Debt is a reality for so many Americans as they battle the country’s rising inflation and other financial problems resulting from the pandemic.
According to a May report from the Federal Reserve Bank of New York, household debt in the first quarter of 2022 rose by $266 billion to a whopping total of $15.84 trillion. That’s $1.7 trillion more than at the end of 2019, before the COVID-19 pandemic.
But the subject of debt is not catastrophic. Some say avoid debt at all costs, but most recognize that in certain circumstances it is a useful tool.
There is good debt and there is 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 fall prey to good debt for “bad” reasons.
To help you avoid these types of financial pitfalls, let’s see how to assess the good debt versus the bad debt in your life.
What is good debt?
Good debt consists of inexpensive loans that help you build wealth. It may sound simple, but the devil is in the details. Good debt can quickly turn into bad debt if you don’t use it wisely.
According to the Fed’s report on the economic well-being of American households published last month, 30% of American adults go into debt to pay for their studies.
Without student loans, college education would be out of reach for many students. And because higher education leads to higher lifetime earnings, student loans are generally 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 student debt for a degree they never used.
Student debt is only good debt if it unlocks more income.
Mortgages are often considered good debt because you are paying for an appreciating asset. If the rate of appreciation exceeds your loan payments, insurance, and taxes, you’re essentially living rent-free.
The problem is that appreciation isn’t guaranteed — just ask anyone who financed a home they couldn’t afford just before the Great Recession.
If you’re buying in an overvalued market or a deteriorating neighborhood, your home’s value could drop, making your loan more expensive than the value of the property. And if you were financing with an adjustable rate mortgage, your rates could go up, resulting in unaffordable monthly payments.
To be sure you’re taking on good debt with 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 your house up as collateral, the rates are lower than unsecured loans.
If used for wealth-building purposes, such as home renovations, a business, or real estate investments, home equity loans and HELOCs are good debt. But if you’re putting your primary residence at risk to finance a new Mercedes that instantly loses 10% when driven off the lot – bad debt.
In business, you have to spend money to make money. If a business loan brings in more money, it is considered good debt.
But as with student loans and mortgages, things don’t always go as planned. The latest data indicates that one in five new businesses in the United States fail within a year, and if your business fails, that business loan debt does more harm than good.
Buy now, pay later
Buy now, pay later (BNPL) programs are point-of-sale installment loans. You make a small upfront payment for a product, then pay off the rest with pre-determined installments, usually interest-free.
A zero interest loan may seem 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 side hustle – buy now, pay later plans can be a tool to increase cash flow.
But there are downsides to BNPL’s accessibility that could get you into debt fast. If it’s for a cushy resort in the Maldives that your future self will struggle to repay, that’s a bad debt.
What is a bad debt?
Bad debts include expensive loans that put you in a worse financial situation. But if used responsibly, bad debts aren’t always as bad as they seem.
High Interest Credit Cards
The Consumer Financial Protection Bureau estimates that Americans shell out $120 billion a year in credit card interest and fees. The convenience of credit cards takes it too far, and with average APRs above 16%, maintaining a balance is an expensive form of debt.
That said, if used responsibly, high interest credit cards can become one of the best types of debt.
If you pay off your balance in full each month, a credit card is essentially a free short-term loan that boosts your credit score. And if you use a good rewards or cash back card, you 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. Aside from pandemics and chip shortages, vehicles lose value over time.
This means that you not only lose money on interest payments, but also on amortization.
That said, there are exceptions. A car loan can be considered good debt if you can’t afford a car with cash, don’t have other better loan options, and need a vehicle to get to work.
Payday loans are short-term loans that mature on the day of your next payday, and they’re extremely expensive — over 600% in some states when calculated on an annual basis.
There really is no silver lining when it comes to payday loans. They are as bad as debt gets and should only be used when you have exhausted all your other legal options and in the most dire of circumstances.
How do these debts affect your credit score?
Any type of debt reported to the national credit bureaus affects your credit score, for better or for worse.
Regular, on-time payments increase your score, while late payments make it disappear. Successfully juggling different types of debt, like revolving loans and installment loans, shows lenders that you are responsible and creditworthy.
Opening credit cards and taking out new loans usually requires a thorough investigation of your credit report, which can temporarily affect your credit score. The long-term effects of new accounts depend on how they affect your credit utilization rate – the percentage of your total line of credit that you are using.
For example, if you open a credit card with a credit limit of $10,000 and only use a small portion of that $10,000, it will lower your credit usage and increase your score.
Student loans, auto loans, mortgages, and credit cards are all reported to credit bureaus. BNPL programs are sometimes flagged, and payday loans usually are not. That said, even if they don’t show up on your credit report, they can indirectly affect your credit score by making it harder to pay your other debts.
Tips for Paying Off Debt
To pay off debt, you need a solid strategy. If you haven’t already, consider:
Consolidation. Simplify your unsecured debt by consolidating it into one personal loan, HELOC or zero-rate credit card. Strategy development. Choose a strategy to pay off your debt – like the avalanche method or the snowball method – and stick to it. Ask for help. If you’re struggling to stay afloat, contact your lenders as soon as possible to discuss your options.
There are a lot of gray areas when it comes to good and bad debt, and the difference often comes down to what you’re using the money for and your alternative options.
Ask yourself: will this debt improve my future financial situation? Or make it harder?
What to read next
The United States is just days away from an “absolute explosion” of inflation — here are 3 shock-proof sectors to help protect your portfolio.
A TikToker paid off $17,000 in credit card debt by ‘stuffing cash’ – can this work for you?
Don’t be fooled by doomsayers, says JPMorgan – the S&P 500 will rebound to 4,900. Here are 3 stocks it uses to bet on a rebound.
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.