Not All Debt Is Created Equal

We all have some form of debt, whether its student loans, a mortgage or unpaid credit card balances. Over time, accrued debt can lead to financial stress as balances increase and monthly payments become unsustainable. In some cases, loans move from 0% APR in the first year to 15%+ APR in the second year.

While all money is green, not all debt is the same. Loans can have different interest rates and terms, based on the type of debt and borrower. At a high level, we can categorize debt into the following based on the type of collateral:

Secured Debt

• It is guaranteed by collateral, something that the lender can take if the borrower defaults. As a result, has lower rates than other forms of debt. Typical examples include mortgages, auto loans where the home and the vehicle serve as collateral respectively. Generally used for large ticket items with amounts up-to $1 million with duration of 5 years to 30 years.

Unsecured Debt

• It is not protected by a guarantor, or any kind of collateral from the borrower. If the borrower defaults, lenders have no asset claims and are limited to debt collection tactics reclaim their principal and accrued interest. Examples include personal loans, student loans etc. with typical size of $1,000 to $30,000. Unsecured debt tends to be for shorter duration i.e. a few months to 3 years.

Revolving Debt

• This type of debt is mainly used for credit cards and represents an open-ended account with a pre-defined limit. Borrowers can accumulate debt as they spend, and pay it off periodically. Revolving debt is a good way to build credit for responsible borrowers and helps them access anywhere from $5,000 to $100,000. Note that HELOCs are classified as revolving debt, but are secured with a lien on the home, so are essentially secured debt.

Given that debt comes in different shapes and sizes, the impact of each type of debt on your credit score is also different.

For example, having a mortgage with a long history of continued payments is a good thing. Alternately, having multiple credit cards with maximum balances can be detrimental to the credit score.

Below we talk about a few basic strategies that consumer should keep in mind, when thinking about paying back their debt obligations, and how to prioritize them.

Develop a consistent payment schedule

• The credit score often fluctuates based on time it takes to repay each type of debt. Late payments can have huge negative impacts on the credit score and overall financial health — increase in APR and monthly payments. A missed payment can drag the credit score lower by 30 to 70 points, based on type of debt. Hence, paying off at-least the minimum monthly payment or a slightly higher amount is a good strategy.

Lower your debt utilization rate

• For unsecured and revolving debt, large balances can limit the ability to access new credit and also negatively impact scores. The reason being that credit scoring agencies look at the debt utilization rate i.e. existing balance/total credit limit, in order to determine your credit worthiness among other factors. Ideally, they want debt utilization ratio to be as low as possible because they don’t like to see borrower rack up large bills every month.
• If you wish to optimize your credit score, paying off high balance credit card debt is the way to go. Take the debt payoff amount, and split it across multiple cards i.e. rather than paying down 100% balance on one card, it’s better to pay down 30% or more across a variety of cards. This will bring the aggregate debt ratio lower and provide a better credit score bump.

Make high impact payments

• As you evaluate options for repaying debt either through debt consolidation or other forms of cash raise, keep in mind that paying off $20,000 of credit cards might boost your score 100 points, whereas paying the same amount of student loans or mortgages will barely bump your credit score, if at all. In general, revolving debt and some forms of unsecured debt are more high impact than secured debt.
• The way to make a higher impact via secured loans like mortgages etc. is to re-cast them i.e. ask your lender to redo the principal and other terms of the mortgage. That could help bring down payments and boost credit score as well.

Overall, it’s important to remember that not all debt is created equal. Some, like revolving debt, need to be resolved sooner than later to avoid incurring significant credit penalties. 

Damage to one’s credit score can significantly impact ones’ future financing efforts, such as qualifying for a mortgage when buying a home.

Make sure to monitor which debt channels need to be settled first to ensure a happy financial future!

If you’re looking pay off debt or optimize your credit score, we can help via our payment free home equity financing solution. Feel free to reach out at hello@patchhomes.com or our website at www.patchhomes.com