September 30, 2020
Categories: Education, Financial Security, Tips
In our society, having debt is common. After all, debt helps people have experiences and improve their lives. It gives people access to cars, homes and higher education that they may not have been able to pay for otherwise. But what is the difference between bad debt and good debt?
In simple terms, debt is thought to be “bad” if it is hurting the borrower’s credit score or is otherwise causing significant hardship for the borrower. Debt used to purchase something of depreciating value is also thought to be bad, though this is not always the case (as you’ll read below).
- Debt with high interest rates
Having a balance on a high interest credit card is bad debt because you’re paying a lot of interest—not to mention possible late fees–that add to the total cost of what you bought. Imagine a $40 pair of pants that ends up costing you 20% in interest and a $25 late fee just for missing one credit card payment. Now those pants cost you $73! If you carry that balance from month to month, you could end up paying multiple times the original purchase price.
- Any debt not paid on time
In addition to not paying that credit card balance each month, missing mortgage payments or owing money on medical or utility bills can significantly hurt your credit score, making it more difficult and more expensive to get future loans.
- Debt to purchase something of depreciating value
Debt on something that quickly goes down in value, such as furniture or a car, is often classified as bad debt. However, this type of debt must be weighed with your needs, as the true worth of an item can extend beyond the purchase price.
Let’s say you take out a personal loan to purchase a bedroom set. Technically, this racks up “bad” debt. However, the depreciating monetary value of the furniture is made up for in what you get from its use: a good night’s sleep and a place to put your clothes. Plus, paying on schedule helps your credit score (more on this below).
Generally, good debt has terms you can afford and low, fixed interest rates. Good debt increases your credit score, and helps you purchase something that will positively impact your life for years to come.
- Debt with favorable terms you can afford
In general, good debt is debt that you can easily pay back on time each month. For instance, if you take out a mortgage, lenders will usually use tools like your debt-to-earnings ratio and your credit score to determine whether you’re a “good risk” for that loan—that is, if you’re likely to be able to pay it back. But be sure to crunch your own numbers, too. And again, paying on time each month will increase your credit score, which will be very helpful down the road.
- Debt with a low, fixed interest rate
Shop around for the best rate. Putting in the time to find the right card for you is an investment in your future. (Start your research by looking at one of The Summit’s credit cards.) Be especially aware of low rates that change to a higher rate after a certain amount of time. These aren’t necessarily bad, but it’s important to make sure you’re not carrying a balance and paying those inflated rates.
- Debt with tax advantages
Certain types of debt can help with your taxes. You can usually deduct interest paid on mortgages or home equity lines of credit up to a certain limit. Likewise, you may be able to deduct the interest on student loans. If you’re not familiar with tax deductions, it’s a good idea to consult an accountant or tax preparer prior to taking out such a loan to see what tax advantages might be available to you.
- Understand all the terms. What is the monthly payment? Is there a penalty for paying off the loan early? Does that low-interest rate switch to a higher one after six months?
- Don’t take on more than you can comfortably repay. Would that mortgage payment be difficult to afford along with utilities, food, health insurance and other living expenses?
- Define why you’re taking on debt. Is the debt to finance a habit for shopping sprees? Or is it for a car so you can get to work?
- Don’t work for your debt. Your debt should work for you! Debt should make your life more enjoyable, not cause a ton of stress. If it has a high potential to just be too much, it probably is!
Carrying a balance on a high-interest credit card? Check to see if transferring the balance to a lower-interest card is a good move with The Summit’s Balance Transfer Calculator.
The Summit FCU is federally insured by NCUA. Member eligibility required. Loans are subject to credit approval and certain limitations may apply.
Cynthia Kolko, The Summit Federal Credit Union