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For some, the word “debt” may come with a negative connotation. But not all debt is bad. While carrying debt may feel overwhelming, having a smart strategy in repaying it can help you achieve your financial goals.
Here’s a look at the definition of debt, its role in your finances, and what you should keep in mind when it comes to the various types of debt.
What is debt?
While debt may be a scary sounding word, debt is simply money owed, based on an agreement between a lender and a borrower. If you have a car loan, mortgage, or student loan, you already have debt. Credit cards, personal loans or a loan between family members that carry a balance are another form of debt.
Taking out debt may be essential in order for you to achieve a goal, such as to purchase a home or access higher education. How you manage your debt is important. A history of making full on-time payments is a huge factor that influences your credit score, which many lenders consider when determining whether or not they will lend to you and with what kinds of terms.
When borrowing money, it’s important that you only take on as much debt as you can afford to repay. And you should always have a strategy for repaying debt in order to avoid racking up high interest costs and to ensure you have a positive payment history.
Different kinds of debt
You may have heard the phrase “bad debt” and “good debt.” You may also have heard that lenders look at these two types of debt differently. While that may be broadly true, an individual may have too much good debt, if they don’t have a plan in place to be able to pay it off. Similarly, someone may use credit cards or a personal loan — so-called bad debt — with a plan in place for how to pay off the balance in full.
When it comes to good debt and bad debt, how it is handled is important.
Good debt is colloquially known as debt that increases your net worth or has future value. For example, a mortgage would be considered good debt, because the home value will hopefully have appreciated by the time the house is paid off in full. Student loans are also considered good debt, as the goal of a degree is to have a larger skill set that will help you net a higher paying job.
Another example of good debt may be debt consolidation, as debt consolidation may minimize interest rates and give you a strategy and plan for paying down consumer debt.
However, this rule isn’t set in stone — and may be especially shaky in this day and age. The recent mortgage crisis showed that house prices have potential to crash well below the market value in which they were purchased, and a higher education degree is no guarantee for a high-paying career.
Good debt includes:
- Home equity loans
- Student loans
- Small business loans
Bad debt is considered debt on something that depreciates, or loses value, as soon as you purchase it. This, of course, includes the majority of things purchased with credit cards. But that doesn’t mean that having bad debt means that you’re bad at personal finance. It just means you may need to be mindful of a payoff plan.
Some examples of so-called bad debt include:
- Credit card debt
- Auto loans
- Payday loans
When looking at debt, it’s also important to consider payments like alimony or child support. While these may not seem like traditional debt, calculating them into your overall financial picture can help you get a sense of how much money is flowing out to debt payments, which can help you figure out how much debt you really have.
Calculating how much debt you have
You may think that calculating your debt is as simple as tallying up all your balances. While this number can be insightful, far more helpful is your debt-to-income (DTI) ratio. This ratio is the amount of debt you have, divided by the amount of income you make. There are several calculations, but here’s one way to do:
- Add up your debts, excluding housing payments. For credit cards, use the minimum payment amount.
- Divide that total by your gross monthly income.
- Multiple that amount by 100 to calculate your DTI as a percentage.
A lower DTI is better, in the eyes of a lender, as it means you’re carrying an amount of debt that you’re more likely to be able to handle. If your DTI is over 35%, it may be a good idea to think of ways to pay down debt — which may include potentially increasing your income via a new job or a side hustle.
Typical uses for debt
While good debt and bad debt are common phrases, the bottom line is that there are gray areas for every financial decision. While it may be easy to argue in favor of a mortgage — and argue against charging your credit card for a consumer purchase like a flat-screen TV — there are mitigating factors to every decision.
One factor in having access to debt at all is that how you manage debt has become a key factor influencing decisions for a loan. Since credit history is analyzed for loan applications, not having any credit history could possibly hurt an applicant for a mortgage, apartment rental or even a job.
And as more stores and services become app-oriented, a credit card (or at least a debit card) has become essential in making reservations or making payments. In fact, some rental car agencies have restrictions on debit-card only transactions. For these reasons, many people have found that having access to a line of credit is necessary.
Of course, the ideal is to pay off balances in full. But sometimes, situations may occur where taking out debt may be necessary. These situations may include:
- Emergencies: Whether a medical emergency or a car emergency, some people end up in debt due to using credit to pay a bill larger than they could comfortably pay with their liquid cash.
- Life changes: Whether it’s an unexpected layoff, divorce or debt, it may become necessary to rely on credit when an income stream isn’t readily available.
- Lack of other options: If your car breaks down, needs a pricey part, and the garage can’t offer a payment plan, putting the part on credit may be a necessary move to be able to get to work. In these cases, debt may be the only option.
Ultimately, it’s a good idea to get used to paying balances in full and try to avoid situations that may result in debt. But sometimes situations do occur despite your best efforts. In that case, it’s important to come up with a plan for how to repay the debt.
How to manage your debt
If you already have debt, it may be tempting to avoid how much debt you have. But facing the number can be the first step in managing your debt and paying down your bills.
Here are some steps you may consider when managing debt:
- Keep a budget: If you’ve found yourself with consumer debt, it may be that you’re spending more than you have. Coming up with a budget, planning ways to cut costs and finding places to save money to pay down debt can be a great step.
- Know what you owe: Knowing what you owe can be the first step in assessing what your next steps may be. If you’re truly drowning in debt, it may make sense to talk to a financial counselor to hear what they think might be the best option for you.
- Speak with your lenders: In some instances, it could be possible to lower your interest rate, which means more money is going to the principle of your debt. If you always pay bills on time, it may be worth a phone call to your lender to negotiate a lower interest rate. Further, if you run into financial trouble, reach out to your lenders; they may be able to help you stay current on payments, such as by temporarily reducing your payments.
- Learn about debt consolidation or refinancing: Whether it’s student loan refinancing or consolidating consumer debt with a debt consolidation loan, it may make sense to explore options. These may lower your interest rates and make bill payments simpler via one monthly payment rather than multiple bills per month.
- Pay more than the minimum: Every dollar counts when it comes to paying down debt, and paying more than the monthly minimum — even if it’s only $5 — can be a good way to begin paying down debt.
- Consider another income stream: Whether it’s a side hustle or asking for a raise at your current job, increasing your income automatically lowers your debt-to-income ratio and may make it easier to find more ways to pay more than your minimum bills. That said, it can take a lot of time and startup expenses to get another income stream off the ground, so this strategy may not be the best one if you’re primarily looking to manage debt.
The more you understand debt and the role it plays in your life, the better you can come up with a payment plan that works for you. Debt may sound scary, but sometimes, it’s necessary or inevitable. Remember: How you handle your debt — ignoring it isn’t an option — can help you reach your financial goals.