The difference between good and bad debt_Man and woman discussing finances together

The Difference Between Good Debt and Bad Debt

If you have debt, you’re not alone. Americans now owe a collective $13 trillion in debt, with consumers between the ages of 35 and 54 carrying the most debt. Some debt is good—not many of us can afford to buy a home in cash. However, it’s best to avoid unnecessary debt. Paying down debt and learning to live within our means can help limit reliance on loans and credit. These can be useful financial habits to embrace. Do you know the difference between good debt and bad debt? The distinction can be tricky.

Characterizing types of debt

Not all debt is bad. For the average person, some purchases wouldn’t be possible without taking on debt. Consider these costs:

Though obtaining these items typically involves taking on debt, homes, degrees and vehicles can all provide clear value. Some people prefer homeownership over renting, a college degree often results in higher income over a person’s lifetime, and owning a car is a necessity for many people. For these reasons, we generally consider buying a home, financing education, or purchasing a vehicle to be good debt. This isn’t the complete list of good debt. Still, the key to evaluating good debt vs. bad debt is determining which purchases can be considered long-term assets.

Not all debt brings you long-term value, though, and those debts are considered undesirable if they cannot be paid off in a reasonable amount of time.

Common examples of good debt

As outlined above, some of the most common types of good debt are loans for education, housing and cars. However, these are not the only types of debt that can bring you long-term value. Here are a few other common types of good debt:

Business loans

Sometimes, “it takes money to make money,” as they say. Often, entrepreneurs working on expanding an established business will take out business loans to support their growth plan or to finance significant updates or improvements. Done right, the revenue generated from the initiative will help pay off the loan.

Personal loans (for certain purchases)

Certain big-ticket items are challenging to buy outright, but a personal loan can help finance them in the short-term. Emergencies happen, and even if you have emergency savings in place, a personal loan may be a good solution. If you have a feasible payoff strategy from the start, taking out a personal loan for an emergency can be worth not depleting your savings. With good credit, you may be able to use a personal loan to consolidate high-interest credit cards. Additionally, a personal loan may be the best option for financing a home improvement project.

Paying medical debt

Medical debt is the No. 1 reason for bankruptcy in the U.S., and it’s rarely your choice to take on medical debt. Injuries and illnesses can be unpredictable, but taking care of yourself or your dependents is a top priority. When a person’s life or health is at stake, taking on debt is often essential, even if you have insurance.

Managing medical debt can be challenging—when confronted with medical debt, many Americans find they need to hold off on major purchases. Reducing spending on household necessities like food and clothing, exhausting savings, or even taking on an extra job are also common steps taken to manage medical debt.

The difference between good and bad debt_Man and woman discussing finances and drinking coffee

Common examples of bad debt

Bad debt is often hard to keep under control or doesn’t provide long-term value. Here are some common examples:

Credit card debt

Credit cards are commonly used for building credit, as well as for added convenience, security and rewards. However, carrying excessive debt from month-to-month can add up over time. The average credit card debt in Portland is more than $5,000. You can find the average interest rate for this week here. Once interest fees begin to add up, it can be challenging to reduce credit card balances. Even though you can use a credit card as a tool to build credit, the best rule of thumb is only to take on debt that you need. How much is your revolving credit card debt costing you?

Retirement plan withdrawal or loan

Investing money can be a great way to plan for the future when your budget allows. As savings in an IRA or a 401(k) begins to grow, it’s important to leave it alone. The key to successful investing is compound interest. Removing funds from your retirement account early often comes with an early withdrawal fee in addition to reducing the benefits of compound interest. It’s best to keep your retirement savings in your retirement account. Still, if needed, there are some exceptions to incurring the early withdrawal penalty or taking out a loan against your retirement account. If you’re considering tapping into retirement savings, it’s important to understand the long-term impact of your decision.

Personal loans

Though some personal loans may be worthwhile, it’s usually better to save for the purchase and buy it outright. Taking out a personal loan for something nonessential or that has a quickly depreciating value (like jewelry or other luxury items) will provide little to no benefit in the long run.

Payday loans

Due to relatively high interest rates, most people use payday loans as a last resort—intending to pay off the loan with an upcoming paycheck. If you’re considering a payday loan, ensure that you have a plan to get caught up and avoid getting into a cycle of payday loans that could cut into your monthly budget. If you find that you have a frequent need for payday loans, take a look at your budget to determine how to break the cycle and keep more money in your pocket.

When a good debt goes bad

Some debts start as good debts and then can get out of control. Here are some signs that your good debt is taking a turn for the worse:

  • You can’t afford your monthly payments or need to cut back significantly to do so
  • You’re racking up interest charges or other fees
  • You feel overwhelmed by your debt
  • Your debt has gone to collections

It’s essential to take action quickly when you experience signs that your debt is becoming an overwhelming burden. Determine why your budget is running short: did your income change? Did you take on more debt than you can manage? Your plan will likely include a combination of decreasing your expenses and increasing your income. Depending on your situation, one may be easier than the other. Sometimes you may be unable to increase your income or decrease your monthly expenses. If so, you may consider reaching out to your creditors to discuss your situation in more detail. In many cases, your lender can work with you to develop a repayment plan that fits into your budget.

To make sure you’re on track with your bills, review your budget periodically. A good first step in establishing your budget includes going over bills and account statements to get a good idea of your current financial standing and spending habits.

The difference between good and bad debt_Man and woman holding hands and reviewing documents

How to manage bad debt

If you have bad debt, develop a plan to pay it off. Here are a few techniques to consider:

Make a budget

With or without debt, everyone should have a budget. A roadmap of your expenses is especially helpful when you’re working to pay down debt. Follow our five-step process to create a budget for your unique financial situation.

Work for additional income

If you have the time, taking on extra work can help you get on top of your bills. Consider a part-time job or taking on freelance work. If you need more flexibility, you could get involved in the gig economy by driving for a rideshare company, walking dogs, or doing other on-demand work.

Get a balance transfer

If you have multiple forms of debt, keeping track of payment due dates can be a challenge in itself. Additionally, various interest rates can cause your debts to snowball. Consolidating your debt can be a good way to get a handle on it.

Using a balance transfer credit card or taking out a debt consolidation loan can help you manage payments or reduce overall interest. In either case, you’re using the loan or credit card to pay off the debt. When you consolidate, all the debt you had will now have a single monthly due date and interest rate.

Before you do this, it’s important to evaluate your options. If you wind up with a higher interest rate through your consolidation efforts, you may end up paying more in time than if you had kept your debts separate. Additionally, in some cases, consolidating debt can disqualify you for specified benefits, like student loan forgiveness plans.

Refinance

Like consolidation, refinancing your debt trades your current loan terms and interest rates for new ones. Refinancing is common with mortgages, but you can also refinance student loans, some auto loans, as well as many other kinds of debt. Like balance transfers and debt-consolidation, refinancing is best when the conditions are right. Typically, the goal should be to receive a lower interest rate and to either decrease your monthly payment or the time it takes to pay off your loan. You may also be looking at refinance options that allow you to tap into home equity.

Don’t have much wiggle room in your budget? Refinancing your mortgage from a variable rate mortgage to a fixed-rate mortgage may work better for your needs. Refinancing for a fixed-rate can help keep monthly costs predictable.

Learn more about managing debt, creating your budget, and find great tools and courses to help you achieve your goals.

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