Not all debt is created equal.
Sometimes, in fact, it’s actually a good idea to get into debt.
Wait! Put your credit card back in your pocket and cancel that order on Amazon for that fancy Lord of the Rings-themed chess set you’ve always wanted since this morning.
What I mean is, there are two types of debt: good debt and bad debt. Here’s a quick summary of what they are.
|Type of Debt||Description||Examples|
|Good Debt||Debt you've taken in order to invest in your future||
|Bad Debt||Debt you've taken on things that will depreciate in value and won't generate a long-term income||
Let’s dive a little deeper into the meaning of good and bad debt, and then I’ll give you some tips on how to dig yourself out of both kinds.
Imagine you’re ready to settle down with your new family, and are looking to buy your first home. In today’s market, you can pay 10% (better to pay 20% or more to avoid Private Mortgage Insurance) and take out the rest in the form of a mortgage. A mortgage is debt. It’s a loan that’s secured by your home, meaning that if you fail to make payments then the lender can repossess your home.
Now imagine that this option didn’t exist. Imagine having to pay for your home upfront, in full. That would be impossible for most Americans.
Mortgages are good. When the media derides the debt levels of American consumers, they’re including mortgages in those statistics.
The same goes for car loans, and student loans. Imagine if you had to pay your tuition in upfront, in full. It would be possible for the lucky few, but not for most. You might have to work for years, with no degree and a low earning potential, just to afford to start studying for your Bachelor’s.
Our ability to access money we don’t currently have is a good thing. Don’t be afraid of debt.
Be afraid of Bad Debt.
Bad Debt is debt you’ve taken things that won’t help you in life, things that will lose value in the long run.
I’m not saying you shouldn’t buy the new TV treat yourself to a night on the town when you’re up for it. If you can afford it, go ahead. That’s what money’s for, after all – to spend it on things that make you happy. If you can afford it.
A general rule of thumb is that you should not be borrowing to pay for luxury items you can’t pay for with cash.
The Effects of Debt On Your Credit Score
You might asks then: why should I get a credit card in the first place if I can afford to pay for everything with cash?
The answer is that getting into debt is the only way of building your credit score.
What is a Credit Score?
A credit score is essentially an estimation of your ability to pay back your creditors. Banks will use your history of paying off your debts to determine how likely it is you’ll pay them back, and they’ll charge you fees accordingly. Let’s look at an example. Jack and Jill are each looking to get $250,000, 30-year mortgages.
|Payment History||Risk Assessment||Credit Score||Mortgage Terms|
|Jack||High Risk||Low Credit Score, ~620||4.1% APR with a monthly payments just over $1,200.|
|Jill||Low Risk||High Credit Score, ~780||5.7% APR with a monthly payments nearly $1,500.|
Okay, it might not look like there’s a big difference in their monthly payments. But let me show you how that plays out over the full length of their mortgage. Overall, here’s how much each will pay, for the right to borrow the exact same amount.
|Total Interest Paid|
That’s a difference of $87,000 over the life of the mortgage.
And it’s all because Jack has shown banks that he’s a higher risk to default, while Jill has been careful to pay off her debts.
How Proper Use of Financial Tools Can Help Your Credit Score
Not all debt is created equal, that much I’ve said already. If you’re like most Americans, you’ll want to eventually buy a home, for which you’ll require a mortgage (good debt). But in order to get the best terms on your good debt, you might even need to take on some bad debt. That’s where credit cards and loans come in.
Using a credit card is borrowing money. Each month, you are borrowing the balance of your credit card from your bank. Whenever you make your monthly payment, you’re signalling to the banks and credit bureaus that you are financially reliable.
Taking on small amounts of debt – and paying your debts in full and on time – can be a great way to build your credit score.
If you’re thinking this won’t really affect you in a meaningful way, I can guarantee you it will. Just like Jack and Jill.
But be careful with credit cards and loans – if you’re late with payments, or miss payments entirely, your credit score will fall. These are dangerous tools – make sure you’re able to pay off your balances before taking on this debt.
How to get out of debt (good or bad)
When I refer to Good Debt, I absolutely don’t mean it’s good to keep. I want to make this abundantly clear. Good Debt is debt that’s good to take on – debt that will help you buy things that will lead to financial security later in life. But even good debt is debt you should try to pay off as quickly as you can. And that goes double for Bad Debt.
So let’s get into how to go about paying off your debt.
The most fundamental tool you can use to get out of debt is budgeting. I know, it sounds boring and cold and you just don’t want to do it. But I promise you, it’s really not that hard, and it will yield so much value relative to the minuscule effort you put in.
One tool we recommend is YNAB – or You Need A Budget. It costs $6.99 per month (the first month is free) but trust me – that’s a small price to pay for the value you’ll get by having a simple and clean budget. Once you understand where you’re spending your money, you’ll be able to cut down on the waste and put the rest towards paying down your debt. For the lower-tech people out there – fear not. The traditional pen and paper will do the trick. Although you won’t get the broad functionality of the YNAB app, it’s still better than nothing.
Budgeting is necessary in order to effectively pay off your debts, because you’ll want to know how much money you have each month – above and beyond your Minimum Monthly Payment number.
Find your Minimum Monthly Payment number
How much money do you actually owe? And how much money do you need to pay out each month in order to meet the minimum payments on your debts?
To answer these questions, make a list of all your debts. Include the following items: Name of creditor, interest rate, balance, and minimum monthly payment.
If your total minimum monthly payment is below the amount of cash you have at the end of each month, you’re in trouble. You’ll need to go back to your budget, identify areas of luxury, and cut back on everything you can. Also check out our article on ways to increase your income to find a way to at least meet your minimum monthly payment.
If, on the other hand, you’re making more money than you own each month (congratulations, by the way) – you’ll need to find the best way of going about paying off your debts. For that, there are two methods you can use: the Debt Snowball and the Debt Avalanche. I’ll break them down for you.
The Debt Avalanche calls for putting all the money you have each month (after you’ve made all the minimum payments on all your debts) into paying off the debt with the highest interest rate. Once you’ve paid that off, you’ll have more money to pay off the next highest-interest debt you have – so on and so on until you have no more debt.
After you’ve made the minimum payments on all your debts, the Debt Snowball method tells you to put all your excess cash into paying off the debt with the smallest balance. After you’ve paid off that debt, you won’t have to worry about the minimum payment on it, and you can use that excess cash to pay off the next smallest debt on your list. Your repayments should “snowball”, if you will, until there are no debts left.
|Name of Creditor||Interest Rate||Balance||Minimum Monthly Payment|
|Bank of America, Credit Card||15%||$2,150||$43|
|Capital One, Credit Card||12%||$1,420||$25|
|SoFi, Student Loan||4.5%||$40,000||$50
Debt Avalanche method
Make all minimum payments; any additional money left over should go towards paying off the Bank of America credit card, as it’s the highest-rate debt. When that’s paid off, move onto the Capital One card, and then finally the SoFi student loan.
Debt Snowball method
Make all minimum payments; any additional money left over should go towards paying off the Capital One credit card, as it’s the lowest-balance debt. Once that’s paid off, move onto the Bank of America card, and lastly pay off your student loan.
Mathematically, the Debt Avalanche method will lead you to paying less interest on your debts in total. The Snowball method has the advantage of being psychologically healthy – and don’t underestimate that. It’s very easy to get discouraged when focusing on paying off debt.
If you can withstand the extended psychological torture of paying off debt with little visible signs of progress, I’d suggest going with the Avalanche method. But if you think you’ll need the extra mental help of seeing debt items disappear from your list, the Snowball method is a perfectly fine alternative.
Other tools to reduce debt
Call your issuers
Simply calling your debtors and asking them to reduce your interest rate can often work. Seriously.
Consolidate your debt
One of the best ways of dealing with high-interest debt is by consolidating your debt onto a balance transfer credit card. These are specialized credit cards that offer no interest payments for an introductory period – which can be up to 18 months! – giving you more time and breathing room to pay off your debts.
One caveat: the best balance transfer cards require excellent credit scores – yet one more reason you should be paying attention to these scores.
Remember, not all debt is Bad Debt. If you’ve taken out student loans, chances are you’ll be earning more, which will help you in the long run. Having debt is not the end of the world, but you should do everything you can to pay it off quickly. Living debt free feels liberating, truly. And you can get there.