Debts to Avoid (and Kinds to Consider)
Even though it’s possible, it may not be the best idea to live totally debt-free.
The majority of people simply don’t make enough money to buy a home or car in cash—and finding the personal funds to start a business or afford an education is likewise difficult. It's at times like these that debt can be helpful.
Unfortunately, debt also keeps a majority of Americans up at night—and COVID-19 hasn't helped, to say the very least. According to the American Psychological Association, 64% of Americans say that money is a major source of stress, and 52% say the pandemic has worsened their financial situation.
Debt can be a source of stress—but it doesn’t have to be.
This phenomenon is so widespread that it even has a name: debt stress syndrome.
There are varying types of debt, however. Certain debts do little more than wreak havoc on your financial well-being. Other kinds of debt can be useful and may be worth taking on.
But which debts are good—and which others are bad? How can you even tell?
A quick primer on debt
How do they differ?
Here’s a simple rule of thumb: if you’re borrowing at a reasonable interest rate to purchase assets that will most likely appreciate in value, then you’re probably taking on good debt.
However, if you’re using high-interest loans to buy depreciating assets—or if you’re saddling yourself with overwhelming amounts of debt (of any kind)—then you’re likely burdening yourself with bad debt instead.
Are you taking on too much debt?
While there’s no one-size-fits-all answer here, there are a few clues. Intuitively, if you struggle to pay your bills in full at the end of each month and don’t feel like you can make ends meet, then you’re probably in a bit too much debt.
Typically, however, lenders will use a more quantifiable metric called the debt-to-income ratio as an indicator of your debt load.
The debt-to-income ratio is calculated by adding up all your monthly debt payments and dividing them by your gross monthly income—which is defined as your regular paycheck plus any overtime pay, commissions, tips, allowances, or projected bonuses.
For example, if you make $1,500 in mortgage payments, $200 in car payments, and $300 a month in credit card payments, your monthly debt burden adds up to $2,000 per month.
Couple that with a monthly gross income of $4,000, and your debt-to-income ratio is 50%.
If this happens to be you, then you likely have too much debt on your hands.
Keep your debt-to-income ratio in check by making sure debt repayments don’t consume too much of your monthly income.
In general, a healthy debt-to-income ratio shouldn’t exceed 43%. Any more, and it’s a red flag to potential lenders, simply because borrowers with higher debt-to-income ratios are more likely to experience financial hardship—and less likely to repay their loans.
Now that we have the basics down, let’s take a look at a few kinds of good and bad debt.
Good debts
1. Mortgages
Mortgages are secured loans (i.e. loans made against a collateral asset) that provide financing for real estate purchases, such as a home or commercial building.
In terms of debt, mortgages are king. For starters, mortgages feature some of the lowest interest rates among consumer loan products, meaning you can readily keep your cost of borrowing in check.
Additionally, you’re using the loan to buy real estate, an asset that has the potential to increase in value—especially if you move into a location that's in high demand.
Mortgages can be a form of good debt.
Home prices tend to rise over time
And this is far from an uncommon scenario. After all, housing prices are often in a secular uptrend.
For example, in 1970, prices embarked on an uninterrupted climb that lasted until the early 1990s. After a brief halt, housing prices resumed their ascent until hitting a peak in November 2006.
In 2008, the real estate bubble burst, and we briefly had to rethink the idea of homeownership as a secure store of wealth in America. Nevertheless, since the Great Recession bottomed out in 2009, the housing market has roared back to life. In fact, the Federal Housing Finance Agency (FHFA) reports that home prices have risen every quarter since September 2011—resulting in prices nearly doubling in the 11 years since.
Even today, housing markets remain red hot. As a case in point, prices rose 10.8% in 2020 alone—even amidst the national Coronavirus lockdown. But what does all this mean in a more tangible sense?
Why mortgages are good for you
Let’s suppose you buy a home for $500,000. You put 20% down, or $100,000—and then borrow the remaining 80%, or $400,000. You structure your loan as a 30-year, fixed-rate mortgage with an APR of 3%. At the end of the 30 years, you’ll have paid back a total of $607,202—or your $400,000 principal balance plus $207,202 in interest.
Though that sounds like a lot of interest, remember that your home will also have appreciated during those 30 years. If the value of your property increases by the same 3% per year, it’ll be worth over $1.2 million by the time you fully pay off your mortgage—more than $700,000 more than what you paid for it.
Not that’s some good debt!
2. Home equity lines of credit
Home equity lines of credit (HELOCs), along with home equity loans, are both close cousins of mortgages.
Equity (i.e. the value of the borrower’s home less the amount remaining on the home’s mortgage, if applicable) is used as collateral against the outstanding line of credit, allowing borrowers to obtain financing at a reasonable interest rate. In today’s interest rate environment, prime-rate HELOCs can feature interest rates as low as 5% to 6%.
Though this is usually a percentage point or two higher than the interest rates carried by mortgages, HELOCs—when used responsibly—are nonetheless affordable, useful, and powerful forms of good debt.
You can borrow against the equity in your home via a HELOC or a home equity loan.
Using a HELOC well
There are many useful ways to use a home equity line of credit. For example, borrowers can use their HELOC to pay off higher-interest debts, like personal loans or outstanding credit card balances.
HELOCs can also be used for home improvements, such as solar panels, whole-home water filters, or energy-efficient lighting. Not only can these upgrades help homeowners save money on utility bills, they can also up the value of your home.
However, there is one notable drawback to the strategy. If you can’t keep up with your payments, you could lose your home to foreclosure—just like you would with a mortgage.
3. Student loans
If you want a good education but don't have the money for tuition, you can consider a student loan. Those studying for undergraduate or graduate degrees can borrow money from student loan lenders like Discover, SoFi, Navient, or Sallie Mae. If you’re approved for a student loan, the money will be distributed to you every semester so that you can make your tuition payments on schedule.
Student loans can help you afford an education.
In contrast to other forms of financial aid, such as grants or scholarships—neither of which have to be repaid—student loans must be paid back. If possible, see if you’re eligible for merit-based or need-based aid first (for example, by filling out FAFSA or combing scholarship databases to find those that you qualify for) and only apply for student loans after you’ve exhausted your other options.
After all, you don’t want your student loans to hold you hostage after graduation. Student loan payments are hefty, and can be as high as several hundred dollars per month.
Don’t think you can get out of your loan payments by declaring bankruptcy either—unlike personal, business, or medical debt, student loan debt isn’t dischargeable in bankruptcy.
Given these pitfalls, make sure you take stock of your other options before committing to a student loan. Though they can be considered a form of good debt, too much of a good thing can be harmful—and particularly so in this case.
4. Small business loans
Starting your own company and working for yourself is a dream for many Americans. Not only do you have the freedom to choose when, how, and with whom to work, entrepreneurship also has the potential to make you wealthy—at least more so than a run-of-the-mill 9-to-5 office job might.
After all, there are plenty of proven and successful small businesses in the wild—and so long as you have some personal backing and a solid plan, you might also stand a chance of “making it”.
However, keep in mind that it’s much more difficult to qualify for small business loans. Lenders view these unsecured loans as riskier than others (e.g. mortgages)—because they have little recourse if your business fails.
And unfortunately, this isn’t an uncommon situation. According to the Small Business Administration, nearly one-third of small businesses fail within their first two years of operation.
Though borrowing money to start a business could be the best investment you ever make, it could also end in disaster. In order to succeed, you'll need ambition, savviness—and most importantly—a whole lot of luck.
A business loan can be a useful source of funding for your new venture.
Bad debts
It's not hard to spot bad debt. If you borrow money to buy things that lose value right after you purchase them, then you’re probably messing with bad debt.
Sadly, much of life's basic needs can be summed up in that sentence. Clothes, automobiles, TVs and furniture all depreciate in value over time, making them unideal to own, at least from an investor’s standpoint.
If money is tight, you should consider spending less on items that depreciate in value. Buy off-brand clothes, used cars, budget appliances, or thrift store furniture instead. In any case, try to avoid borrowing to make these purchases if at all possible—you’ll end up better in the long run.
Here are a few more examples of bad debts to avoid.
1. Credit cards
Though popular, plastic money can have disastrous consequences on your finances, especially if you spend recklessly.
High-interest rates are the killer in this kind of bad debt. Many consumers are unaware that if they carry a long-term balance on their cards, they’ll end up paying back far more in interest than they’ll have ever borrowed in the first place.
So here's the rule: don't buy anything you can't afford and won't use.
Credit cards charge sky-high interest rates—so try not to carry a balance.
How do credit cards work?
Credit cards are a form of unsecured, revolving debt. They’re unsecured because they aren’t backed by collateral, and revolving because consumers can borrow repeatedly, so long as they pay their balance down.
Unlike other loans, credit cards don’t feature regular repayment schedules. Though you must make minimum monthly payments, those payment amounts aren’t fixed, and you can choose to pay off as much or as little of your balance as you wish.
If your balance is not cleared in full each month, you’ll be charged interest, and the longer it takes you to repay the money, the more interest you will pay. In general, interest rates on credit cards are notoriously high, and most cards feature 10% to 30%+ APRs.
On the other hand, if you fail to even pay the minimum required amount each month, credit cards can become even more expensive, since lenders with tack on penalty APRs and late fees.
Use credit cards to your advantage
Nonetheless, if they are managed sensibly, your plastic can be a surprisingly cheap way to borrow. Here’s why.
Generally, if you pay off your account balance in full every month, you won't be charged interest. If you never carry a balance and spend with rewards credit cards, you can receive points or cash back that may help you lower the cost of your purchases—effectively amounting to a form of negative interest.
As long as you clear your credit card balance completely and don't exceed roughly 25% of your credit limit, credit cards can help boost your credit score and serve as a smart and strategic way to make everyday purchases.
Use credit cards responsibly and don’t borrow more than you can comfortably pay back.
2. Payday loans
Payday loans, also called cash advance loans, are the worst of the worst. In fact, they are ten to fifteen times more expensive than credit cards. These loans are essentially ultra-short-term loans that are meant to cover your expenses before a borrower’s next paycheck comes in.
With payday loans, finance charges for every $100 borrowed range between $15 and $30. If a borrower takes out a payday loan every two weeks, this would amount—on an annualized basis—to an eye-watering 400% APR!
In short, try to avoid payday loans at any cost—and we mean that quite literally. If you have no choice and must take on a cash advance to pay your bills, see if you can get help from a local charity or nonprofit organization instead of a predatory payday lender.
3. Auto loans
Cars are infamous for depreciating in value. As a case in point, a brand-new car loses about 10% of its value the moment it’s driven off the lot.
In contrast, automobile interest rates are usually low—roughly 1.4% to 2.5% when you have good credit and between 2.5% and 3.5% if you have subprime credit.
But don’t let these low interest rates fool you. Keep in mind, first and foremost, that you’re buying a rapidly depreciating asset that’s bound to be worth far less than its original purchase price by the time you pay off your auto loan in full.
However, a car is a basic necessity these days, and it’s difficult to go without one. To avoid borrowing, opt for a used car over a new one, and an affordable brand over a luxury vehicle. If you must borrow, try to borrow as little as you can, and go for an old (but still reliable) car that has already lost most of its value.
Though auto loans have low interest rates, remember that you’re financing a depreciating asset.
Why avoid bad debt?
Bad debts are disastrous because their high costs and inflexible payment terms leave you worse off than before. Bad debts that are used to finance depreciating assets, for example, chip away at your hard-earned wealth—while high-interest loans force you to service crippling monthly payment loads.
Luckily, it’s not too difficult to avoid bad debt. If an asset won't appreciate in value—or if the financing options on the market are too expensive—then you shouldn't go into debt to buy it.
After all, bear in mind that the stakes are high. Bad debts have the potential to harm every aspect of your financial life, including your credit profile.
Missed payments, high debt burdens, and frequent loan applications, for example, can cause your credit score to decline severely and may have detrimental effects on your creditworthiness.
This in turn will have a cascading effect on your future loan and credit card applications—and make it more and more difficult for you to qualify for lower-interest loans and other kinds of good debt down the road.
Don’t let bad debt suck your finances dry.
How should you manage your debt load?
To save yourself from the perils of bad debt (or too much debt), you’ll need to manage your debts properly. Fortunately, there are many ways you can manage and pay off your debts smoothly so that they no longer burden your financial life.
1. Get your debts consolidated
Debt consolidation can be an effective way to manage your debt. It’s the process of first using a single loan with a lower interest rate and more favorable repayment terms to pay off your existing high-interest debts, and then paying off the remaining debt consolidation loan bit by bit.
Consider this option if you carry balances on multiple credit cards, or if you have a variety of other high-interest loans you want to refinance all at once.
2. Lower your credit card spending
It can be fun to use your credit card, but only if you don't overspend. If you spend too much, you'll have trouble paying off your debt within the deadline, and your balance will roll over to the next billing cycle. This time, it'll begin to accrue interest that ruthlessly compounds—until you pay it all off.
To avoid overspending (and credit card debt altogether), you should limit your spending to cash or debit cards. Additionally, maintaining a credit utilization rate within 30% can help to improve credit rating.
Alternatively, you can consider treading your credit card like a debit card. Disregard your credit limit altogether and only allow yourself to spend up to the amount you have in your checking account.
3. Budget well and budget often
Budgeting can help you get a clearer picture of your income, expenses, and cash flow. While there are many budgeting techniques that work, an easy one to learn is the 50/30/20 approach.
With this method, you’ll ideally apply 50% of your income to meet essential expenses, 30% to saving and paying off debt, and the remaining 20% towards discretionary purchases. This way, you’ll budget enough for all the basics, leave enough room to pay off your existing debts (or save for retirement), and have a bit left over to spend as you wish.
Budgeting well can help you keep your debt load in check.
Final thoughts
Debt isn’t something to be feared. When used right, it can even be a powerful financial tool. Learning to distinguish between good and bad debt is a good starting point, as is knowing how to manage your debt load. If nothing else, remember these key points:
Good debts have low interest rates and are used to purchase assets that appreciate.
Bad debts have high interest rates and are used to finance depreciating assets.
Good debt can turn into bad debt if you have too much of it and can’t comfortably pay it off.
Keep tabs on your debts by refinancing high-interest loans, budgeting intelligently, and spending below your means.
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