bad thing, but if you’re already struggling to pay down existing debt, it’s best not to add more debt. That being said, since your credit utilization ratio and average account age factor into your credit score, you may still wish to keep your revolving credit accounts open even after paying them off.

Snowball vs. Avalanche Method

There are two primary strategies experts recommend for paying down debt such as the avalanche and snowball method. Either way, experts recommend focusing on one debt at a time, while making the minimum payments on the other debts.

• Avalanche method: The avalanche method involves a focus on paying down the loan with the highest interest rate first, and once it’s paid down, you focus on the loan with the second-highest rate. Rinse and repeat. This saves you money in the long-term on interest. But since it may take a while to pay off the first debt, many consumers report getting frustrated and struggling to stay motivated.
• Snowball method: When using the snowball method, you pay down the loan with the lowest balance first. Then keep moving on to the next largest loan. This doesn’t reduce your interest charges as quickly, but seeing tangible results earlier keeps many consumers motivated.

Consumer Debt Counseling 

What is consumer debt counseling, and what can consumer debt counselors do to help you?

Consumer debt counseling helps consumers establish a debt management plan and can sometimes negotiate with lenders to consolidate consumer debt in one monthly payment with a goal to become debt-free in 3–5 years. 

You’ll want to look for an accredited nonprofit agency; a good place to start is the National Foundation for Credit Counseling. A reputable agency will have the mission of helping consumers get out of debt and gain financial knowledge. 

Handling Cash Shortages

Here at the Prosper blog, we talk a lot about putting your money to work for you. Money is a powerful tool to generate more money and solidify your financial empowerment. If your money is sitting stagnant and not earning interest, it’s not at work.

However, unexpected expenses happen, and you need a plan to deal with them. You build wealth by making your money work for you. But sometimes bills come due or an unexpected payment comes in.

And it’s not always possible to liquidate an investment in a timely fashion to pay those unexpected bills without paying a penalty. So sometimes, taking out a loan is the best strategic decision when you consider the money your investments are making and the opportunity cost of using your liquid funds to pay for an expense.

Prior planning is key in this scenario. If you have an unexpected expense, especially an emergency, knowing your options can help you make a financially empowered decision.

Especially when interest rates are at historic lows, it makes sense to keep your liquid funds to a minimum and invest them wisely while strategically taking on debt as needed for emergencies.

Good Debt and Bad Debt: It’s All How You Use It

What is consumer debt? We hope you have a better understanding of this topic, how to understand the difference between good and bad debt, and how to use debt strategically as part of your overall financial empowerment. 

Investing in your future? Good debt. Debt that enables you to make smart financial decisions? Good debt. Living beyond your means? Not so good debt. It’s all about making careful and far-sighted decisions.

Debt means making a commitment now to pay for something in the future. It’s only smart to think about the future before making that commitment.

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Depending on the lender, qualified home equity applicants may borrow up to 80% – 95% of their primary home’s value and up to 80% – 90% of the value of a second home. In Texas, qualified applicants may borrow up to 80% of their home’s value. HELoan applicants may borrow up to 85% of the value of an investment property (not available for HELOCs).

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