The amount of debt that U.S. households have is growing, reaching $12.58 billion, according to the 2017 report from the Federal Reserve, which is the highest since 2008. But is being in debt a good thing or a bad thing? The truth is that it can be both depending on the types of debt.
The good side to carrying debt is that if you handle it responsibly, you can build credit. According to the Experian credit bureau, a good credit score will help you qualify for low-interest rates and favorable terms when you need to borrow money.
Additionally, it can impact your ability to get a job, rent a home and get a good rate on your life insurance. The bad side is that you can get in over your head, fall behind on payments, accrue interest charges and fees and not be able to catch up.
How do you manage debt so it works to your advantage?
Types of debt: the good and the bad
A good rule of thumb is that a good debt will offer some form of long-term return while a bad debt is more for instant gratification. Here are a few examples of each.
- Buying a house
- Investing in starting or growing your business
- Paying for education
- Buying a car
- Lavish weddings
- Shopping for items outside of your means
- Everyday expenses like groceries, clothes, gas, etc.
The good debts can be categorized as long-term investments, as they offer something in return for years to come. When you buy a house, you are investing in a home in which you will gain equity. Investing in a business is done with the intention that the business will grow and generate income to pay you back.
Paying for education can provide you with a degree that will likely help you to get a job and earn a higher income. Buying a car enables you to drive to work and school, thus helping you to earn money. All of these types of debt can enable you to pay back the loan and continue to grow financially.
On the other hand, when you use credit to pay for something like gambling, a vacation or a lavish wedding, you enjoy the experience, but then the money is gone. You have nothing to show for it, except maybe some great pictures and memories, and you’re stuck paying for it.
Furthermore, using credit to pay for your necessities creates a reliance on credit for survival, which will be problematic if limits are reached. When borrowing isn’t an investment, it’s likely to grow into an amount of debt that’s difficult to pay back.
With all this said, moderation also has to be considered. Even if you are using a loan for a wise purpose, if you overspend, you can still end up having debt you can’t repay. So it’s best to ensure your payments are within your means. According to the Consumer Finance Protection Bureau, a 43% debt-to-income ratio is the maximum before payments begin getting difficult.
You may have a combination of both good and bad debts, as there is often a learning curve to proper debt management. If so, here are some tips on how to manage them.
How to manage multiple sources of debt
Before you can manage your debts, it’s important to understand them. Start by writing down all of the debts you have. Prioritize them by interest rate, as the higher the interest rate, the more expensive it is to carry that debt and the more beneficial it is to pay it off sooner. Before you start making extra payments, consider your options for getting a lower interest rate on any high-interest debts you’re carrying. Here are a few ways to do so.
Balance transfer credit card
You can consider opening a balance transfer credit card that offers a period of no or low interest. In doing so, you can pay off the existing card’s balance and save money during the period of reduced interest on the new card.
However, be sure to look at the length of the reduced interest offer and how much the interest rate will be when it ends. If you can pay off the balance during the interest-free period, great. If not, you want to make sure it won’t end up costing you more than if you would have stayed with the original card and interest rate.
You can also see about getting a lower interest rate on an existing debt by looking into refinancing. Whether it be a mortgage, a student loan or an auto loan, shop around for a lender who can offer a lower interest rate than you currently have and use the new loan to pay off the old one.
In doing so, you can pay less for that loan over time and lower the monthly payments. However, be sure to carefully vet potential lenders to ensure that refinancing will be a better deal overall. You’ll need to look at the full picture including any fees, the loan length and the interest rate.
Debt consolidation loan
Another approach to managing multiple sources of debt is to consolidate them all into one loan. In doing so, you will take out a loan with a new lender in the amount of all of your debts. Then, you pay off all of the debts so you only have one payment to make each month toward the new loan.
Why move all of your debt around when you will still owe the same amount? Debt consolidation can help you get a lower interest rate than the average of all the interest rates you’re currently paying, which will reduce your monthly payment amount and the total you pay over the duration of the loan. Additionally, paying various lenders each month can be stressful, so combining them into one loan will be more convenient.
Get control of your debt
Whether you have good debt, bad debt or both, there are ways you can manage multiple sources of debt and work toward a healthy financial future. It starts with analyzing your current debt situation, identifying opportunities to cut costs and then strategically paying down debt by debt.
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Jessica Walrack is a personal finance writer at SuperMoney, The Simple Dollar, Interest.com, Commonbond, Bankrate, NextAdvisor, Guardian, Personalloans.org and many others. She specializes in taking personal finance topics like loans, credit cards, and budgeting, and making them accessible and fun.