Good Debt vs. Bad Debt: How To Use Debt Safely
- Nearly everyone has debt. Managing it correctly is an important part of your overall financial health.
- There are two types of debt: good debt and bad debt. Good debt should have a place in your financial plan as a tool to help you meet your goals. Bad debt that you carry should be paid off – include it as a goal you would like to achieve.
- List all the debt you have, including the interest you pay. Make a priority to pay down high interest debt.
Perhaps one of the best things you can do for your financial situation is to get smart about debt. Almost everyone has debt of some kind. The most common types are:
- Mortgage debt
- Credit card debt
- Student loans
- Car loans
- Personal loans
The first thing you should do is get organized: list out all the debt you have and find out the interest you pay to each lender. Generally speaking, you should avoid high-interest debt. If you find yourself with debt that costs more than roughly 7% in interest, you should make it a priority to pay this debt off. Look for opportunities to reduce your overall balance, but also find ways to avoid the temptation of adding more debt to your pile (unless it’s for something smart, like education).
Using Good Debt
Good debt plays an important role in your long-term financial plan, if you use it correctly. Good debt carries a low interest rate and can be used to help you pay for large purchases that add to your net worth over time.
- Example 1: certain types of student loans have low interest rates. If you can increase your salary by going back to school, taking on a little bit of debt today is beneficial for your long-term financial situation. It will increase your net worth over time.
- Example 2: Home ownership is another example of debt playing a constructive role in your financial plan. Most people cannot afford to buy a house without a mortgage, and there are many benefits to paying off a mortgage instead of paying rent to a landlord.
Of course, both of these are simple scenarios designed to demonstrate how debt can help in an ideal situation. Student loans and home ownership have plenty of risks and pitfalls, so make sure you do your homework before you use debt in these scenarios.
Managing Bad Debt
Bad debt is high-interest debt. Credit cards are the most common type of high-interest debt. In many cases, you can end up paying more in interest to the credit card company than you did to pay for whatever you used the credit card to buy! This is the type of debt you should avoid as much as possible. If you currently have any high-interest ‘bad debt’, make it a goal to pay it off. Prioritize it, along with all your other goals.
Don’t forget, when you have debt, it impacts 2 parts of your financial plan. The first part is your budget: you’ll need to include the monthly payments and interest as a budget item. The second part is your goals: if paying down debt is a priority, you need to rank it as a goal that you prioritize, along with all the other goals you have.
- Make an inventory of all your debt, including the amount, the due date, the interest rate, and the monthly payment.
- Identify any high-interest ‘bad debt’ and make a plan to pay it off.
- Integrate ‘good debt’ into your financial plan to ultimately help you meet your long-term goals.
- Update your budget and goals based on the priorities you identified in this section.
Read more of Nathan’s articles at AskMeAboutMoney.com