With rising inflation and a flagging stock market weighing heavily on Americans, is there such a thing as “good debt” right now?
Debt is a reality for so many Americans as they grapple with the country’s soaring inflation and other financial problems arising from the pandemic.
Household debt increased by $266 billion to a whopping $15.84 trillion in the first quarter of 2022, according to a May report from the Federal Reserve Bank of New York. That’s $1.7 trillion more than at the end of 2019, before the COVID-19 pandemic.
But the issue of debt isn’t all doom and gloom. Some say to avoid debt at all costs, but most recognize that it’s a useful tool in certain circumstances.
There is good debt and bad debt. The tricky part is that the difference between the two isn’t always black and white. And if you’re not careful, you could end up using good debt for “bad” reasons.
To help you avoid these types of financial pitfalls, let’s look at how to rate good versus bad debt in your life.
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What is good debt?
Good debt consists of cheap credit that helps you build wealth. This may seem simple, but the devil is in the details. Good debt can quickly turn into bad debt if you don’t use it wisely.
Corresponding the Fed’s report on the economic well-being of US households published last month, 30% of adult Americans take on debt to pay for their education.
Without student loans, a university degree would be unattainable for many students. And since higher education translates into higher lifetime income, student loans are usually considered good debt.
In a perfect world, that’s true. But not all majors lead to higher-paying jobs. And we all know someone who racked up mountains of college debt for a degree they never used.
Student debt is only good debt if it allows for higher income.
Mortgages are often considered good debt because you’re paying for a value-added asset. When the rate of appreciation exceeds your loan payments, insurance, and taxes, you’re essentially living rent-free.
Trouble is, appreciation isn’t guaranteed—just ask anyone who financed a home they couldn’t afford just before the Great Recession.
If you buy in an overpriced market or a deteriorating neighborhood, your home’s value could decline, making your loan more expensive than the property’s value. And if you’re funding with an adjustable rate mortgage, your interest rates could go up, resulting in unaffordable monthly payments.
To make sure you’re getting good debt on a mortgage, you need to understand exactly what you’re getting yourself into.
Home equity loans and HELOCs
Home equity loans and HELOCs allow you to borrow against the equity you have built up in your home. Since you are putting up your home as collateral, interest rates are lower than unsecured loans.
When used for wealth accumulation purposes such as home renovations, a business, or real estate investments, home equity loans and HELOCs are good debt. But if you put your primary residence on the line to finance a new Mercedes that immediately loses 10% if driven off the property – bad debt.
In business, you have to spend money to make money. When a business loan results in more money, it is considered good debt.
But similar to student loans and mortgages, things don’t always go according to plan. The latest data says that 1 in 5 new businesses in the US fail within a year, and if your business goes under, that business credit debt will do more harm than good.
Buy programs now, pay later
Buy now, pay later (BNPL) programs are point-of-sale installment loans. You pay a small upfront payment for a product and then pay off the rest in fixed installments, usually with no interest.
An interest-free loan may sound like a no-brainer, but it depends on what you’re buying.
If your purchase helps you build wealth — like a laptop to start a freelance side hustle — Buy now, pay later can be a tool to increase cash flow.
but The accessibility of BNPL has disadvantages that could quickly leave you in debt. If your future self is going to fight to pay off a cozy resort in the Maldives, that’s a bad debt.
What are bad debts?
Bad debts involve expensive loans that put you in a worse financial position. But when handled responsibly, bad debts aren’t always as bad as they seem.
High-interest credit cards
The Consumer Financial Protection Bureau estimates that Americans pay $120 billion a year in credit card interest and fees. The convenience of credit cards makes it easy to go overboard with average Annual interest over 16%holding a balance is an expensive form of debt.
However, when used responsibly, high-yield credit cards can become one of the best forms of debt.
If you pay off your balance in full each month, a credit card is essentially a free short-term loan that builds your credit score. And if you use a good reward or cash back cardyou can even get paid to take out these short-term revolving loans.
Auto loans may be cheaper than personal loans, but that doesn’t necessarily make them good debt. Pandemics and chip shortages aside, vehicles depreciate in value over time.
That means you lose money not only on interest payments, but also on depreciation.
That means there are exceptions. A car loan might be considered good debt if you can’t afford to buy a car with cash, don’t have other better borrowing options, and need a vehicle to drive to work.
Payday loans are short-term loans that are due on your next payday, and they’re extremely expensive — over 600% in some states when calculated on an annual basis.
There really is no good side when it comes to payday loans. They are as bad as debt and should only be used after you have exhausted all your other legal options and under the direst of circumstances.
How does this debt affect your credit score?
Any type of debt reported to national credit bureaus affects your credit score — for better or for worse.
Consistently on-time payments will boost your score, while late payments will take it down the drain. Successfully juggling a mix of different types of debt — like revolving and installment loans — shows lenders that you’re responsible and creditworthy.
Opening credit cards and taking out new loans usually require a tough query of your credit report, which can temporarily falter your creditworthiness. The long-term impact of new accounts depends on how they affect your credit utilization ratio – the percentage of your total line of credit that you use.
For example, if you open a credit card with a $10,000 credit limit and only use a small portion of that $10,000, it would decrease your credit utilization and increase your score.
Student loans, car loans, mortgages, and credit cards are all reported to the credit bureaus. BNPL programs are sometimes reported, but payday loans generally are not. That means, while they don’t appear on your credit report, they can indirectly affect your credit score by making it harder to afford your other debts.
Debt Settlement Tips
Paying off debt requires a solid strategy. If you haven’t already, consider the following:
consolidation. Simplify your unsecured debt by consolidating it into a personal loan, HELOC, or interest-free credit card. strategize. Choose a strategy to pay off your debt – like this avalanche method or the snowball method – and stick to it. Asking for help. If you’re struggling to stay afloat, contact your lender as soon as possible to discuss your options.
There’s a lot of gray area when it comes to good and bad debt, and the difference often comes down to what you’re using the money for and what alternative options you have.
Ask yourself – will this debt improve my future financial situation? Or make it difficult?
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This article is informational only and should not be construed as advice. It is provided without any guarantee.