We get mixed messages about debt.
Mortgage loans are practically a given in the journey toward homeownership. Credit card spending can boost your credit score. Having no credit history actually limits your financial options. Yet, Americans are overwhelmed with debt and bombarded by tips and tricks to get rid of it.
Why does debt seem like such a necessity in our lives but also a burden that promises financial doom?
It’s because not all debt is the same.
“Good Debt” vs. “Bad Debt”
Many financial experts define “good debt” as any money you borrow to pay for something that appreciates in value and “bad debt” as money you borrow for things you don’t need. That assessment is, however, almost offensive in its simplicity.
The concept of good versus bad debt has good intentions: It aims to help consumers think carefully before borrowing money without a plan to pay it back, thus spiraling into a cycle of debt and a lifetime of troubled finances. But ascribing a level of virtue to borrowing money is impossible to do objectively; financial decisions are necessarily subjective.
For example, experts considered mortgages good debt for decades because of the American ideal of homeownership and because homes typically appreciate in value over time. But if you qualify for a mortgage with a payment that eats up more than half of your monthly budget, that debt could be detrimental. And if you owe money on a mortgage and need to sell your home in 2009, you risk losing money on the sale, even after years of paying interest on the home loan.
Instead of labeling any kind of debt strictly “good” or “bad,” consider what you’ll use the debt to purchase and how that fits into your financial plan.
8 Questions to Consider Before Borrowing Money
Before you borrow money, ask yourself these questions to determine how taking on any kind of debt might affect your financial future:
- Do You Have Cash Reserves? Some people become hyper-focused on savings goals to the point they’ll use credit cards before pulling cash from savings. Before charging a purchase, consider whether you can pull from savings instead.
- What Is Your Cash Flow Like? You may have enough cash on hand to cover a major purchase, but would it force you to live paycheck to paycheck or without an emergency fund? Taking on some debt in this case ensures you have cash on hand when you need it.
- How Will You Repay It? The biggest difference between helpful and harmful debt is whether you can repay it on time without being gutted by interest and fees. When you swipe your credit card or take out a loan, consider how you’ll fit the repayment plan into your budget.
- Does the Purchase Promise Future Value? Do you stand a good chance of earning back enough money from the purchase to cover the loan and interest? This might be the case with student loans, mortgages, and business loans, which are investments in expected future earnings.
- Is the Purchase a Must-Have? Determine whether what you’re buying is a want or a need. Only you can decide what constitutes each, but ask yourself the question — and answer honestly — before taking on debt to buy it.
- Is This Urgent? Do you have to make the purchase now, or can you wait until you save up for it and buy it later?
- What Is Your Debt-to-Income Ratio? Your debt-to-income ratio (DTI) usually comes into play when you apply for a mortgage, but it can be a useful measure of the health of your finances overall. It’s the percentage of your monthly income you put toward debt repayment. Most experts consider 36% or less a healthy DTI and recommend a maximum of 45%.
- What Is Your Credit Score? Your credit score affects the interest rate you pay on most types of debt, which plays a major role in how costly the debt is. A strong score (720 or above) can likely get you favorable terms on a loan or credit card. If you have a low or no credit score, borrowing a little and carefully managing the debt can boost your score over time.
There’s no perfect answer to any of these questions that makes taking on debt a good or bad choice. Instead, answering the questions will help you understand your decision to take on debt, how various purchases affect your finances, and how the debt will impact you going forward.
Pro tip: If your credit score is lower than you’d like, we recommend signing up for Experian Boost. Typically bills such as cable and utilities do not affect your credit – positively or negatively. However, with this free program, you can use the on-time payment for these bills to help boost your credit score.
Risks & Rewards: How Different Debts Affect Your Finances
To determine whether any type of debt is good or bad for you, understand how it impacts other areas of your finances.
A home loan helps you purchase an asset with significant financial upside. As you pay down the loan, you work toward ownership, so you can eventually live in the home for free, sell it for a profit, or leave it for heirs to inherit after you die.
A home is also a valuable asset that makes it easier to borrow more money when you need it in the future via home equity loans and lines of credit.
You typically have to supply a hefty down payment and undergo income verification to confirm you have a stable income that’ll cover your monthly mortgage payments. Post-housing-crisis government regulations under the Truth in Lending Act (TILA) and the Dodd-Frank Act require this verification to prevent you from taking on bad debt — that is, a mortgage you can’t afford to repay.
Still, do the math yourself to determine how much house you can afford and make sure your monthly payments will fit comfortably into your budget, given your expected career and income.
Student loans help you pay for a college education, which could pay off throughout your life in the form of high-paying jobs. Statistically, workers with at least a bachelor’s degree earn more money than those with a high school education.
If your student loan costs you 10% of your monthly income, but the degree it helped you earn boosts your income by 50%, that’s a pretty positive return on investment. That high-paying job is not guaranteed, however, and college graduates have increasingly been questioning their decisions to take on student loan debt.
Whether you borrow federal versus private student loans significantly affects how this debt impacts your finances.
- Federal Student Loans: Loans through the U.S. Department of Education are a safer choice, especially if your future income is uncertain. They include flexible repayment plans to accommodate changes in income, possibility for cancellation, and more forgiving default and forbearance options.
- Private Student Loans: Loans you borrow from private banks or lenders are far less flexible than federal loans but may come with a lower interest rate if you have a stellar credit rating.
You may need to borrow money — through loans, lines of credit, or credit cards — to finance a new or expanding business. Business financing should come with a plan to generate more revenue and, therefore, repay the debt in a timely manner.
Business debt lets you spend the money necessary to grow a business without taking on investors who could compromise your ownership and autonomy over the business in the future.
Borrowing money for a business poses a risk, but you can prepare for and mitigate that risk by creating a smart business plan and taking care only to borrow what you need and to budget for repayment.
You could use personal credit cards to get a small business off the ground, but those tend to come with higher interest than a small-business credit card, loan, or line of credit. If you’re unable to qualify for one of those, it could be a sign your business isn’t yet stable enough to take on debt.
Home Improvement Loans
You can borrow money through a personal loan, home equity, or credit cards for home renovations and improvements such as remodeling, landscaping, or adding a deck.
These improvements typically add value to a home, so you could earn back the cost of the debt in added profit when you sell the home. You may also enjoy a better quality of life in an improved home, which has value, if not a clear price tag.
Because this is optional debt, you can plan ahead for it. Account for the monthly payments in your future budget and determine whether you have to sacrifice any of your typical spending to afford them.
If you have urgent home improvement needs — like replacing a furnace in the winter or modifying your home to be accessible for people with disabilities — seek grants or low-interest government loans before taking on a pricy personal loan.
You can find ways to deal with medical debt, but you cannot replace a human life. Loans and credit can fund expensive treatments or surgeries health insurance doesn’t cover — but the resulting debt could be overwhelming.
Medical issues continue to be a key contributor for two-thirds of people who file for bankruptcy, according to a recent study published in the American Journal of Public Health. That makes medical debt a scary proposition, but many people don’t have better options.
Before putting medical bills on a credit card or borrowing to pay them off:
- Consider ways to cut health care costs, including using walk-in clinics and urgent care.
- Research your health insurance options under the Affordable Care Act to make sure you get the best coverage you can.
- Review your medical bills and insurance statements carefully to make sure your medical providers charge correctly and your insurance providers process claims properly.
- Negotiate with your health care providers to reduce costs or set up a payment plan. Get free help with this from the Patient Advocate Foundation.
Strict financial experts often consider car loans bad debt because vehicles lose value over time. You’ll sell the car for less than you paid for it, plus pay extra over time in interest. But many people need a reliable car to navigate daily life, and many of us can’t afford to pay for it in cash.
If you have to own a car, it will cost you money. Your best option is to limit the debt you assume by getting a good deal on a car. That includes:
- Prefinancing: Get preapproved for an auto loan from a bank, credit union, or online lender before you shop to avoid high-interest dealer financing.
- Shop Around: Look at multiple dealers in your town, out of town, and online to find the best price.
- Negotiate Loan Terms: Always negotiate financing on a car. Ask for a lower purchase price, lower monthly payment, and/or lower interest before agreeing to an offer.
- Consider Used Cars: Buy a late-model used car to potentially save thousands on the sticker price.
- Watch Your Loan Terms: A rule of thumb for a car loan is to get a repayment term no longer than five years to limit how much you pay in interest. The shorter the loan term, the better.
- Save for the Down Payment: If you can wait, save for a large down payment to limit how much you have to borrow.
You can borrow money in a lot of ways that don’t restrict how you use the loan the way auto loans or mortgages do. These could help you weather emergency expenses or job loss, or fund costly events like weddings and vacations.
Examples of these loans include:
- Personal Loans. Borrow money from a bank or online lender, usually with a repayment term between three and five years. Interest rates tend to be favorable, and lenders favor borrowers with good or excellent credit.
- Auto Title Loans. Borrow against collateral: your vehicle. These loans are easier for people with bad credit to qualify for, but you risk losing your vehicle if you can’t repay.
- 401(k) Loans. Borrow from your 401(k) balance if your employer allows it, and avoid paying taxes as a withdrawal if you repay the loan with interest within five years. Because you borrow from yourself, you can qualify for a 401(k) loan without a credit check. Bear in mind that you risk paying taxes on the early withdrawal if you don’t repay on time, as well as reducing how much you contribute to retirement as you pay off the loan.
In addition to their unique risks, all loans come with the drawback of repaying with interest, which increases the cost of everything. A debt burden that could strain your budget for months or years to come.
Using a credit card is a simple way to build your credit and rack up rewards like free travel or cash back. That works best if your spending is within your budget so you can pay off the balance by the due date each month. Carrying a balance on your credit card means accruing interest and risking late fees if you don’t make minimum payments on time.
Low minimum payments and high interest rates paired with the ease of making everyday purchases with the swipe of a card makes it easy for credit card debt to pile up quickly without you noticing.
To make credit card debt work in your favor, use credit cards wisely.
Payday loans are high-interest, short-term loans meant to help you cover expenses if you run out of money between paychecks. The amount you can borrow is based on your anticipated pay, and the balance — with interest — comes due within a couple of weeks.
Payday loans are easy to qualify for and help workers when money is tight. Many payday lenders exploit that need with predatory practices that push borrowers into a cycle of debt. If you can’t repay the loan with your next paycheck — which is often the case, as more expenses inevitably arise — you might extend the loan and accrue more interest or take out another loan and add to your debt.
Building and maintaining an emergency fund could help you avoid the need for short-term loans.
If you have stable income but occasionally run into a tight budget between paychecks, you could qualify to use a paycheck advance app that makes small, interest-free loans and automatically takes repayment from your paycheck.
Credit cards are even a better option than payday loans; the lower interest and longer repayment periods have a less damaging effect on your finances. If you have trouble qualifying, start with a secured credit card, which gives you a low credit limit and helps you build your credit score.
Prioritizing Your Debt: Pay Off “Bad Debt” First
Once you have debt, whether it’s good or bad determines how you prioritize repaying it.
When you can’t afford payments on all your debts at once, you’re faced with choosing which debts are OK to sit on for a while. To make that decision, consider:
- Collateral. Will you lose your home, car, or other asset if you don’t repay the debt? Pay off those risky debts as fast as you can.
- Interest Rate. Lower-interest debts cost less to hold onto month to month, so prioritize repaying the high-interest debts first. This approach of paying off debts from highest interest rate to lowest is called the debt avalanche method.
- Repayment Flexibility. Does a lender allow a deferment period, skipped payments, extended term, or income-driven repayment? These options are typically restricted to student loans, but some online lenders are getting creative with loan terms, so find any flexibility you can.
- Credit Score Impact. Some debts, like student loans, carry less weight in credit decisions than others, such as credit cards. If you have to carry a balance, eliminate the most impactful debts first.
Modern life makes debt nearly inevitable — and, because of the power of your credit score, almost necessary. Knowing the difference between good and bad debt can help you make sound financial decisions and control the impact on your long-term financial health.
What’s considered good debt versus bad debt is relative, and only you can decide which borrowing options make sense for your values and financial goals. Whether taking on debt is a good idea is often related to whether you use it to purchase something you need or something you want. Using debt to pay for fleeting wants might be satisfying in the moment, but it’ll likely lead to disappointment down the road when repayment bogs down your financial plans.
Don’t be afraid of debt as a general concept. Instead, use it as a tool to improve your life and your financial situation, increase earnings, and invest in your future.
What types of debt have helped you improve your finances and your life? Have you fallen into the traps of any bad debts?