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Something unusual happened in 2023. For a few months there, Americans actually reduced one major category of debt.
Given how steadily consumers have generally increased their debt balances over the years, even a temporary reduction of any type of debt is noteworthy.
Unfortunately, it was the wrong type of debt. While balances in relatively low-cost and manageable debt declined, the amount owed on a more toxic form of debt continued to increase.
Non-revolving balances declined for the first time since 2015
First the good news. According to the Federal Reserve, in the third quarter of 2023 the seasonally-adjusted total amount of non-revolving debt declined.
How unusual is that? It was the first calendar quarter since the last quarter of 2015 in which this debt level declined.
This type of debt is a big deal simply because there’s so much of it. Nearly $5 trillion, according to the latest Fed numbers. That’s up from $3.4 trillion since the end of 2015, the last time consumers managed to reduce this type of debt.
With debt growing so fast, any reduction in debt – even just for a few months – is a step in the right direction. However, paying down loan debt wasn’t the most effective step consumers could have taken to ease their financial burden.
Revolving balances continue to rise
While loan balances declined in the third quarter of 2023, revolving credit balances continue to rise.
While revolving balances represent a smaller total amount of debt than non-revolving ones, over the past couple years they’ve been growing much faster than non-revolving balances. That’s a cause for concern.
Credit card debt vs. loan debt: what’s the difference?
If you owe money, does it really matter what type of debt it is?
It matters a great deal. While both loans and credit cards can be beneficial forms of credit for consumers, used incorrectly credit cards have the potential to become a much more toxic type of debt.
Here are two key differences between loans and credit card debt:
1. Credit card interest rates are generally much higher
The average interest rate charged on credit card debt is 22.77%.
This is much higher than the average rate of 12.17% on unsecured personal loans. The average rate on car loans is around 8%, and the average mortgage rate is lower still.
In other words, credit card debt is much more expensive than most other forms of debt. On the other hand, you can use many credit cards at no cost at all, as long as you pay off your balance each month.
2. Most loans have a set repayment period
When you take out a loan, you are typically given a clearly-defined repayment schedule. For personal loans this might be last just a couple years. For car loans the repayment term might be around five or six years, while mortgages are typically for terms of 15 or 30 years.
The point is, with loans you usually know from the start how long it will take you to pay off the debt. Along with that, you will typically know what the total cost of the loan will be before you sign up for it, including principal repayments, interest, and fees.
In contrast, the repayment period for credit card debt is uncertain. There may be a minimum monthly payment, but you have a lot of latitude to vary your payments from month to month. Beyond that, you can add to your debt at any time, which is likely to extend the repayment period.
That flexibility is part of what makes credit cards so popular. For some people though, it also explains why their credit card debt seems to drag on and on, with the cost of that debt increasing with each month that goes by.
How to prioritize your debt
For the above reasons, credit cards should be used differently from loans. Credit cards give you the convenience of not having to carry cash for everything you want to buy. However, they work best if you pay the balance off in full every month.
In particular, it isn’t the best financial strategy to be paying down loan debt while building up credit card debt. Unfortunately, that’s exactly what consumers started doing in 2023.
➤ LEARN MORE:How to juggle student loan and credit card payments
Long-term, reducing any form of debt is likely to be good for your financial health. However, to get the most out of your payments, it helps to prioritize your debt. Reducing the costliest form of debt first allows more of each subsequent payment to go towards reducing what you owe instead of just keeping up with interest charges.
With this in mine, here are four tips for prioritizing your debts:
- Don’t borrow without a repayment plan. Whether it’s a credit card or a loan, don’t borrow without having an idea of how the payments will fit into your budget.
- Choose the right type of debt for each expense. If it’s something you can pay off within a few months, convenience might make a credit card the best choice. If repayment is likely to stretch over a longer period than that, a loan may be a better tool for keeping your costs down and keeping repayment on a schedule.
- Put extra payments towards high interest debt. Make all your minimum required payments, but then put any extra money towards paying down the debt that’s costing you most.
- Consider refinancing credit card debt. If you find yourself with high-cost credit card debt you can’t repay quickly, consider refinancing it into more cost-effective options. Possibilities include balance transfer credit cards, personal loans and even home equity loans under some circumstances.
➤ LEARN MORE:How to eliminate credit card debt
Loans and credit cards have different characteristics for a reason. To get the most out of each type of debt, it’s important to use them differently.
Credit cards are ideal when you want immediate access to credit, but can pay them off soon after. In short, they work best as a cash substitute.
On the other hand, if you don’t anticipate being able to pay the balance off quickly, you may be better off with a loan. This will reduce your borrowing costs, and give you a set schedule for repayment.
Keep this in mind, and you won’t find yourself accumulating too much of the wrong kind of debt.
