05 Feb What is High-Interest Debt?
If you are currently in debt, thinking about getting a loan, or applying for new credit cards, you have likely heard of the term “high-interest debt.” What does that mean? Today we are going to cover what high-interest debt is, how you get it, how it works, and most importantly: how to get rid of it! Let’s jump right in!
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What is it?
To put it plainly, high-interest debt is a debt that has an interest rate that is higher than anything you could possibly earn in returns from typical investments. A real quick example would be if you had an index fund that earned 8% annually and a credit card debt with a 12% interest rate. As you can see, your index fund isn’t earning enough money to off-set that credit card debt so you would be losing money faster than you could earn it. You would have to be earning greater than 12% to make it worthwhile.
Therefore, high-interest debt is debt that costs more than any investments can make. We will go into the simple math supporting that in just a few minutes, but first, we need to tackle where it originates!
Where Do You Find High-Interest Debt?
Getting wrapped up in high-interest debt is easy, so if you have it, then don’t feel bad. Most Americans will face debt at some point in their lives, so we just need to do our best to avoid the high-interest variety. So, where can you get caught up in it?
The easiest place to find high-interest debt is with credit cards. There is no single number for interest rates (also known as annual percentage rates (APR)) of credit cards. The interest rate depends on the card type, the company, your credit score, and more. Depending on what you have, you can see interest rates ranging from 9% to 25%, with the Federal Reserve reporting an average of around 15%-16%.
What this means is that if you hold an outstanding balance (i.e., you didn’t pay off your credit card in full), you will have to pay that in interest. For example, if you left an outstanding balance of $1000 on the credit card with a 15% interest rate, you would also have to pay $150 worth of interest annually.
Other common places to get “high-interest debt” is with personal loans and payday loans. Value Penguin reported that in 2019 the average annual interest on personal loans was between 10%-28%, with some loans going as high as 36%. This, however, didn’t even come close to the interest rate on Payday Loans. Payday loans average 400% for interest rate, some even skyrocketing to 780%! That is insane! People should only ever get these loans when they have hit rock bottom and have no other alternative because that is simply craziness!
Now, you may be wondering about the more traditional loans you hear about, are they considered high-interest debt? Generally, federal student loans, mortgages, and car loans are not high-interest debt, but they can be depending on the type of loan and interest rate you get.
For example, if you were to go out and buy a new car, your interest rate could range anywhere from 3.5%-15.3% depending on your credit scare. Value Penguin reports that the better the credit score, the lower the interest rate. This means that if you were to buy a new car when you have a poor credit score, you could be getting what is considered “high-interest debt.”
Essentially, any loan can be high-interest debt if you get a terrible deal or if your credit score is poor. For the most part, though, the main place you will find high-interest debt will be with credit cards, personal loans, and other random high stakes loans. The next step to think about is whether you should invest or pay off your debt?
High-Interest Debt Final Answer
If you were to look through dozens of finance websites and blogs, they all might have a slightly different opinion of what is “high-interest debt.” However, we like to look at numbers. To do that, we are going to compare high-interest debt to the average annual rate of return (the average amount of money earned over the years) on the stock market. Let’s take a peek at the Dow Jones as an example:
By taking data from the past 100 years, we can see that the market has an average annual rate on return (the money you make) of about 10% at best. Granted, there is a lot of ups and downs, but in the long-term OVERALL, your money can earn 10%. This is also assuming that the majority of your financial portfolio performed well, which isn’t always the case. That is why we like to give ourselves a 2% wiggle room, meaning that we expect our rate of return to be around 8%.
What this means is that anything OVER that 8% rate on return would be considered a “high-interest rate.” This would include an 11% auto loan, a 15% credit card debt, a 20% personal loan, etc.
Why is this? This is because, if you were to invest your hard-earned money instead of paying off your debt, you wouldn’t make enough to make it worthwhile. Looking at a quick math equation:
8% earned in the market – 15% credit card debt = -7% loss
Even though you are making 8% in the market, you are still losing 15% to credit card debt, for an overall loss of 7%. Thus, it is classified as high-interest debt. So FINAL ANSWER, 8% = HIGH-INTEREST DEBT!
So, the next time that you sign up for a new credit card or get a loan, consider the interest rate. Do you best to avoid doing into high-interest debt, because once you are in, it can be tricky to get back out!