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Good debt vs. bad debt—what’s a healthy balance?

The word debt can be triggering. Perhaps you get a pit in your stomach when you hear it and think about whatever types of debt are hanging over your head. But the reality is there’s good debt and bad debt.

If you find yourself overwhelmed by bad debt, you can consider a do-it-yourself repayment method, like the debt snowball approach, or a debt consolidation loan. But first, it’s important to understand the difference and find a balance between good and bad debt that ultimately benefits you. 

What is “good” debt?

Good debt is debt that you’re able to repay in a responsible manner or a loan that offers a good return on investment. A couple of the important elements of showing you can repay your debt responsibly is your payment history and demonstrating an ability to handle multiple types of debt, i.e., your credit mix. For a loan to be considered good debt, it typically has a relatively low-interest rate and some or all of that interest is tax-deductible. Let’s take a look at some examples of good debt.

Mortgage

The sole purpose of a mortgage is to borrow money to pay for your home with the hopes that the value of your property increases by the time you go to sell it. Mortgage debt can be tax-deductible in some cases. 

Home equity loans and home equity lines of credit (HELOC) also can fall into the “good” credit category. While you’re using your home as collateral with these types of loans, the interest you paid on your home equity loan or HELOC can be tax-deductible if you “buy, build, or substantially improve [your] home that secures the loan,” according to the IRS.

Student loans

As with mortgages, interest paid on student loan debt also can be tax-deductible. Student loans are used to finance an education, which can potentially lead to better career opportunities, and along with that, higher incomes.

If you’re unable to responsibly repay your student loans, though, they can move from good debt to bad debt. 

Auto loans

Car loans, like student loans, can be either-or debt as well. The value of a car decreases significantly as soon as you drive it off the lot, but owning a car can help you get or maintain a job as many jobs require a reliable form of transportation. In this case, an auto loan would be good credit. Alternatively, if your loan comes with a high-interest rate, then it might fall under the bad debt umbrella.

What is “bad” debt?

Bad debt, to put it simply, is debt that you’re not able to repay or a loan that doesn’t offer a good return on investment. If a debt hurts your credit score, that could also make it “bad,” i.e., if you’re carrying a lot of debt or have a high credit utilization ratio. Your credit utilization ratio is the amount you owe compared to your credit limit. Here are some examples of bad debt.

Credit cards

If you pay off your credit card balance in full every month, that’s not bad. But when you carry a balance, particularly on a card with a high-interest rate, that’s when your credit card debt is considered bad.

Any high-interest loan

This can be any type of loan, like a payday loan or unsecured personal loan, that has a particularly high-interest rate. High-interest debt is much harder for the borrower to repay, which could lead to a precarious financial situation.

Ways to get out of bad debt

There are strategies you can implement to try to avoid bad debt in the future. Consider having an emergency fund to cover unexpected expenses in a pinch to avoid using a credit card and falling deeper into debt. Try to keep your credit utilization ratio low, ideally below 30%. Repay the debt that you have and try to limit new large purchases. And most importantly, always pay your bills on time.

But what can you do about your current bad debt?

Do-it-yourself debt repayment methods

If you want to take a DIY approach to repay your debt, you may want to consider the debt snowball or debt avalanche approach. With the debt snowball method, you pay off your lowest balance first and work your way toward the highest balance. This approach allows you to get small victories early on to stay motivated on your debt repayment journey.

With the debt avalanche approach, you focus on paying off your highest-interest balance first and work your way toward your balance with the lowest interest rate. This strategy allows you to save money on interest in the long run.

Debt consolidation loans

Debt consolidation loans allow you to combine multiple debts into one manageable monthly payment with a lower interest rate. This streamlined approach can help you pay down debt faster and help you save money on interest. Using this approach on your bad debt, like credit cards or high-interest loans, can help you create a better balance between your good and bad debt.

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