How Debt Works

While it's possible to live completely debt-free, it's not necessarily smart. Very few people earn enough money to pay cash for life's most important purchases: a home, a car or a college education. The most important consideration when buying on credit or taking out a loan is whether the debt incurred is good debt or bad debt.

Good debt is an investment that will grow in value or generate long-term income. Taking out student loans to pay for a college education is the perfect example of good debt. First of all, student loans typically have a very low interest rate compared to other types of debt. Secondly, a college education increases your value as an employee and raises your potential future income.

Taking out a mortgage to buy a home is usually considered good debt as well. Like student loans, home mortgages generally have lower interest rates than other debt, plus that interest is tax deductible. Even though mortgages are long-term loans (30 years in many cases), those relatively low monthly payments allow you to keep the rest of your money free for investments and emergencies. The ideal situation would be that your home increases in market value over time, enough to cancel out the interest you've paid over that same period.

An auto loan is another example of good debt, particularly if the vehicle is essential to doing business. Unlike homes, cars and trucks lose value over time, so it's in the buyer's best interest to pay as much as possible up front so as not to spend too much on high-interest monthly payments.

Good debt can also simply be low-interest debt. Home equity loans are usually considered good debt (or at least "better" debt), because their interest rates are lower than other types of debt, like auto loans or credit cards. With a home equity loan, the lending institution uses your home as collateral. The amount and interest rate of the loan depends on the appraised value of the house. While it may seem smart to consolidate other debts under a lower-interest home equity loan, carefully consider whether or not you can really make the payments. If not, you could end up losing your home.

Bad debt is debt incurred to purchase things that quickly lose their value and do not generate long-term income. Bad debt is also debt that carries a high interest rate, like credit card debt. The general rule to avoid bad debt is: If you can't afford it and you don't need it, don't buy it. If you buy a fancy, $200 pair of shoes on your credit card, but can't pay the balance on your card for years, those shoes will eventually cost you over $250, and by then they'll be out of style.

Payday loans or cash advance loans are some of the worst kinds of debt. In a payday loan, the borrower writes a personal check to the lender for the amount he wants to borrow, plus a fee. Then he has until his next payday to pay back the loan amount, plus the original fee and any interest incurred over that time period. Interest rates for payday loans are astronomical, starting at 300 percent annually [source: FTC]. And if you fail to pay back the amount by your next payday, you incur yet another processing fee to "roll over" the loan.

Now let's talk about some of the most effective ways to get out of debt.

The simplest way to get out of debt -- and for many the most difficult -- is to budget your spending and save enough cash to pay off your debts.

A budget is a financial plan that allocates a specific amount of money to be spent on certain commodities like food, clothing, mortgage or rental payments, entertainment and savings. Here's how to use a budget to lower your overall debt:

Debt consolidation is another way to reduce your debt load. Debt consolidation means taking out a lower-interest loan to pay for higher-interest debts. It's called consolidation because you take several high-interest debts and consolidate them under one lower-interest payment. It's not an ideal way of reducing debt, because you're technically incurring more debt to pay off the debt you already have.

Typical forms of debt consolidation are a home equity loan or a second mortgage. Second mortgages are like home equity loans in that they use the home as collateral and carry relatively low interest rates (although certainly higher than the original mortgage). An example of debt consolidation would be to take out a home equity loan to pay off credit card debt.

Credit counselors are trained professionals that can help a chronic debtor come up with a manageable budget, develop a "debt management plan" and even negotiate with creditors for lower interest rates or better loan terms. However, not all credit counseling services are legitimate. Some of them charge hidden fees, called "voluntary contributions," that can quickly get expensive. Others are able to win lower interest rates only after purposefully defaulting on all of your loans and ruining your credit score.

If you find yourself up to your neck in debt with no possible way out, there are two final options: debt settlement and bankruptcy. Debt settlement is an arrangement between a debtor and a borrower to pay one lump sum to satisfy the debt rather than monthly payments that incur interest. This lump sum is typically less than the total debt that is owed. It's important that debtors know their rights when negotiating with creditors. In the United States, these rights are established by the Fair Debt Collection Practices Act.

The only advantage of debt settlement for the creditor is that he will at least receive some money. If the debtor is allowed to declare bankruptcy, the creditor may receive very little or nothing. Declaring bankruptcy is a legal process in which the debtor's assets are turned over to a trustee who then liquidates the assets to pay off the various creditors.

In the United States, the most common type of personal bankruptcy is called Chapter 13, in which the debtor retains some assets -- like a home or car -- and is required to adhere to a court-ordered debt repayment plan in which a percentage of his regular income is used to pay off creditors. After the debt repayment is completed, the debtor receives an official discharge clearing him of any further obligations to his creditors.

Now let's look at consumer debt and its effect on the overall economy.

Consumer debt is the debt held by individuals, not by governments. Consumer debt can come in the form of credit card debt, home mortgages, student loans, auto loans and other loans. Consumer debt is also known as household debt. According to statistics from the Federal Reserve, the total household debt of the United States in 2007 was $13.3 trillion. The household debt of the average American in 2007 is equal to 14.29 percent of his total income, a figure called the household debt service ratio (DSR) [source: Federal Reserve].

But the DSR doesn't include mortgage or rental payments. Those numbers are calculated in a figure called the financial obligations ratio (FOR). The latest figures from the Federal Reserve have homeowners spending 18 percent of their income on debt and renters spending 25.9 percent.

It's widely reported that the average United States citizen owes over $9,000 in credit card debt alone. That's actually a misleading statistic. True, if you took the total credit card debt of the United States and divided it by the number of U.S. citizens, it would be $9,000. But a more accurate statistic is the median credit card debt -- half of households owe more, half owe less -- which is $2,200. According to statistics from the Federal Reserve, 56 percent of U.S. households owe nothing in credit card debt (25 percent have no credit cards at all) [source: MSN Money].

Americans aren't the only ones up to their neck in consumer debt. According to 2005 statistics from England, British citizens owe an average of $6,500 in unsecured debt (primarily credit cards). That's over twice the European average of $3,200. In Greece, unsecured borrowing rose 29 percent from 2001 to 2005, and new lending has jumped 52 percent in Turkey over the same time period [source: BBC News].

On the flip side, around 70 percent of the United States and British GDP is fueled by consumer spending [source: Money-Zine.com]. A nation's GDP is often used as a measurement of the health of its economy. Consumer debt begins to negatively affect the health of the economy when it forces consumers to spend less. This is why some governments do everything they can to encourage consumer spending (and borrowing), including lowering taxes and lowering interest rates. If consumers spend less, the economy is said to have stalled, possibly leading to a longer-term recession.

Complicating the matter is that the United States is entering a housing crisis (see How Subprime Mortgages Work), which will only make consumer debt problems worse. The UK already experienced this exact situation. The UK housing boom (and resulting slump) happened 18 months ahead of similar economic developments in the States. Since the end of 2005, British credit card delinquencies have risen 50 percent, causing banks to lose billions of dollars [source: Fortune]. According to a recent survey, credit-crunched homeowners in the UK are even beginning to use their credit cards to pay off mortgages, a dangerous economic precedent that will only lead to deeper debt and more defaulting on credit card payments [source: Fortune].

A big fear of United States economists is that the economy could be entering a powerful recession equal to the 13-year Japanese economic crisis of the 1990s, also sparked by the collapse of the credit market [source: TheStreet.com].

On that cheery note, let's look at public debt and its effect on the economy.

The deficit is the difference between how much money the government takes in through taxes and how much it spends each year. The public debt is the same as the national debt, and it's the accumulation of all of the deficit, plus any other money the government spent that wasn't part of the budget. The United States public debt is currently well over $9 trillion. (You can look up the exact public debt at the ­U.S. Bureau of Public Debt­.) In 2006, the interest alone on the national debt cost U.S. taxpayers $405 billion [source: CBS News].

The total public debt is actually divided into two categories: the debt held by the public and intragovernmental holdings. According to MSNBC, here's how the debt held by the public works:

Intragovernmental holdings -- the other $4 trillion -- are treasury securities that the U.S. government buys itself to bolster huge federal savings programs like Social Security, Medicare and Medicaid.

Obviously, the United States is not alone in holding a large national debt. But a better indicator of a nation's indebtedness is the ratio of its public debt to its GDP, or total national income. The U.S. public debt ratio in 2005 was calculated as 61.8 percent of the GDP. In the same year, the UK's ratio was 46.7 percent, France's was 76.1 percent and Japan's was an astonishing 173.1 percent [source: OECD].

But how does the public debt affect the economy as a whole? Is a large public debt an indicator of bad economic times to come? The United States Government Accountability Office (GAO), says that a rising national debt, particularly when viewed as a percentage of a nation's GDP, is a big problem, although a long-term one.

The GAO explains that the more debt a country holds, the less money it's able to put away in savings and reinvest in the nation's economy. In the United States, in particular, the Social Security, Medicare and Medicaid savings accounts are going to be hit hard by the retirement of the Baby Boomers. The government will no longer be able to tap into these accounts to pay for other federal programs. The GAO also warns that federal borrowing to pay off the deficit will inevitably lead to higher interest rates, affecting the ability of citizens to buy homes and take out loans. That could lead to a broader economic slowdown, or even recession [source: GAO].

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