Debt is something many people don’t really like to think about, even though it impacts their lives in numerous ways. The truth is, debt is one of the underpinnings of our financial system. Corporations make money off of your debt in various ways: They charge you interest on things like your mortgage, automobile loans and credit card balances; they collect and then sell your debt history to companies so they can determine whether to extend credit to you; they sell you your own debt information (or try to); and, of course, they sell you products aimed at helping you manage your debt or improve how your debt is presented to potential creditors.
That’s why it’s so important to understand how debt works, how you use debt, how your debt impacts your credit and what types of debt are considered “good” and “bad” when it comes to evaluating your own personal finances. “Good” debt is generally thought to be debt that can help you grow your overall net worth over time – like your mortgage or student loans. “Bad” debt, on the other hand, is generally thought to decrease your net worth.
Why should you worry about whether your debt is viewed as “good” or “bad?” Well, for one thing, if you want to figure out the most effective way to pay down your debt so you can reach your future financial goals, it can be important to determine which debts to focus on first. To improve your credit standing, you’ll want to focus on getting rid of the “bad” debts first.
Let’s take a closer look at different types of debt and why they’re considered “good” or “bad.” We’ll start with credit cards…
Credit Cards: Bad Debt
As ubiquitous as credit cards are, and as much credit card debt as there is (the average American household has about $8,000 in credit card debt) you’d think credit card debt would be seen as “good” debt.
Generally speaking, credit card debt, or revolving debt, is viewed as “bad” by the credit industry if you carry a balance from month-to-month. If you pay off your balances each month, however, your credit card debt can be viewed as very positive or “good.” If you’re carrying a lot of credit card debt, you may want to consider applying for a balance transfer credit card to help you consolidate your debt and pay it off faster.
Auto Loans: Good Debt
Most auto loans are seen as “bad” debt, though as “bad” debt goes, they aren’t all that horrible, especially if you’re making your payments on time. Auto loans, don’t typically help you grow your net worth, and in many cases your loan is more than your vehicle is worth. In addition, for many people, monthly auto loan payments make up a large portion of your monthly income.
Home Mortgages: Good Debt
Mortgages are typically considered to be “good” debt for a variety of reasons. In most cases, homes appreciate in value, letting you build equity in your home. However, if your home has depreciated for some reason and is worth less on the current market than you actually owe, your debt could be viewed as “bad.” The same is true if your mortgage payments make up more than about 35% of your monthly income.
Student Loans: Good Debt
Like mortgages, most student loans are viewed as “good” debt. That, of course, is dependent on a few different factors, including whether you borrowed a reasonable amount based on the lifetime earning potential your degree provides. That’s because your ability to repay the debt hinges almost exclusively on that single factor. If you fall behind on your payments or, worse, default on your loans, your student loans obviously become “bad” debt.
Obviously, your credit standing is impacted greatly by your ability to manage your debt successfully. If you’re struggling to make ends meet, you can check out our explainer on how to pay off debt quickly using a couple of tried-and-true methods called the debt snowball and debt avalanche. Doing so can not only make you feel more in control of your financial life, but also put you on the right track when it comes to saving enough for retirement.
[Editorial Disclosure: PayDownMyDebt.com is a service that provides people with tools to pay down their debts through automatic payments. The purpose of this article, however, is not to encourage users to purchase that service. This article is educational and journalistic in nature and aims to help people learn how to pay down their debt, whether they use our site, another, or go it alone.]