Loans and Credit
In modern society, it is almost impossible to carry no debt at all. The key is to tell “good debt” from “bad debt”, and to maintain a good credit record.
Definition
A definition is a precise description of what a concept, a term, or an object means. Understanding definitions is the foundation of learning any field, and every concept has its own exact meaning.
Debt that helps you create future value or increase your net worth.
- Examples:
- Mortgage: buying property that appreciates in value.
- Student loan: investing in education in order to raise your future earning capacity.
- Business loan: used to expand the scale of the business.
Definition
A definition is a precise description of what a concept, a term, or an object means. Understanding definitions is the foundation of learning any field, and every concept has its own exact meaning.
Debt used to buy depreciating assets or for pure consumption, which cannot generate any return.
- Examples:
- Credit card balances (if you cannot pay them off in full): clothes and dining.
- High-interest consumer loans: a new phone, a holiday.
- Car loans (when purely for consumption): a car depreciates the moment it is driven off the lot.
A credit score (such as the domestic credit report and Sesame Credit in China, or FICO in the US) is the numerical expression of your financial reputation.
Factors That Affect Your Credit
- Repayment history: whether you pay on time (the most important factor).
- Amount owed: your credit card utilization rate (keep it below 30% of your limit).
- Length of credit history: the longer you have used credit, the better.
- New credit applications: applying for loans frequently lowers your score (hard inquiries).
- Mix of credit types: using a combination of credit cards, mortgages, and so on.
The Benefits of Good Credit
- Lower interest rates on loans.
- Easier approval for credit cards and loans.
- A bonus when renting, applying for a job, or even meeting a potential partner.
If you are already carrying debt, how do you get out from under it?
1. The Debt Snowball
- Method: regardless of the interest rate, start paying off the smallest balance first.
- Advantage: you quickly see the number of debts shrink, which gives you a sense of achievement and motivation.
- Disadvantage: you may pay more interest in total.
2. The Debt Avalanche
- Method: regardless of the balance, start paying off the highest interest rate first.
- Advantage: mathematically the cheapest option, since you pay the least total interest.
- Disadvantage: if your largest debt also carries the highest rate, it may take a long time before the number of debts shrinks, which is discouraging.
That depends on the interest rate on the debt and the expected return on the investment.
- If the interest rate on the debt is high (such as 18% on a credit card), you should absolutely pay off the debt first. It is hard for any investment to reliably earn 18%.
- If the interest rate on the debt is low (such as 3% on a housing provident fund mortgage) and you have a sound investment channel (such as a long-term 6-8% return), then you can consider paying only the minimum and investing the rest.
- Exception: in any case, build up a full emergency fund first.
Credit is an adult’s second ID card. Use good debt as a lever, stay away from the traps of bad debt, and protect your credit record.
Terms Used in This Article
| English Term | Explanation |
|---|---|
| Good Debt | Debt that creates value |
| Bad Debt | Debt that drains wealth |
| Credit Score | A number used to assess a borrower’s credit risk |
| Debt Snowball | Paying off the smallest debts first |
| Debt Avalanche | Paying off the highest-interest debts first |