Most people talk about debt as something to fear and avoid, but not all types of debt are the same. While debt can hamper your financial flexibility and lessen your ability to save for future goals, like retirement, taking on some debt may also help you achieve important financial goals, like buying a home or sending a child to college.
The important thing to remember is to only take on debt that you’re comfortable with paying back. As you think about debt, its uses and how to manage it effectively, keep the following points in mind.
What is good debt?
Good debt may allow you to achieve a goal that you may be unable to achieve without a loan. It can include mortgages,student loans and even some low-interest personal loans, such as those you might use to build a business. While you will have monthly payments and accumulated interest costs for these debts, they generally add to your wealth over time. In addition, mortgage and student debts may have tax benefits, depending on your situation. Talk to a tax advisor to find out if the interest on your mortgage may qualify you for a deduction.
That said, consider your options carefully when taking on good debt. For student debt, there might be scholarships, grants or a less-expensive school available that would reduce the amount you have to borrow. For a mortgage, determine how much house you really need instead of how much the lender decides you can borrow. You may be approved by a lender to take out a large loan, but a smaller home could translate to less debt and lower monthly payments, reducing your financial stress and freeing up money for other priorities.
What is bad debt?
Bad debt typically means unsecured consumer loans, such as high-interest credit cards. And, although a low-interest auto loan may be a reasonable way to finance a car purchase, taking on a big payment to buy an expensive car—especially if you don’t qualify for the lowest rate—may negatively impact your finances.
How should you manage multiple debts?
The average interest rate on new credit cards is 17.8%, 1 which means it’s a good idea to pay them off as quickly as possible. Mathematically speaking, paying off the debt on your credit card with the highest interest rate first will lower the total amount you pay to get out of debt. This is known as the avalanche repayment strategy. However, some people prefer the alternate strategy of paying off the credit card with the lowest balance first while making minimum payments on the rest. Once that first card is paid off, they focus on paying off the next-lowest balance. Called the snowball method, this strategy can get them to a zero balance on a card more quickly, which helps create a sense of accomplishment.
To pay off high-interest debts faster, you may consider low-interest balance-transfer offers or a home equity line of credit (HELOC), which uses your home as collateral and may be offered to you at a lower interest rate than what your credit cards have. However, taking out a HELOC, especially when you have a debt problem, is financially risky because you could lose your home if you cannot pay back the loan in accordance with the terms. If you are under financial stress, you may want to consult a credit counselor to help you understand all of your options before considering a HELOC.
What is debt-to-income (DTI) ratio?
Your DTI ratio is a mathematical calculation dividing your total monthly debt payments by your gross monthly income. Generally speaking, lenders prefer that you have a ratio lower than 43%, including your mortgage payments. Lenders know that if your DTI ratio is higher than that, there’s an increased risk that you will not be able to keep up with your loan payments. While a mortgage lender may allow you to take on a high DTI ratio, you should always consider your personal circumstances and what level of mortgage debt you can take on with confidence.
What’s the difference between secured and unsecured debt?
Secured debt relies on collateral—something that the lender can make a claim to if you can’t pay what you owe. One example of secured debt is a mortgage, because the home is the collateral on the loan. Another common example is an auto loan. Unsecured debt, such as a credit card, has no collateral to back it up. Secured debt is less risky to a lender because of the collateral, so those loans may be offered to you at a lower interest rate.
As you consider how to manage various debts, keep in mind their interest rates, tax benefits and other factors. When you’re planning on how to pay down your debts, don’t forget to make sure you’re still balancing your other financial priorities, such as saving for retirement and building a dedicated emergency fund for unplanned expenses.