While the thought of living completely debt-free may sound like financial freedom, it's not always feasible or smart. While you should avoid a significant amount of debt due to the interest it will accrue, it's important to understand the difference between good interest and bad interest. Let's dive into the importance of debt, and why some interest is beneficial while some can be detrimental.
Why Having Debt is Important
In short, debt (when paid off according to your agreement) equals credit. If a company has no history of your debt repayments, they have no way of knowing you will pay a future loan off promptly.
It's unlikely that you'll be able to live your life without accruing some form of debt from buying a home, a car, or even funding your education. But even if you did have the means to pay cash for these high-ticket items throughout your life, your credit score would suffer and lead to difficulties with future purchases — even smaller purchases like a phone plan.
That's why having some debt important, and it's even more important that you pay off your debt according to your loan terms.
What is Bad Interest?
Bad interest is associated with high interest rates and is usually the result of a revolving line of credit where the items you purchase have little value. These purchases are seldom considered necessities. An example of this would be store-specific credit cards.
If you have store credit cards to take advantage of additional savings and shop sales, you won't save money unless you pay off your purchases within that billing cycle. Never drag these balances out for several months because you will pay a significantly higher amount of interest for something that loses its value right when it leaves the store.
Another example of bad interest is a payday or cash advance loan. These loans are appealing because of the quick cash and low credit requirements offered, but they generally have super high interest rates, and you will likely pay on them longer than you anticipated. With this "bad interest," you may end up paying almost three times the amount you originally borrowed.
These bad interest practices can damage your credit score and cost you more money in the long run, so they should be avoided. However, there are better ways to use good interest to your advantage.
What is Good Interest?
Good interest results from purchases that are considered necessities and have lower interest rates. A perfect example of good interest is a mortgage. Mortgage rates are lower so that you can build equity in your home eventually turn it into an asset. Compared to the purchase value of your home, the amount of interest you pay for the length of the loan is a good trade-off. Additionally, the cost of the loan plus interest will often provide you with an asset or future collateral if ever needed. A good mortgage payment history can have a significant and positive impact on your credit profile. Making timely monthly mortgage payments can do a lot to raise your credit score.
Most loans with good interest require some form of collateral from you, be it a down payment, home equity, or something else. Good interest loans help you to achieve a lower interest rate since the risk of loss is decreased for the financial institution. With all interest, you take a certain amount of good in with the bad.
Pay attention to interest rates when taking out any kind of loan or credit card. Credit unions like RMCU generally offer lower interest rates on credit cards, vehicle loans and mortgages than banks, for example.
For most of us, being in debt is unavoidable. Find comfort in knowing the difference between good and bad interest, and pay special attention to interest rates when deciding whether it's worth it to take out a loan or a credit card. Need more information about low-interest loans and ways to improve your credit score? Reach out to RMCU and a member service representative will be happy to help answer your questions!
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