Good Debt vs. Bad Debt: What You Need to Know
If you’re like most Americans, you likely have some form of debt. While the percentage of Americans with debt varies by age, most groups hover around the 80% mark, carrying an average of $38,000 in debt.
However, not all debt is created equal. Some debts you can leverage to your advantage. Others, you’ll want to pay off as soon as possible. Read on to understand your good debts and your bad debts as well as how you can prioritize your debt payoff strategies and improve your financial portfolio.
Leverage Good Debt
Debts that help you achieve your goals, grow in value, or generate long-term wealth are considered good debts. It’s best to view these debts as investments in your future, investments you expect to come with positive consequences, such as technical or college education. Those with higher education have a higher earning potential, making it worth it for many to take on the student loans and other debt that comes with funding a college education.
Your mortgage is another debt in this category. Beyond providing you housing, your home is a financial asset that’s likely to appreciate in value over time, increasing your wealth.
These debts help you build good credit, but you’ll want to keep an eye on the ratio between your debt and income. LendingClub recommends keeping your total debt under 40% of your gross income. Your debt-to-income ratio is key to unlocking more credit. Keeping your debt much lower than what you make proves that you’re using debt in a way that benefits your financial future.
Another way to benefit from good debt is by leveraging other people’s money (OPM). But wait, if you’re using other people’s money, how do you have debt? As Rich Dad explains, you have two options when you want to invest in something: Use your money or find investors. Investments that leverage funds from others can help you increase returns on an investment and grow your own wealth faster.
Pay Off Bad Debt
The Balance sums up bad debt as anything “consumer-focused.” These are the debts that negatively impact your credit score and, if you’re not careful, can have harmful consequences. Debts you have to pay with cash, such as high-interest credit cards and payday loans, fall into this category.
The high interest rates make your debts more expensive, if not outright unaffordable, and, instead of helping you grow your wealth, take away from your wealth. That’s why you want to pay off these bad debts as soon as possible.
For some homeowners, the snowball payoff method is the most effective. By paying off your smallest balance debt and then tackling the next smallest debt and so on, you see small wins that keep you motivated. Others prefer to pay off high-interest credit cards first to ensure the interest doesn’t get out of control. Whatever strategy you choose, try to stay current on bills and monthly payments to avoid paying extra in late fees and additional interest.
Calculate Your Debt Ratio
The less bad debt you have, the better your credit. The better your credit, the more likely you’ll receive approval for home, car, or personal loans, and the more likely you’ll have a lower interest rate on these loans.
Start improving your ratio by paying off the highest-interest loans first, such as those high-interest credit cards; every extra bit you can put toward it helps. Also try to postpone any purchases you can. Keep checking on your debt-to-income ratio to monitor progress and stay motivated.
For homeowners that need funds, Hometap can be a smart way to access cash from their home’s equity to pay down debts, while working toward meeting long-term financial goals.
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The opinions expressed in this post are for informational purposes only. To determine the best financing for your personal circumstances and goals, consult with a licensed advisor.