Debt is simply an obligation which requires you to pay cash or some agreed-upon monetary value to another party, your creditor. When comparing debt to other obligations such as a mortgage or rent, debt is clearly not an obligation we want to take on ourselves. While debt is a commitment, unlike most of those listed above, debt should never be considered an automatic solution to financial problems. Debt is essentially a delayed payment, or collection of a debt, that differentiates it from a regular purchase.
Debts come in many forms and types. Debts can be incurred for items such as homes or cars, whereas loans are obligations that are made against specific items. For example, mortgages are obligations to buy a home. A mortgage is an agreement to buy a home. A loan is an agreement to buy a certain item, and the property will be used as collateral in the event you do not make your payments. Because both mortgages and loans are similar in function, both need to be considered when determining whether to use debt or a solution such as a home equity loan.
The first question you must answer when comparing debt to other financial obligations is whether the debt itself is “secure” or “unsecure”. This answer is determined by taking two factors into consideration: interest rates and credit ratings. Interest rates refer to how high the lender is willing to lend you money. Credit ratings are a measure of how credit worthy a consumer you are. When considering whether or not to use debt, you must consider how financially sound you are and whether or not you will be able to make the monthly payment requirements. Most unsecured debt, such as credit cards and personal loans, have low interest rates and can be handled by almost anyone.
When comparing debt to a solution such as a home equity loan, it is important to remember that both utilize a form of leverage. Leverage refers to the ability to borrow against the equity in your property. If you are able to repay the amount borrowed in a timely manner, your lender has secured a debt. However, if you are unable to keep up with the payments, your lender has nothing to secure the debt but your home. A home equity loan is often referred to as a second mortgage.
Another way to compare debt to other financing options is to examine your debt to income ratio. The debt to income ratio is the total amount of debt relative to your current disposable income. Ideally, this ratio should be no more than 40% of your disposable income. In order for your debt to be considered “secure”, your lenders ratio must be less than 40%. Typically, lenders will require a five percent down payment in order for you to qualify for an equity loan.
Many individuals mistakenly believe that when working with private investors that they are not being charged a fee for their services. While it’s true that these firms do not charge fees for their services, they are also not allowed to give you any equity in your home or debt ratios. As with all lending programs, these firms are looking for the highest return on investment possible. If your debt to income ratio exceeds 40%, these investors may decline your application. It’s always best to discuss these and other potential financing options with an experienced debt consolidation consultant.