Is debt bad?

What is debt?

Simply put, debt is the money that you owe. It can be the result of purchasing goods and services on credit or borrowing money from an individual or a lending institution. While striving to be debt-free is a commendable financial goal, most of us will encounter debt at some point in our lives. When managed strategically, though, debt can be a useful tool for building wealth.

Types of debt

Debt comes in many forms and serves different purposes. Money owed by individuals for personal expenses is known as consumer debt. The most common types include mortgages, car loans, credit cards, and personal loans. Generally, all consumer debt falls into one of five categories:

• Secured vs. unsecured debt. With a secured loan, the borrower pledges a valuable item (collateral) to guarantee repayment. In a mortgage, the house is the collateral and will be used to satisfy the debt if the borrower fails to repay the loan. However, unsecured debt, like student loans, is not backed by collateral.
• Installment vs. revolving debt. An installment loan offers a lump-sum amount that is repaid in smaller, scheduled payments, as seen with mortgages or car loans. Revolving debt differs by providing an open line of credit that borrowers can access in varying amounts up to a specified credit limit. Examples include credit cards and home equity lines of credit.
• Short-term vs. long-term debt. Loans requiring repayment within a year or less are considered short-term loans, while long-term debt can be repaid over multiple years.
• Callable vs. noncallable debt. Callable debt allows the lender to demand repayment before the due date stated in the loan agreement. With noncallable loans, the lender cannot demand payment before the loan’s maturity date.
• Fixed-rate vs. variable-rate debt. Fixed-rate loans charge a set interest rate that remains unchanged throughout the loan term. Variable-rate loans have interest rates that can fluctuate based on the current market rates.

Any debt can have several of these characteristics. For instance, a mortgage is a secured, long-term installment loan that can take the form of a fixed-rate or adjustable-rate mortgage. Credit card debt, a form of revolving credit, is generally noncallable with a fixed interest rate. Before accepting a loan, it’s crucial to know all the terms to avoid surprises when it comes to repayment.

Good debt vs. bad debt

While debt can be a powerful, wealth-building tool, it can have negative consequences if mishandled or taken under unfavorable circumstances. If you’re thinking about taking on debt, it’s important to consider its benefits as well as the overall effects on your financial position. Factors that can have significant implications include:

• Added costs. Interest rates are used to calculate the cost of borrowing money and increase the total amount you pay for an item purchased on loan or credit. Determining whether the item provides enough value to justify the added cost is an important step in evaluating debt.
• Potential for return on investment. When purchasing an appreciating asset, you may be able to recover the cost of the loan and build wealth as the asset increases in value.
• Collateral requirements. When securing a loan with collateral, it’s essential to consider how losing the item used to secure the loan would affect you and your family if you’re unable to repay the loan.
• Repayment terms. How a loan is to be repaid is just as important as the amount to be repaid. Will you be able to pay the loan by the required date? If the loan is callable, do you have the resources needed to pay it off immediately? Also keep in mind that loans with variable interest rates can lead to higher payments and total loan costs as the market fluctuates.
• Impact on credit score. Building a history of successfully paying off loans with consistent on-time payments helps establish a strong credit score, which in turn can make it easier to access credit with better interest rates in the future. However, late or missed payments will have a negative effect on your credit score.

What is good debt?

Debt that has the potential to build wealth and improve your quality of life is generally considered good debt. This can include borrowing money for education, to start a business, or to purchase a home. Consider a home mortgage, for instance. Depending on its condition and location, a property’s value typically appreciates over time. Owning a home helps you build net worth, and as a bonus, a portion of your mortgage interest may be tax deductible.

What is bad debt?

Debt that cannot be repaid is one definition of bad debt. However, certain types of loans, regardless of their repayment status, are also considered bad debt:

• Loans for depreciating items and consumable goods like food and clothing are viewed negatively because, between the loan interest and depreciation, you end up paying more than necessary and lowering your net worth.
• Payday loans are widely viewed as bad debt due to their extremely high interest rates and harsh repayment terms.
• Borrowing money to invest in the stock market is highly discouraged because of the risk of loss due to market downturns.
• Even debts that are traditionally considered good debts can have a negative impact. Examples can include a mortgage that’s too large to repay comfortably, a student loan toward a career with low job prospects, or a car loan with affordable monthly payments but a high total cost. Additionally, while credit card usage can help you build credit, making only minimum payments coupled with high, daily compounded interest rates can cause debt to snowball. A key factor in determining whether a debt is good or bad is how it’s managed.

Managing debt responsibly

Managing debt wisely requires planning before you borrow and taking measures to ensure that debt doesn’t derail your financial goals.

Before taking on debt

Taking these considerations into account before going into debt can help you protect your net worth and ability to build wealth.

• Moderation is key. Steer clear of taking on more debt than you can handle and keep your debt as low as possible. Just because a lender qualifies you for a certain loan amount, it’s best to give yourself some breathing room and not take the maximum allowed.
• Some debt isn’t worth it. Avoid buying consumables like food, clothing, and furniture on credit. It’s also best to avoid debt on depreciating items or situations involving a significant risk of losing your initial investment. It’s also advisable to avoid loans on luxury or splurge items with no lasting value beyond current enjoyment.
• Patience is a financial virtue. Saving up for a down payment before taking a mortgage, and choosing the shortest term you can manage, will save you thousands of dollars.
• Treat special offers with care. Same-as-cash offers allow you to purchase items on credit without paying interest. However, make sure you can pay in full by the end of the free term before interest starts to accrue. Interest is usually calculated and compounded from the purchase date—not when the interest-free period ends.
• Emergencies happen. While it’s not necessary to establish an emergency fund before taking on debt, creating and maintaining one is an important part of a sound financial strategy. It can help you avoid debt or reduce the amount you need to borrow when unexpected expenses occur, and it can help you stay current with loan payments if there is a gap in income.

In addition to an emergency fund, cash value life insurance can be a valuable resource. These policies not only provide financial assistance for your family should the unthinkable happen, but they also accumulate cash value that you can access during your lifetime. You can borrow against the policy at rates that are usually more favorable than loans from other sources.

Managing existing debt

When handling debt you’ve already incurred, these steps can help you keep debt under control and minimize the effects of interest.

• Pay on time consistently. To maintain good credit, making payments on time is a must. If you face a situation where you can’t make a payment, contact the lender and find out what options are available to prevent a default and steep penalties.
• Pay ahead. Paying off debt early can save you money by avoiding the effects of compounding interest. This can be done in a lump sum or by paying more than the minimum on each monthly payment.
• Debt consolidation. Combining multiple loans into a single debt can be helpful when managing your finances. You can simplify repayment with a debt consolidation loan that has a lower interest rate or by transferring credit card balances to a 0% interest card. To transfer credit card balances successfully, make sure you can pay off the debt by the time the 0% interest promotion ends. Also, beware of offers that seem too good to be true. If your interest rate and monthly payments are dramatically lowered, extending the duration of the loan may cause you to pay more on the loan overall.
• Avalanche method. Paying off the debt with the highest interest rate first, while making minimum payments on lower interest debts, can help you save money by easing the effects of compound interest. Once the debts with higher interest rates are paid off, the funds that would have gone into those debts should be used to speed up the repayment of any remaining debts.
• Snowball method. Paying off your smallest debt first, while making minimum payments on the others, provides a sense of accomplishment while allowing you to put more toward the other debts as each of the smaller debts is paid off. When deciding between the snowball and avalanche methods, it’s important to consider the specific details of each of your debts and your overall financial circumstances.
• Maintain an ideal debt-to-income ratio. Taking on too much debt can be harmful to your financial health. Your debt-to-income ratio, the amount of debt you have compared to your overall income, is one way to measure financial well-being. To calculate it, divide your monthly debt payments by your gross monthly income. It’s best to keep this ratio below 35%, with no more than about 30% going toward housing. A higher debt-to-income ratio may signal difficulty in meeting your general expenses and lenders may be reluctant to extend further credit.

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