Managing Good Debt vs Bad Debt

We hear a lot about getting out of debt and how avoiding debt is a good financial move. MOs of the time this is true. The most frequent type of debt in the United States is credit card debt, and in most cases, this is a clear example of bad debt. There are, however, some times when debt is necessary and can even be a good thing.

The question becomes how to tell the difference and how to judge when debt is good or bad. What are times when it is okay to go into debt and even beneficial? The answers are easier and closer than you think. Here is a quick look at good debt, bad debt, debt reduction, and how all of it affects your credit score.

What is Good Debt?

Generally good debt is defined as debt that is secured by an asset, especially one that appreciates in value or debt that is utilized to help your financial position and carries an interest rate lower than the rate you would earn if you invested that same amount of money instead.

How does that break down? Think of some kinds of good debt you can carry:

  • Your Home Loan: Your home will go up in value over the long run, and as you continue to pay your loan, you will gain equity.
  • Your Car Loan: While not as good as your home loan, if your credit is good your car loan will carry a low interest rate, and while your car does not appreciate, it still has value, and you can potentially pay off the loan far before the useful life of your vehicle is over, saving you money long term.
  • Business Loans: Sometimes you need funding to start a business, and that type of loan will eventually pay off as your business turns profitable. Business loans can be anything from Small Business Administration long term loans to shorter term personal loans from a more traditional lender.

Good credit can also be money you have borrowed to make certain kinds of investments, but generally speaking borrowing to invest is like borrowing to gamble. It isn’t a good idea. There are exceptions, but not many.

What is Bad Debt?

To understand bad debt, you need to understand how investment and borrowing works. On average the stock market makes between 7-9% per year, at least it has historically over the last century, even including stock market crashes. (If you hung in for the long term even in the Great Depression you would have come out ahead.) This means in theory you should be able to make that percentage on your money with very little risk.

Debt typically accrues interest, and that interest is compounded at least annually if not more often. This rate is typically the prime rate set by the Fed plus a point or two at least. If you have poor credit or are considered a lending risk, your interest rate will be higher.

Essentially if you are paying a higher interest rate than 7-9% on any debt, it is considered bad debt. This is why most credit cards, which carry an interest rate of 14-30% APR are considered bad debt. If you carry small balances and pay off cards regularly, this is not as much of an issue, but if you carry a balance long term, this type of debt is bad news.

This does not mean that every credit card is bad. Some carry short term offers of low or zero interest rates which almost allow you to use the lender’s money for free. Taking advantage of these can actually be good debt. So can paying off cards every month and not carrying a balance that will accrue interest. This can build your credit score with no negative effects.

How Do You Reduce Bad Debt?

The key of course is to reduce bad debt and avoid it whenever possible. What if you already have credit cards and bad debt? There are ways to reduce this type of debt and get yourself in better financial shape.

  • Reduce Spending: Even temporarily, reduce what you spend going out to eat and doing other activities until debts are paid down.
  • Make Double Payments: Even if you can’t pay double, pay extra every month to reduce interest you will owe and pay off debt faster.
  • Make More Money: Take on a side gig. Drive for Uber or Lyft. Get a part time job. Do whatever you can to increase your income and pay off your debt sooner.
  • Negotiate with Collectors: Sometimes collectors will settle your debt for less than what you owe if you pay it in full. Try this approach yourself or use a debt reduction service.

With a little creativity you can reduce your bad debt fairly quickly. Just be careful not to fall back into your old debt patterns once your cards are paid off.

What Does Credit Score Matter?

A lot of bad debt can hurt your credit score. Good debt can help. Even if you are not planning to buy a home or go into debt, a good credit score can help you in a number of ways. First, you can get a loan and lower interest rates in the case of an emergency This can be very helpful when you are facing a crisis.

Second, your credit score often helps with other things, even getting a job. Some employers do a consumer credit check as part of your background when you apply for a job. A low score can hurt your chances of getting hired especially where security is a concern.

Managing your good and bad debt is essential for not only a good credit score, but a healthy budget and good financial picture. Take these tips as a starting point, and evaluate where you are now and then set goals for what you would like your debt picture to look like.

 

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