4 Debt Misunderstandings That Can Destroy Your Finances

Debt may very well be a four letter word in your house that you choose to ignore as much as possible, but the more you understand about your options in how to manage debt, the more control you have.

Here are four common debt misunderstandings, and why separating fact from fiction can change the direction of your financial life:

1. Taking baby steps to reduce credit card balances

If you assume the only way to pay down credit card balances is paying whatever money you have left at the end of each month toward debt, you’re missing a potential opportunity to get more aggressive in your debt reduction strategy.

Peer-to-peer lending sites like LendingClub have become a popular alternative for borrowing money at more competitive rates than traditional financial institutions offer.

[pull_quote align=”left”]Peer-to-peer lending sites pair investors who have money to loan with borrowers who need money for reasons including funding a business, improving a home, or paying off debts.[/pull_quote]By pairing investors who have money to loan with borrowers who need money for reasons including funding a business, improving a home, or paying off debts, the concept is as a win-win. Those who loan money get higher rates than stock markets traditionally yield, and borrowers get lower rates than banks offer.

The sites have become a haven of sorts for those with credit card debt. In a phone interview, LendingClub chief marketing officer Scott Sanborn said that the average LendingClub borrower has a credit score of about 716, an established credit history that spans about 14 years, and an average income of about $69,000.

Yet, as many as 70% of LendingClub borrowers seek loans to pay off high interest credit card balances that they accumulated in their younger years.

Average rates to borrow from either site start at about 6.5%, but like a traditional loan, you’ll pay higher rates if you’re a higher risk borrower.

2. Assuming ‘good debt’ doesn’t need to be paid off

Major purchases like buying a home, paying for college, and even financing a car (depending on how long you intend to keep it) are often referred to as “good debts,” because they have long-term value.

By contrast, “bad debt” includes credit card balances, auto leases, and anything that ends up costing you more than the item is ultimately worth.

The danger behind the connotations, however, is the misunderstanding they evoke. In truth, no debt is good when you are trying to build wealth. If you own a house, your strategy might include staying in it for the long-term, or taking on a shorter-term loan, so that you’ll pay less interest, and own it outright sooner, versus selling and upgrading every few years.

Likewise with students loans: Even a low 3.4%  fixed rate Stafford loan is costing you money that you could be saving, or investing, to build for the wealth long-term.

3. Not saving because you have debt

Only 55% of Americans have more emergency savings than credit card debt, according to research published by Bankrate.

[pull_quote align=”left”]Despite the balance decreases, the proportion of people who lack emergency savings in proportion to credit card debt really hasn’t changed at all in the past 24 months.[/pull_quote]Greg McBride, CFA, and Bankrate.com’s senior financial analyst, says that despite the balance decreases, the proportion of people who lack emergency savings in proportion to credit card debt really hasn’t changed at all in the past 24 months, especially considering the poll’s margin of error.

Though the rationale to pay down higher interest debts before saving makes sense numerically, there is a costly danger in ignoring the intangible value of a financial fallback plan.

Using McBride’s example above, a consumer could’ve built an emergency savings fund worth more than $2,400 by contributing just $100 a month to a savings account earning 1%, over the course of 24 months.

If having those funds set aside for unforeseen emergencies is the difference between maxing out credit cards to survive as soon as the car breaks down or a medical expense hits, the value of saving outweighs the math behind interest rates.

4. Paying for everything in cash to avoid debt

While sticking to a cash only system will certainly rein in overspending, it’s not doing you any favors in the credit department, which can impact every area of life, including your ability to find a place to live, work, and the cost of car insurance.

Whether you like it or not, the financial system in the United States uses credit scores to make a judgment call about who you are, and how responsible you are with money.

If you’re trying to “beat the system” by refusing to build credit, you’re missing an opportunity to use your positive money behaviors to your advantage.