In the West, we’re used to living above our means, by borrowing money to pay for what we can’t afford. Bad loans – or bad debt – is one of the most destructive behaviors we can do to our personal finances, yet many people don’t quite understand just what bad loans are, or how to identify one.
Most of the time, people would push away from finding solutions to their debt in hopes that it would fix itself. In reality, the only solution is to manage your debts of any size and to make sure it doesn’t get out of control.
In this post I’ll explain just what bad loans are, and actionable steps you can take to start getting yourself out of one.
So, What are Bad Loans?
To put it simply, bad loans are those that do not contribute to an increase in your net worth over time. On the contrary, they usually do the opposite, deprecating in value and dragging the rest of your fiances with you.
What is considered a bad loan?
Distinguishing a bad loan from a good one is not always clear as black and white. In general, a bad loan as mentioned is any type of debt that doesn’t increase your net worth. However, even a good loan can go bad if not paid off or if the payments are more than your income.
One’s financial habits hugely affect whether their loans are good or bad.
Some examples of a bad debt include:
- Spending money you don’t own by using your credit card and not paying the full amount on due date
- Using an auto loan to pay for a car
- Taking out a payday loan
According to a report from Lexington Law, America owed a total of around $870 billion in credit card debt in the Q4 of 2018. Household members who are not paying credit cards on time and letting payments roll over on a monthly basis contribute to the growing amount of household debt which is increasing at a staggering rate.
How does a bad loan affect your credit score?
Bad credit refers to a person’s poor history of not paying bills on time and is often reflected in a low credit score. Some of the causes of a bad credit score are defaulting on a loan, filing bankruptcy, and not being able to pay on time. If you are interested to understand it further, read more here.
Credit Score is commonly expressed using the FICO Score Model, where a score of 850 is considered a perfect credit score:
Having a poor or even average credit score can make your life a lot harder in many ways, from home rental, higher insurance premiums, to getting any kind of loans (home, car loans etc).
One of the less talked about ways a bad loan can negatively affect your credit score is by hurting your credit utilization rate.
A credit utilization rate is the amount of the available revolving credit you’re using that is relative to your total credit limit. It basically goes up and down based on the payments and purchases you’ve made.
To calculate your credit utilization rate, here’s a simple formula:
- Simply combine all the balances on all your credit cards.
- Add up the credit limits on your cards.
- Divide the total balance by the total credit limit.
- Multiply by 100 to see your credit utilization ratio as %.
Say you have three credit cards with different credit limits:
Card 1: Credit Line: $3,000, balance $500
Card 2: Credit Line: $4,000, balance $1000
Card 3: Credit Line: $8,000, balance $5000
Your total revolving credit would be = 3,000 + 4,000 + 8,000 = $15,000.
Your total credit would be: $500+ $1000 + $5000 = $6,500
Therefore, your credit utilization ratio would be: $6500 divided by $15,000, multiply by 100 = 43.3%
It is essential to keep your credit utilization rate below 30%. If you have a lot of bad loans, it’s probably because you’re using more than 30% of your available credit. This in turn can significantly lower your credit score.
There is no specific formula for calculating how much a bad loan lowers your credit score but typically, the higher the loan, the greater its impact.
How to Prevent and Deal with Bad Loans
The first thing in solving a problem is determining what it is — there are two ways you can deal with your bad loans:
1. Make a budget and stick to it
Not knowing how to manage your finances can lead to bad loans. Making a budget and sticking to it helps you manage your income and expenses.
One way to quickly optimize your spending is by following the 50-30-20 method. It’s a smart way to break down your household budget and help them reach their financial goals.
This is where you put 50% of your income toward necessities such as rent, car payment, groceries, the 30% toward your discretionary spending like buying new clothes or eating out, and the 20% toward your financial goals like paying your debt or savings.
Another excellent way to manage your finances is by meticulously tracking your spending. Doing so helps you set your budget and shows you where your money really goes. This helps you redirect the money you spent on not-so-important things to reducing your debt.
Always set and follow a realistic budget to help you make steady progress toward achieving your financial goals.
My favorite budgeting app is called Mint. It’s a comprehensive, easy-to-use app where users can sync their financial accounts.
- This free app guides you on your day-to-day spending by helping you by automatically categorizing your expenses
- It alerts you when you’re going over your budget
- It helps you reduce fees you may incur from your loans, and
- Since this app alerts you when you go over your budget, it’ll keep you abreast on your credit score as well.
2. Consolidate your loans
If you have numerous loans or ones with high-interests, loan consolidation might be a method that would work for you.
Loan consolidation is when you use one larger loan to pay off several small loans. It works by combining your different loan accounts into a single monthly payment with a lower interest rate.
There are two ways to consolidate debt:
- Get a 0% balance-transfer credit card.
This method works by transfering all your debts onto this credit card and paying the full balance using their 0% introductory promo.
Finder.com is a useful site that helps consumers compare credit cards based on their features. Check out which one works for you.
- Get a fixed-rate debt consolidation loan
Alternatively, you can opt for debt consolidation loans. These are used to pay off and simplify existing debt by consolidating multiple payments into a single account.
This option lowers your monthly payment with a long term.
You can use Wells Fargo’s Debt Consolidation Calculator, which is a great tool for determining whether debt consolidation is a viable option for you.
Of course, both of these options have risks tagged to them, so it is crucial to review and understand before you make a decision.
For example, if you’re consolidating your debt onto one 0% balance-transfer credit card, you can’t afford to miss your payments anymore. Balance-transfer credit cards reserve the right to cancel your promotional interest rate once you make a late payment.
With debt consolidation, it’s common to use a secured loan or home equity line of credit. The downside of this is that you may lose that asset in the event you can’t pay back the loan.
Whether you are trying to reduce or avoid your bad loans, knowing your credit score is always a wise move to make. It’s best to check your credit score at least once a year to keep tabs on how you are managing and handling your loans.
If you want to learn more about your credit score, you can check the USA Gov website to help you get your credit report, make corrections, etc.
If you’re already facing the challenges of having bad loans, start by evaluating the risks and opportunities for each loan you have. You can seek help from a financial adviser or underwriter to help you determine how and when to start eliminating your bad loans.
Avoiding bad debts can be obtained by making wise decisions about your financial future. Invest time in learning and applying the tips above to start gaining control over your finance in no time!
Bestofbudgets.com is a collaboration between two MBA graduates George Guillelmina and Kate Camillo. On there site they share best tips and resources on budgeting, saving money, and earning an income online.