Good Debt vs. Bad Debt
Debt has gotten a bad rap. Living without debt these days is next to impossible. Debt falls into two categories: good debt and bad debt. It’s good to know that all debt (or money owed) isn’t created equal, and it’s even better to know the difference.
Before buying anything on credit, it’s a good idea to determine whether you’re accruing good debt or bad debt. How can you tell? Here is a snapshot of how it shakes out.
Good debts are those that create value and can be seen as an investment. Think mortgages, loans for college education or business loans. School loans and mortgages often have lower interest rates than other kinds of debt. Student loans can increase your ability to command a larger income. An ideal situation in a home loan is that the property increases in value over the course of the loan term, an increase that could offset the interest paid on your loan.
Bad debt comes into play when you purchase items that quickly decrease in value and don’t generate income. Bad debt often carries a high interest rate—think store credit cards and payday loans or cash advance loans. The rule of thumb for avoiding bad debt is: If you can’t afford it, don’t buy it. Every month that you make a partial payment on a high-interest loan, that item loses value while the price you paid for it increases.
When it comes to your credit history, well-managed debt can actually help improve your credit score. When purchasing on credit, know what you’re getting into and take on only as much debt as you can afford to pay off.
Keeping Debt Manageable
The simplest way to maintain a manageable amount of debt is to ensure you never owe more than you can pay, but simple isn’t always easy. Follow these tips to better manage your debt:
- Know how much you owe. Make a list of all of your debts. Include the debt total, monthly payment, interest rate and due date. Track your progress by updating the list regularly as you make payments.
- Pay your bills on time each month. Set up automatic payments so you don’t miss payments and incur late fees. Determine which bills are due first and pay them in order. Pay more than the minimum on each bill if you’re able. Paying the minimum on high-interest debt usually doesn’t help you make real progress, but if that is all you can pay, it does keep debt from growing.
- Pay off the high-interest debts first. High-interest debt costs you the most, so you’ll want to immediately wipe it out. The faster you pay these debts off, the less interest you’ll pay.
- Start an emergency fund. That way, should an unexpected expense come up, you won’t have to add to your debt to pay it.
Credit Card Debt
According to statistics collected by the Federal Reserve and other government data, NerdWallet reports that credit card debt is the third highest source of household debt behind mortgages and student loans, with an average owed of $15,863.
You might not realize it, but every time you use your credit card, you’re essentially taking out a loan. The purchases you put on your card are bought with your line of credit, and you’re responsible for paying your credit card company back for whatever you buy. When used responsibly, a credit card can be a great tool for building credit history; used incorrectly, it can lead to debt.
Credit cards can offer the temptation to overspend, but you can curb that urge by using these tips to be smart about your spending:
- Budget. Budget. Budget. Keep track of your finances with an up-to-date budget that accurately reflects your income and output. Knowing your finances is a huge step in knowing how much you can afford.
- Borrow only as much as you repay. A good rule of thumb is to not tie up more than one-third of your income in debt, including mortgage, credit cards and installment loans. Borrow only as much as you can pay back in a reasonable time, while staying on top of the daily necessities.
- Pay bills in full and on time. Don’t overextend your funds. Be mindful of when your credit card bills are due and make a concerted effort to pay them off in full each month.
- Check your credit report regularly. By keeping an eye on your credit report, you can monitor your status and whether there are mistakes that could negatively affect your score. You can check your credit report for free on an annual basis at annualcreditreport.com.
Smart Credit Card Use
Used wisely, credit cards are a great tool for everyday spending, for making large purchases (such as airline tickets or furniture) or to use in emergencies to supplement your savings.
Keep in mind that in addition to paying off whatever you charge to your credit card, you’re also responsible for paying any interest that accrues on your balance. Always strive to pay in full and on time to avoid accumulating interest and adding to your debt, along with annual fees, finance charges and penalties that could grow even higher.
Credit cards come with a fixed or variable rate of interest. Look for a low, fixed-rate card to avoid a higher interest rate when rates change. Card companies can raise rates on fixed-rate cards if interest rates rise, but they must give you 45 days’ notice before doing so. Variable-rate cards can change without notice. Know the real cost before you use a credit card. Consider the following:
- What is the APR (annual percentage rate), and will it increase after the introductory rate? If so, how much?
- Does it have an annual fee? How much?
- Are there late fees? How much?
- Does it have a grace period before interest rate kicks in? How long? What is the APR when the grace period ends?
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