The 2 Ways To Tell What Counts as “Good Debt” and “Bad Debt”
The average American is carrying around quite a bit of debt right now. According to a 2021 American household credit card debt study conducted by NerdWallet, consumers have racked up a shocking $15.24 trillion in bills. While that staggering number seems like it paints a disastrous picture of consumer finances, not all of that debt is actually a bad thing. In fact, some debt can actually be good for you.
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Here’s the lowdown on debt.
The word “debt” can mean a lot of things. In this context, I’m talking about everything from the Instacart order you just charged to your credit card to the check you cut your bank each month for your house. People take out all sorts of debts for all sorts of reasons, but not all of those financial obligations carry the same weight.
Why is some debt considered “bad”?
Not all debt is a bad thing, according to Nick Holeman, CFP and director of financial planning at Betterment. However, some debt isn’t as beneficial for the borrower as others. For example, money borrowed to pay for things that aren’t expected to increase in value (like auto loans and credit cards) is generally considered “bad” debt. “These types of debts should ideally be avoided, or at least paid off as quickly as possible and before most investing,” he says.
So it’s possible for debt to be “good,” too?
When talking about the difference between good and bad debt, there are a few things to take into consideration, explains Holeman, like what you used the money for and how much it’s costing you to borrow it. “If a loan is for something that is expected to appreciate in value (i.e. a home) or boost your income potential (i.e. a student loan), it could be good debt as long as the interest rate is not too high,” he explains.
However, just because something falls under the umbrella of good debt doesn’t mean you should load up on it.
Is your debt good or bad?
If you’re wondering where your existing bills fall on the scale, Holeman says there are three main questions you can ask yourself. First, what is your interest rate? If it’s below five percent, your debt likely falls on the good side of the aisle. However, if your rate is higher than that, your debts are likely doing more harm than good.
Next, you should ask yourself if you can afford the monthly payments. Holeman says a good way to measure how affordable your debts are is to make sure they don’t exceed a third of your income. Lastly, why you’re borrowing the money really does matter. Like Holeman said, borrowing money to pay for things that appreciate can be a good thing, but sometimes debt is good if it solves a problem (you’re probably going to feel good about putting an emergency call to the plumber on your credit card as long as it gets your hot water restored).
Here’s how to get out from under debt.
While debt isn’t necessarily a four letter word you want to avoid, having too much of it can make you look less appealing to lenders, especially if you’re looking to apply for a mortgage in the near future. That’s why Holeman says you should always have a strategy for paying off your debt. “Focus on paying off bad debt before good debt, as they can cost more in fees and interest,” he says, adding that you should focus on paying off credit cards and car loans before tackling mortgages or student loans.