Debt: The Good, The Bad and How to Manage Each
Reading time: 4 Minutes
June 18th, 2021
Having debt doesn't have to be a bad thing. In fact, there are multiple kinds of debt—good and bad—and the key to managing your debt is knowing which is which.
To help you get a better handle on your finances, use the information below to learn more about the different kinds of debt and how to manage both for a healthy financial future.
What is Good Debt?
Good debt creates value and adds to your wealth. A student loan is an example of good debt because borrowing money for a college degree can increase your earning potential and thereby increase your wealth. Mortgages provide the opportunity to buy a home, giving you the ability to own an asset that will most likely appreciate over time. Business loans help you invest in your business, increasing the value of your business and your wealth.
When you take on good debt, you're essentially borrowing money to add value to a certain aspect of your life.
These types of loans generally have lower interest rates and make the big goals in life more affordable, especially since you'll be paying back these loans for several years.
What is Bad Debt?
Bad debt is usually seen as loans taken out on things that quickly lose value. While not all credit card debt is bad, maxed-out credit cards can be bad debt if you're taking on more debt than you can afford. Other types of debt such as payday loans can also be considered bad debt because they do little to increase your wealth.
Interest rates on bad debt are typically higher than those on loans considered to be good debt. Credit cards have an average interest rate of roughly 16 percent and payday loans can be as high as 460 percent in Hawaii.
How Do You Avoid Bad Debt?
The easy way to avoid carrying bad debt is to build an emergency fund and don't spend more than you can afford to pay in full each month on your credit cards. Before taking on any new debt, ask yourself if it will help meet your financial goals or make them more difficult to accomplish. Take an auto loan, for example. For most of us, having a car is one of life's essentials. However, having a car you can't afford can quickly lead to a bad financial situation. As a general guideline, be sure your car payment is less than 10% of your take-home pay, and maintenance is less than 15 percent. To see how much car you can afford, check out this auto loan calculator.
Credit card payments, are another example, that if not managed carefully, can quickly get out of control. Here's how carrying credit card debt impacts your finances and how to rein it in.
However, life happens and you might find that your credit card balances creep up and catch you by surprise.
Controlling Credit Card Debt
Credit card debt is the most likely type of bad debt you might have. Americans currently carry $756 billion in credit card debt, averaging $6,270 per person. If you have a credit card at the average interest rate of 16 percent and carry the average $6,270 balance, it will take you five years to pay off that balance assuming you are only making the 2 percent minimum payment each month. You'll also end up spending over $3,000 in interest, a huge amount that could have been used towards a number of other goals (increasing your savings, down payment on a home or child's education).
Carrying excessive credit card debt can also lower your credit score and make it harder for you to get loans for the good debt in life, such as buying a home.
Use these tips to pay off debt you carry on credit cards and avoid future run-ins with bad debt:
- View every credit card charge as a mini-loan. Do you really want to take out a loan for that lunch you just bought?
- Only charge what you can afford to pay off that month. This will keep your credit card debt to a minimum.
- Pay off your highest interest rate credit cards first. Once those are paid in full, put that same amount towards paying off your next highest interest rate debt to speed paydown.
How Do You Keep Manageable Amounts of Debt?
One of the biggest questions you might have is, “How much debt is too much?" While the amount of debt you carry often comes down to comfort, these tips can help you with debt management in every phase of life.
- Don't skimp on your emergency fund. Having cash on hand can help you avoid using your credit cards when emergencies come to call.
- Keep your credit utilization below 30 percent. Credit utilization means the amount of credit you have used compared to how much you've been given by a lender. Experts recommend using no more than 30 percent of your available credit to keep your credit score high. So, if you've been given a $5,000 monthly limit on a credit card, plan to spend only up to $1,500 (30 percent) balance on that card.
- Take a break from spending. The less you spend, the more you have in your budget to pay down debt and build your emergency fund. Even a short break can add up to big savings.
Should You Pay Off Debt or Save?
With all the talk above about emergency funds, you might be wondering if you should pay off debt or save for a rainy day. The best answer is both.
Putting money away into your emergency fund while paying down debt is a wise debt management strategy. Not only are you building your savings, you're also lowering the likelihood that you'll have to use your credit cards if an emergency comes to call. Putting money towards both goals also gives you peace of mind that you're managing all aspects of your financial future, from having solid savings to living a low- to no-debt lifestyle.
If you find yourself in a situation where you can't save and pay off debt at the same time, here are some guidelines to help you prioritize.
Focus on saving when:
- You have not built an emergency savings fund - having an emergency fund should be a top priority as you could wind up going into even more debt to pay for that unexpected emergency.
- You have access to an employer 401(k) match program - with compound interest, even the smallest contributions to a retirement account can grow significantly, even more if your employer is matching your contribution.
Focus on paying off debt when:
- You have loans with high interest rates - Paying off these loans will provide a guaranteed boost to your savings by lowering the amount of interest you are paying each month.
To learn more ways to pay off debt, read Get out of Debt: Tips for Taking Control of Your Finances
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