Opening that first credit card is tempting. It promises to increase credit scores, provide relief in unexpected emergencies and calm minds stressed by financial insecurity. However, good and bad debt can be challenging to discern.
With so many influences impacting credit line agreements — from interest rates to fees — how are people supposed to know if what they agree to will serve or hurt them? Luckily, there are telltale signs for what signifies good debt and tips on managing it responsibly.
Types of Debt
Analyze every avenue you can borrow money. You could take out loans to buy a car or home or fund your education. Personal loans could save you from unexpected emergencies like medical costs. Anyone can use credit cards to pay bills they would already be paying, but they can earn reward points or airline miles for being responsible and paying balances off every month.
Therefore, good debt encourages financial security in the long term. For example, a low-interest loan to invest in a property to rent out is good debt because renters assist in the debt repayment, and returns continue with revenue. Student loans can be good debt because education increases the likelihood of higher-paying careers.
However, none of the benefits matter if the repercussions outweigh the usefulness of the debt. Plus, too much of any debt will prove unmanageable, and that behavior could permanently impact a credit report.
Ultimately, good debt could fall under any category — you must ensure the terms and conditions serve your purpose and stay within your means to benefit your future.
Managing Each Kind
Student loans, mortgages and auto loans are the most common types of good debt. Good and bad debt requires attentiveness and budgeting for success. Debt management strategies work for all kinds, including more neutral debt like medical.
There are recommended percentages of your income that can help you determine how to balance your bills which indicate a good debt-to-income ratio:
- Student loan: Remain below 10% of your after-tax earnings post-graduation.
- Mortgage: Stay around 35-45% of your income, if not less.
- Auto loan: Down payments are the key to auto loan success, which will help you stay beneath a recommended 20% investment.
Keeping an eye out for low-interest rates and loan periods is ideal. The longer the term, the more interest the loaner can take from you, and the more easily it keeps borrowers demotivated — the time seems neverending.
Management is also about being discretionary about other forms of debt you accumulate. Opening lots of credit cards, buy-now-pay-later loans and taking out a personal or payday loan increases the financial and emotional burden of outstanding good debt.
Tips for Success
The first step in analyzing debt is asking yourself if the cost of debt is worth the result. Opening a credit card to pay for a vacation you can’t afford is a less worthy venture than putting a down payment on a new car can give you agency in a job hunt. The latter is an example of good debt, assuming the loan receiver purchases a vehicle within their current capabilities.
Once you take out a loan, it doesn’t have to remain at that servicer with the beginning terms. Refinancing is a wise option to analyze a couple of times a year to see if another provider is willing to negotiate better interest rates or benefits to grab you as a customer.
Next is to understand the two most prominent methods in debt repayment — the snowball and the avalanche. The debt snowball method encourages paying off the smallest loans first to build momentum, like rolling up a snowball. This smaller loan requires more aggressive payments to eliminate it as quickly as possible. Then, the amount previously allocated to that payment shifts to the following loan, reducing the payoff time for every loan even more.
The avalanche method advises the opposite — first, pay off the largest and most intimidating loan to provide peace of mind. You can choose to pay off the loan with the highest balance or the one with the highest interest rate. The benefit is that it could reduce long-term spending because the accounts will not accumulate as much interest.
Choose the method that best fits your personality and financial situation. Both are equally viable. After deciding, the best way to maintain good standing is to automate payments, keep a strict budget and always pay every bill on time, even if it isn’t debt related. These habits compound to develop a financial mindset that sets you up for success.
How to Champion Every Kind of Debt
Knowing distinctions in debt will help you stay on a positive financial path, creating a healthy relationship with borrowing money. For many, it is an inevitable step in their financial future. It can be not very comforting, but knowing the best practices ahead of time can foster productive money-borrowing habits for funding a thriving future for anyone.