Good Debt vs Bad Debt[yoast-breadcrumb]
Good Debt vs Bad Debt: A Guide to Managing Loans and Credit
When it comes to debt, not everything is created equal. Some types of debt can help you achieve your financial goals, while others can hold you back. As a financial services company, we want to provide guidance on managing debt responsibly so you can build wealth over time. This article will cover the key differences between “good” debt and “bad” debt, and offer tips on how to handle both scenarios.
What is Good Debt?
Good debt has the potential to improve your finances in the long run. Here are some examples of debt that is generally considered “good”:
Taking out a mortgage to purchase a home is often seen as good debt, as home values tend to appreciate over time. This means you can build equity as you pay down your loan. Mortgage interest is also tax deductible, which helps reduce your taxable income.The key is keeping your monthly payments affordable based on your income. Our rule of thumb is to keep housing costs below 28% of your gross monthly income.
Student loans allow you to invest in your education and increase your earning potential. Having a degree often leads to higher pay and lower unemployment. While student debt levels are rising, a college education still offers a significant boost in lifetime earnings for most graduates.Focus on minimizing costs and borrowing only what you need. Federal student loans usually have the lowest interest rates and most flexible repayment options.
Borrowing to start or expand a business can be smart if you have a solid business plan. Just be sure to research lenders and compare loan options to find the best rates and terms. The goal is to borrow on your business’ potential for growth, not its existing collateral.
While cars lose value over time, having a reliable vehicle is essential for most working adults. Aim to put at least 20% down and keep your loan term under 4 years to avoid being underwater on your auto loan. Shop around for the best interest rate you can qualify for.
Home Equity Loans
Home equity loans allow you to access your home’s equity for large expenses like home improvements. This can help you increase your property value. Just be sure to borrow conservatively, as foreclosure is possible if you can’t repay.
What is Bad Debt?
On the flip side, bad debt does not help your financial situation. It is expensive, depreciates in value, and can damage your credit if not managed properly. Here are some examples of debt you’ll want to avoid or minimize:
Credit cards offer convenience but temptation for many. Carrying a balance results in costly interest charges that can take years to pay off. Our advice? Treat your credit card like a debit card and avoid spending beyond your means each month.If you already have credit card debt, focus on paying it down aggressively. Consider doing a balance transfer to a 0% intro APR card to save on interest while you pay it off.
Payday loans seem like quick cash, but they come at an incredibly high cost. Annual percentage rates often exceed 400%. If you miss a payment, fees can pile up instantly.Always exhaust other options before considering a payday loan. Borrowing from family or friends, taking out a personal loan from your bank, or using a credit card cash advance would all be better alternatives.
Personal Loans for Discretionary Purchases
Borrowing for vacations, clothing, or other wants rather than needs is rarely a good idea. The item you purchased likely loses value rapidly, but your debt remains.Aim to save up cash for discretionary expenses rather than financing them. But if you do take out a personal loan, compare multiple lenders to get the lowest rate possible.
How Much Debt is Too Much?
You may be wondering how much debt is acceptable. While there aren’t hard limits, aiming for a debt-to-income ratio below 36% is a good target.This means keeping your total monthly debt payments at or below 36% of your gross monthly income. Here’s how to calculate it:Total Monthly Debt Payments / Gross Monthly Income = Debt-to-Income RatioSo if you pay $2,000 per month towards debts like your mortgage, student loans, and auto loan, and you earn $6,000 per month, your DTI would be:$2,000 / $6,000 = 33%Ideally you want to keep your DTI in the 20-30% range or lower. Much above 36% and you may have trouble qualifying for new loans or credit cards.
Tips for Handling Debt
No matter your current debt level, here are some tips to manage it wisely:
- Make a budget – Track your income and expenses to see where your money is going each month. This allows you to prioritize debt payments in your spending plan.
- Pay down high interest debt first – Focus on paying off debts with rates above 10% most aggressively, while making minimum payments on lower rate debts. This saves you money on costly interest charges.
- Consider consolidation – You may be able to lower your interest costs by consolidating multiple debts into one. This works best if you can qualify for a lower rate through a balance transfer or personal loan.
- Build emergency savings – Having cash reserves helps you avoid relying on credit when unexpected expenses come up. Aim to save at least 3-6 months’ worth of living expenses.
- Use windfalls wisely – Put any financial windfalls like tax refunds or bonuses towards paying down your most expensive debt rather than spending it. This accelerates your debt payoff.
- Review expenses – Look for areas to cut back like dining out, subscriptions, or other non-essentials. Any savings can go towards paying off debt faster.
When to Seek Debt Help
If you feel overwhelmed by debt and unable to keep up with payments, it may be time to seek professional help. A reputable nonprofit credit counseling agency can help you manage debts through services like:
- Debt management plans
- Credit counseling and financial education
- Budgeting assistance
- Negotiating with creditors for lower payments or interest rates
They can also advise when more serious options like debt consolidation loans or bankruptcy may be appropriate. Don’t wait to get help when you are already in default.
The Bottom Line
Not all debt is bad, but unrestrained debt spending can put your financial stability at risk. By understanding the differences between good debt and bad debt, monitoring your overall debt load, and using smart repayment strategies, you can manage credit and loans to improve your finances over time. The key is borrowing with intention and always keeping your long-term goals in sight.