Note that the situation for debt has changed in some cases due to the impact of the coronavirus outbreak and relief efforts from the government, student loan lenders and others. Check out our Student Loan Hero Coronavirus Information Center for additional news and details.
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Good debt and bad debt both represent an unpaid balance on an outstanding loan or account, but that’s where the similarity starts to fade.
Good debt, like student loans and mortgages that are borrowed in the right proportion, can help you invest in yourself or your portfolio. Bad debt, such as unwieldy credit cards and auto loans, however, can seriously hamper your life and finances. If your balances grow so high that you can’t afford to pay even the minimum amount due, you could begin racking up delinquencies (late payments by 30 days or more) on your credit reports.
But not all debt is necessarily worth avoiding. As long as you limit what you borrow and routinely pay your bills on time, a reasonably priced loan can often help, not hurt, your finances.
- Good debt versus bad debt
- 4 types of good debt
- 4 types of bad debt
- Turn your bad debt into good debt (or no debt)
According to credit expert Beverly Harzog, determining whether a loan is good or bad largely comes down to how affordable it is and how you use it.
“A lot of people don’t understand that not all debt is bad,” Harzog said. Some loans can help you build credit so that you can afford lower priced loans in the future. Others help you invest in assets — or in yourself — so that you can start to build wealth at a younger age.
If you’re considering taking out a loan and know that you can’t pay it off immediately, you may want to first ask yourself:
- Is this loan helping me reach an important goal?
- Am I paying a fair and affordable interest rate?
- Can I pay off this loan within a reasonable time period?
- Will I have to make major trade-offs in my life to repay this loan? (And am I OK with that?)
In general, the best loans are those for which you don’t pay any interest because you paid off the loan in full before the end of a statement period or you received an introductory 0% APR.
But it’s not always possible to go through life without ever paying interest. There are times when a loan is worth the extra cost.
Experts consider the following loans to be forms of good debt because they can help you …
If you’re trying to improve yourself and your life circumstances but don’t have the cash to finance your venture upfront, a loan can help — as long as you borrow within reason.
For example, financing your education would be considered a worthwhile reason to borrow, said Bruce McClary, vice president of communications at the National Foundation for Credit Counseling.
“There are certain types of debt that are more like investments in your future, like a student loan that helps you obtain a degree and that allows you to increase your future earning potential,” he said.
Some loans can help you earn more money over time by allowing you to purchase an asset upfront and reap the benefits later if that purchase grows in value. A home loan would be considered an investment, McClary said.
“You are making payments toward ownership of property,” he said. “As you own that property, the hope is that it will increase in value and build equity.”
A loan can help you finance purchases that you need but can’t afford to pay in cash, such as a reliable car you can drive to work or a new furnace or refrigerator.
Some loans can help you shave your overall costs, Harzog said. If you have good credit and use an interest-free financing deal or a low-rate personal loan to pay off your debt, that loan would be considered a net positive, she said.
Similarly, a credit builder loan can help you improve your credit score and save money on interest.
|Good debt: Real-life examples|
|● A student loan that allows you to get a great education and leads to your desired career|
● A small business loan that helps you get your big idea off the ground and builds an income stream
● A home loan that paves the way for equity in a property that gains value over time
Debt becomes harmful when it starts to hold you back in life rather than help you move forward. That could be the case if a loan …
If you have a large balance and are being charged a double-digit APR, that would be considered bad debt that you want to pay off quickly. For example, credit cards and payday loans charge notoriously high APRs.
“Carrying a balance and paying interest, this is just toxic debt,” Harzog said. “Your balance can just grow so quickly.”
If your debt is holding you back in life — by making it difficult to save for retirement, buy a home or invest in yourself in other ways — that debt would also be considered bad debt.
That’s why some debt that’s traditionally considered good debt, such as burdensome student debt or a large mortgage, can turn toxic if you borrow too much of it.
Some loans are so expensive that they are notoriously hard to get rid of once you’ve taken them out. Payday loans, for example, often come with APRs near 400%.
“This can drag people into a terrible debt cycle,” Harzog said.
Some borrowers, for example, wind up taking out additional payday loans just to cover the expenses they incurred with their last one, she noted.
“It can get out of control in a hurry,” she said.
Spending money on interest when you don’t have to can be harmful.
If you revolve a balance on your credit card when you can comfortably afford to pay off your balance in full, you are throwing money away for no good reason.
|Bad debt: Real-life examples|
|● An auto loan that calls for you to pay far more your wheels than they’re worth|
● A credit card balance that rolls over month to month
● A payday loan that continues your cycle of debt instead of ending it
If you have a lot of toxic debt, you should work to pay it off as soon as possible. Consider these strategies:
- Continue to pay at least the minimum amount due on every loan since you’ll have more options if you have good credit. Then, map out a plan to shrink your debt.
- A balance transfer card with a lengthy 0% promotional period or a personal loan with a lower interest rate can help you consolidate your debt and pay it off more quickly.
- You may be able to lower your interest payments or work out a sustainable repayment plan by contacting your lender. “Negotiate with your creditors,” McClary said. “If you feel that your progress toward paying off debt is stymied by paying a higher interest rate than you deserve, it’s on you to make the first move.”
- For education debt specifically, look into student loan refinancing as a way to turn bad debt into good debt. If you have strong credit or a qualified cosigner, you could refinance your loans to a lower interest rate or monthly payment, bringing your debt closer to its final act.
Finally, don’t forget to think back on how you accumulated so much debt in the first place, Harzog said.
“Sometimes it’s an emotional issue,” she said. If you’re overspending because you feel anxious or you get a feel-good boost each time you charge your card, it’s important to work through those issues before you return to borrowing. That way, “once you’re out of debt, you can stay debt-free,” Harzog said.
Andrew Pentis contributed to this report.