Good debt versus bad debt

This article will ...  Describe how debt chips away at your ability to achieve your financial goals.  Explain how some debt can potentially provide the leverage to accumulate personal wealth. Identify your ideal debt-to-income ratio and explain why you need to revisit it regularly.

Debt is often perceived as a four-letter word, burying borrowers in hefty balances and double-digit interest fees. And for many Americans, that’s the case.

According to WallHub’s most recent debt survey, U.S. households carry an average credit card balance of $.10,479.¹

Debt eats away at disposable income and limits the borrower’s ability to meet other financial goals, such as saving for retirement. It also forces those who carry a monthly credit card balance to overpay for consumer goods — including furniture, clothes, and flat-screen TVs — due to the interest charges that accrue.

Assuming a 17 percent interest rate, for example, that $5,000 vacation you paid for with plastic would take 13.2 years to pay off and cost a total of $9,030 if you made only the minimum monthly payments, according to the minimum payment calculator on CreditCards.com.²

Good debt? Appreciating assets

Yet, if used properly, debt can also potentially provide the leverage to accumulate personal wealth. Very few people could afford to purchase a primary residence without a mortgage loan.

Not all property appreciates in value, of course, but for most Americans, their primary residence is their single largest asset. As of 2022, U.S. homeowners are sitting on a record $11.5 trillion of “tappable equity,” defined as the total amount of equity a homeowner with a mortgage can borrow against their home, according to Black Knight, an analytics software firm.³

In most cases, student loans are also necessary to pay for a college degree, which costs in-state residents an average of roughly $24,030 per year for tuition, fees, and room and board at public, four-year universities and nearly $56,190 annually at private, four-year colleges, according to the College Board.⁴ (Learn more: Refinancing student loans)

Americans currently owe more than $1.5 trillion in student loans, but the payoff for graduates can be huge.⁵ Georgetown University found bachelor’s degree holders earn 31 percent more on average than those with a two-year degree and 84 percent more than those with only a high school diploma.⁶ 

It bears noting, too, that even credit card purchases, if balances are paid on time and in full, can help consumers build or restore their credit rating. And that’s the metric most lenders use to determine how much interest to charge borrowers or whether to qualify them for a line of credit at all. The higher your score, the less you will pay for your home, auto, or personal loans. (Related: Is college worth it? A cost-benefit analysis of college)

Bad debt versus good

Financial educators generally divide debt into two distinct camps: bad debt, which consists of high-interest credit cards and car loans (a depreciating asset), and so-called good debt, which are loans tied to an investment that may build wealth or generate income over time, such as real estate or student loans. In truth, car loans straddle the line, as they can potentially provide the transportation to apply for a higher paying job farther away.

Paul Golden, a spokesperson for the National Endowment for Financial Education, however, argues that any loan can become “bad debt” if you don’t borrow responsibly.

“Any debt has the potential to be bad, especially if you don’t understand the product,” he said in a phone interview. “Even student loans can be bad if you over borrow or take on more [pricey] private loans than public loans. Or, if you borrow all this money for college, but never finish your degree, then that’s a double negative.”

Some lenders also charge higher interest rates than the industry average or assess prepayment penalties, which puts consumers at a disadvantage, said Golden.

For anyone managing debt, he said, the key is to understand what you’re borrowing, shop around for the lowest rates and, above all else, keep your debt level firmly in check.

“You need to know your credit score and understand your financial identity before you go shopping for a loan, which can help you be more thoughtful with your budgeting and borrowing,” said Golden. (Learn more: Saving money — and staying safe — when shopping for a loan)

How much debt is too much?

So what’s a reasonable amount of debt? That varies depending on your unique financial picture, but most lenders like to see a debt-to-income ratio of anywhere from 28 percent to 36 percent.

Golden reminds consumers, though, that debt-to-income ratios are based on gross income and do not include such expenses as childcare, health care, groceries, or utilities.

“That’s why budgets become so important, so you can really get a sense of the full scope of your expenses,” he said. “And it’s not a one-time deal. You need to review your budget regularly because while some of those expenses, including your mortgage, may be static, others like your grocery bill and entertainment costs will fluctuate.” (Related: How to set up a budget and follow it)

Five red flags that suggest you may have taken on too much debt include:

• Missing payments.
• Only being able to afford to make minimum payments.
• Borrowing money to pay bills.
• One or more credit cards maxed out.
• A new credit card or loan denied.

Solutions for paying down debt

If you’re in over your head financially, or simply wish to rid yourself of debt, financial experts suggest you start by paying down your highest-interest credit cards first, while continuing to make the minimum payments on your other debt obligations. After the first card is paid off, apply those extra payments toward the next highest-interest debt and continue until your balance is zero.

You can rid yourself of debt faster if you take a part-time job, lower your monthly living expenses, and above all else, stop making new purchases with your credit cards. (Learn more: Handling credit card debt)

A credit counselor may also be able to help you create a budget for a debt-free lifestyle and stick with it, such as those available through the nonprofits National Foundation for Credit Counseling or the Financial Counseling Association of America.

The Consumer Financial Protection Bureau, however, cautions borrowers to beware of debt settlement companies, which are different from nonprofit groups, especially those that charge up-front fees, guarantee they can make your debt disappear, or tell you to stop communicating with your creditors.⁷

“It’s very easy to get into debt, and it takes so long to dig out,” said Golden, noting that those who struggle with debt should do some thoughtful introspection about their saving and spending choices. “Consider not just how you’ll pay off your debt, but how you got into this situation in the first place.”

Debt isn’t all bad, especially if managed responsibly. But if you’re spending more than you should on monthly debt obligations or you’re unable to save for other financial goals, it may be time to put a debt reduction plan in place.

Discover more from MassMutual…

Setting financial goals: Debt

When student loans are unaffordable

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The article was originally published in September 2018. It has been updated.

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