How Can You Tell The Difference Between Good And Bad Debt — And Achieve The Perfect Balance Between The Two?

October 19, 2020

We’ve always been told that only two things in life are inevitable: death and taxes. To that maxim, we might add a third unavoidable life situation: debt.

To have the things we believe to be necessary for our existence — as well as some items that, while not essential, would be nice to have — we all may have to borrow sums of money that will need to be repaid, and with interest.

As of this writing, consumer debt in the U.S. totals $14.3 trillion. The typical American household is saddled with an overage of more than $137,000 in debt, including $6,500 in revolving credit card debt.

Staggering as those figures may appear at first glance, not all of that debt is created equal. There is “good debt” and “bad debt.” Achieving financial literacy means more than understanding the difference between the two. It also means knowing how to keep both under control.

What is good debt?

Good debt is the debt you incur by acquiring an asset that’s expected to grow in value (appreciate) or generate recurring income with the passage of time.

An excellent example of good debt is a home loan or mortgage. Under normal circumstances, the home will appreciate as you build equity through your monthly mortgage payments. At some future date, if desired, you may sell the home for a much higher price than you paid for it originally. Also, if purchased as a rental property, a home can be used to produce passive income.

Student loans are another example of good debt. A college degree can help you pursue a more lucrative career and increase your lifetime earning potential.

Further, both mortgages and student loans are considered good debt because:

  • These loans carry relatively low-interest rates.
  • Much or all of the interest you pay on this debt is tax-deductible.

In other words, good debt is any debt that can be sustainably repaid and contributes to one’s financial success. For example, a businessperson should not hesitate to take on good debt if the benefit of borrowing will improve profit margins or spur their organization’s long-term growth.

What is bad debt?

Debt is generally classified as bad if the money borrowed is used to purchase an asset that loses value (depreciates), does not generate income, or cannot be reliably repaid. Much credit card debt is considered bad because the cards carry interest rates of up to 20 percent (or more), meaning the costs of borrowing can accrue rapidly.

One of the worst examples of bad debt is a payday loan. In exchange for an immediate advance on their regular wages or salary, a borrower pays both a fee and an exorbitant interest rate — one that the lender might set as high as 300 percent. If you fail to repay the full loan, fee, and interest by the expiration date, this unsecured personal loan “rolls over” and incurs another processing fee.

Is an auto loan a form of good or bad debt?

Auto loans occupy something of a gray area between good and bad debt.

A vehicle begins depreciating as soon as you drive it away from the dealership. But if a vehicle is essential for your career or your education — and you haven’t overspent on a model well beyond your actual needs — an auto loan on a budget-friendly vehicle could be considered good debt.

To hit that budget-friendly target, try to make a 20 percent down payment on an auto loan running four years or fewer.

Are medical bills considered good or bad debt?

Medical debt does not fall into either the good or bad debt category, as it is an expense that is largely uncontrollable. Moreover, medical debt may or may not carry interest. Finally, some unreimbursed medical expenses may be tax-deductible.

Can good debt become bad debt?

Yes. If you borrow too much, whether for college, your home, or a luxury auto when a lower-priced vehicle would serve your purposes, you could end up paying too dearly for what is otherwise good debt.

Many financial experts recommend sticking to the “28/36 rule” for managing your debt. This guideline specifies that you should spend no more than 28 percent of your pre-tax monthly income on housing, and no more than 36 percent of that same income on all debt (mortgages, auto loans, student debt, etc.). 

How do the different forms of debt affect my credit score?

When you apply for credit, lenders need a fast and consistent way of deciding whether to loan you money. In most cases, they will check your FICO score, a three-digit number based on information pulled from your credit report.

While several different factors go into determining your credit score, credit mix — or the diversity of your credit accounts — is among the most significant and frequently overlooked. Your credit mix accounts for 10 percent of your FICO score.

Maintaining different types of credit accounts, such as a mortgage, auto loan, student loan (if any), and credit cards, indicates to lenders that you are adept at managing your debt. It also helps them get a clearer image of your finances and ability to pay your creditors. In other words, a healthy credit mix helps to qualify you as a low-risk borrower.

While having a less diverse credit portfolio won’t necessarily cause your FICO score to go down, the more types of credit your have — as long as you make on-time payments — the better.

What advice do you have on credit cards and credit card debt?

Credit cards can be beneficial, provided you pay off your balance each month. Using a credit card can also help you earn rewards such as cashback rebates, discounts, travel miles, and other perks. Responsible credit card use has a positive impact on your credit score as well, especially if your timely payments allow you to increase your credit limit and credit utilization rate.

Guaranty Bank & Trust offers an array of credit cards, including the Visa Platinum Card. This card allows you to enjoy the everyday convenience of a non-rewards card while saving on interest and paying down your other credit card balances faster.

What are some strategies for getting out of bad debt, especially credit card debt?

Consider setting up automatic payments with your credit card issuers. Most credit card companies offer an autopay option that allows you to have either your balance or your minimum monthly payment automatically paid each month when your statement is posted. You can discontinue these programs at any time. 

If autopay does not appeal to you, consider these self-help options.

  1. Pay the lowest balances first. This approach prioritizes paying off your smallest debts first, whatever the interest rate on them may be. First, make a comprehensive list of your debt accounts, from the lowest balance to highest. Each month, pay as much as you can on the lowest balance while making minimum payments on the others. Once you have paid off the lowest balance, move on to the next lowest, and concentrate on paying it. Because this approach — sometimes known as the debt snowball — focuses on eliminating the most manageable debt as quickly as possible, it is particularly well-suited to individuals who find motivation in crossing items off their to-do list.
  2. Pay the high-interest debts first. This top-down approach entails first paying off your high-interest debt. Each billing cycle, after making the minimum payment on all other debt, you dedicate your remaining budget to the debt carrying the highest interest rate, regardless of balance (or principal). Once you have paid off this debt, you focus on the debt carrying the next highest rate, and so on. In contrast to the debt snowball, some financial planners refer to this strategy as the debt avalanche. If you’re the kind of person who responds well to challenges, such as sticking to a strict regimen, this may be the accelerated debt repayment plan for you.

Are you ready to begin truly mastering rather than simply managing your finances? If so, consider joining the Guaranty Bank & Trust community. We’ve been growing to help Texas and Texans grow since 1913. We’ve done so by offering an array of banking products — from savings accounts to IRAs — designed to maximize the value of our customers’ hard-earned cash. Invest in your future by opening an account or booking an appointment to speak to one of our bankers today.  

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