Sizing Up Debt
In recent years, many Americans have become quite familiar with the different types of financing solutions available to them - whether it is in the form of student loans used for higher education, a home mortgage, an automobile note or the all-too-familiar staple of consumer debt: credit cards. Is there such a thing as "good debt" and "bad debt?" What amount of debt is "acceptable" for an individual? These are questions that we endeavor to answer here.
Does "Good" Debt Exist?
In a word, yes! "Good" debt does exist, as most people simply cannot afford to purchase pricier, big ticket items such as a home or a car without tapping a line of credit. To determine whether or not debt is "good," ask yourself if the debt is being used to purchase something that adds value to you (like some higher education degrees, or certain vocational schools). Another question to ask yourself is whether or not your purchase will appreciate in value; for example, homes in certain areas will increase in value over time, or loans used to finance small businesses may result in the business becoming more profitable. If the answer to either of the above questions is "yes" then the debt you are undertaking to finance the purchase is likely to be dubbed as "good" debt.
A quick note on higher education loans, which have been something of a topic of interest in recent months: many question whether or not student loans are "good debt" or "bad debt" given the unfavorable combination of high unemployment rates and the average undergraduate student loan debt being roughly $25,250. Therefore, when it comes to debts undertaken to finance higher education, it is important to consider whether or not you will graduate from your university or vocational program with favorable job prospects. If not, then excessive student loan debt could be dubbed as "bad" debt.
"Good" debt is useful because in addition to adding tangible value to you, it may improve your credit score. Just be sure to make all of your payments in a timely manner!
What Is "Bad" Debt?
While "good" debt generates value for a person, many financial advisors label credit card debt as "bad" debt. "Bad" debt is incurred to purchase non-durable goods and services (such as clothing, meals at a restaurant, vacations and unnecessary gadgets). When these short-lived items are financed using a credit card that is not paid off within a reasonable time frame, normally one to two billing cycles, then this type of debt falls into the "bad" debt bucket. In most instances, the purchase of these non-durable goods and services does not add tangible value to a person's life and is not necessary.
Auto loan notes may fall into either the "good" or "bad" debt categories; it really depends upon the value of the car and its primary use. If your car is a reasonably priced, reliable and well-maintained machine used to transport you and your family to work and school, then it may fall into the "good" debt category because it is an asset being used to add tangible value to your life. However, if you are driving a lavish automobile that is pricey to maintain and repair, or if you have access to public transportation to work and school, then an auto loan would likely fall into the "bad" debt bucket. When considering if an auto loan is "good" or "bad" debt, an important question to ask yourself is, "how necessary is an automobile for me? Can I get around without it?"
How Much Debt Is Enough?
Lenders tend to offer more favorable interest rates to those with a debt-to-income ratio lower than 36%. To calculate your debt-to-income ratio, simply add up all your monthly debt payments and divide them by your monthly income before taxes. Many lenders also favor borrowers whose balances on each credit card or line of credit are no higher than 30% of their available credit line. That is, if you have $10,000 of available credit on a single credit card, a balance of $3,000, which is 30% of $10,000, is as high as you would want to go on that particular credit card. It is important to maintain a debt-to-income ratio that is below 36%, and if you use credit cards, try to use no more than 30% of the credit available on each card.
"Good" and "Bad" Debt: They May Help Your Credit Score
Finally, remember that 10% of your FICO score, one of the most popular credit scores used by lenders, depends upon the different types of credit used. Lenders prefer borrowers who have successfully used several different types of credit. Of course, payment history and amounts owed continue to have the highest weight in your credit score, but responsible use of the different types of credit will also help your score.
The Bottom Line
Essentially, "good" debt is debt used to add value to a person while "bad" debt is debt used to finance the purchase of non-durable, unnecessary goods. Many financial planners recommend a debt-to-income ratio lower than 36%, but be mindful of credit card balances that go higher than 30% of the total available credit! Responsible use of the different types of credit is an effective way to improve your credit score.