Debt: The Types and How to Manage Debt

Debt: The Types and How to Manage Debt

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For many people, debt is a necessary evil, or even something to avoid at all costs. But debt is actually not a black and white issue. Not all debt is bad, but not all debt is good either. In order to avoid financial ruin and maximize your money’s potential, it’s important to know the difference between good and bad debt, how much debt you should have and how to make debt work to your advantage.

Bad Debt

Paying interest on an item that depreciates in value over time is the definition of bad debt. Most credit card debt, especially when used to purchase clothing, electronics or other everyday items, is bad debt. Using this definition, a car loan is also an example of bad debt. Your car loses value as soon as you drive it off the lot, yet you’ll be paying interest on the loan you took out for years. Going into debt for vacations, food or other consumables is a bad use of your money because you’ll be paying interest long after the purchase has been consumed.

Good Debt

Student loans, business loans and mortgages are generally considered to be good debt. That’s not to say you are in bad shape if you don’t have these debts, but rather, it’s not a bad financial move to take out a loan for educational expenses or a home if you can’t afford to pay cash. 

What makes these purchases different? 

They all have the ability to increase your wealth over time. You’re taking on debt to invest in something and potentially make more money in the long run.

Student and business loans

A student loan is an investment in yourself; the idea is that you’ll have better job prospects with a college degree, which will allow you to not only repay your loans and interest, but also continue earning more throughout your life. Similarly, a business loan allows you to create a new way of earning money – assuming your business is successful, you’ll be able to pay off your loans and still continue to build wealth. It takes money to earn money, so a loan may be the only way you can afford to start a business. 

Home mortgages

A home mortgage gives you a place to live and the opportunity to build equity when you most likely couldn’t afford it on your own. Real estate generally increases in value over time, so mortgages are also seen as good investments for the future.

Leverage

Leveraging your debt – borrowing at a low interest rate and investing at a higher rate of return – is also good debt. The most common occurrence is investing in a home through the use of a mortgage. But there are other ways to make your money work harder using debt.

Loan interest

When you take on a loan, you owe a certain percentage of interest on that loan. Similarly, when you invest in the stock market, you get a percentage of interest added to your investment, depending on how well the market does. If the percentage of interest you earn is greater than the percentage you pay, you’re successfully leveraging your debt. When done correctly, leveraging can be extremely effective at building wealth. 

This type of investing can have much higher returns than regular investing, but it also carries higher risk – if your investment doesn’t pan out, you not only lost the amount you invested, but you also owe interest on your loan. 

When leveraging doesn’t work

Leveraging also doesn’t work if your interest rate is too high or your rate of return is too low. Investing when you have credit card debt is a bad idea, because no investment can guarantee a return higher than your credit card interest rate. It’s also a bad idea to borrow money just to have it sit in a low-interest savings account – the interest you’re paying must be lower than what you’re earning on the investment, or you’re not successfully leveraging your debt.

Using Credit Cards Wisely

If you’ve used a credit card before, you probably realize that credit is not “free money.” You do eventually have to pay it back, and you’ll pay interest on top of that if you don’t pay it on time. Paying only the minimum balance each month may leave you paying more than double in the long run. Since credit card debt is bad debt, you might be tempted to avoid credit cards altogether. 

However, there are some benefits to using a credit card:

• Rewards points: Many credit cards offer rewards programs that provide cash back and other incentives based on how much you spend. It’s not a smart idea to spend more in order to get rewards, but if you’ll be spending money anyway, it can be beneficial to put those charges on your card – only if you pay off the balance in full every month.

• Build credit: Having a history of responsible credit use on your credit report will help you when applying for loans in the future. If you can regularly use your credit card and pay it off you’ll build credit while avoiding fees and interest.

• Security:A credit card is generally considered to be more secure than a debit card or cash – you can dispute fraudulent charges more easily or cancel the card if it’s stolen. If you’ll be using a card anyway, such as shopping online or at the gas pump, it’s safer to use credit than debit.

How Much Debt Should You Have?

If you have too much debt, lenders may be less willing to extend further credit to you, and you risk not being able to pay it all back. If you don’t have enough debt, your money might not be working as hard as it could be. There’s no scientific way to quantify exactly how much debt each individual should have. 

Many experts agree that your monthly debt payments should not exceed 36 percent of your monthly gross income. This ratio will change depending on your living expenses, lifestyle and personal feelings about debt. 

There are three factors to consider when deciding how much debt you can comfortably take on:

  • Your assets: savings, investments and your overall liquidity

  • Your job security and potential for income growth
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  • Your discretionary income – what’s left over after you pay all necessary monthly expenses

Computing debt ratios

You can use several ratios when determining how much debt is appropriate. You can compare your monthly debt payments to your monthly income, your combined debts to your assets, your housing expenses to your monthly income or your monthly consumer credit payment to your monthly income, among other ratios. 

Advisers will recommend various ratios as ideal – your housing expenses shouldn’t exceed 28 percent of your income, and your monthly credit card payments shouldn’t exceed 20 percent – but it’s important to take your own unique situation into account.

Understanding debt

It’s important to understand that debt is not all good or all bad. If you acquire the right kind of debt, in the right amount, and use your credit cards wisely, you can become more financially successful than you would have without the use of debt.

Take the first step toward achieving your financial goals.

Learn More: I Have Student Debt. What Are My Options?

Read about how you can manage your student loan debt, the types of repayment plans that may be available to you, and explore options to stay in control of your student loans.