Credit Management: Good Debt vs. Bad Debt

March 26, 2021
Flash Financial Guide
Credit Card Debt Relief

Before incurring some kind of debt, it’s a good idea to realize whether it’s considered good debt or poor debt. Not all debt has the same effect on your financial wellbeing. Certain forms of debt are considered fine, while others are considered poor.

Credit card debt, for example, is widely known as bad debt, as are other forms of high-interest debt such as payday loans and cash advances. Mortgages, car loans, and student loans, on the other hand, are commonly regarded as decent debt. However, if such conditions are met, there are still exceptions to these laws.

What is Good Debt ?

Any form of debt that has a low-interest rate and can raise your net worth is considered good debt.

  • Mortgages
  • Car loans
  • Student loans

When these debts are paid off, you will have a valuable object or talent that will increase your net worth over time. Mortgages and car loans are examples of secured debt.

Mortgages

Purchasing a home is one of the most significant financial choices that most people can make in their lives. Since the lender’s loan risk is much smaller, home loans have historically had relatively low-interest rates, ranging from 2.5 percent to 8.75 percent for banks and 3 percent to 4 percent for credit unions. The 2008 mortgage crash, on the other hand, served as a cautionary tale about subprime lending. If you can afford it, a home loan is a decent debt! Borrowing beyond your means puts you in jeopardy. 

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Red flags

  • Mortgage payments that are greater than 36% of your gross income
  • You may not have enough money for a down payment.
  • Mortgage insurance requirements; this money serves as a penalty for high-risk investors and is not invested in your house.

Car Loans

Since they are secured debt, car loans narrowly make the successful debt list. They are also a requirement for the majority of people. Many people rely on their cars to get to work and to get around in their daily lives. The trick is to buy a car that is within your budget and worth the price you will pay for it. Your car payment should be no more than 20% of your take-home pay.

Red  flags

  • Your car payment is more than 20% of your take-home pay.
  • You may not have enough money for a down payment.
  • Your loan period is more than four years.

Student Loans

Student loans are thought to be an investment in your future, but colleges are becoming more costly, and graduates often find themselves in financial difficulty when their debt totals surpass their future earning potential. To avoid incurring more student loan debt than you can afford in the future, crunch the numbers and strive for a monthly payment that is 8% or less than your future projected earnings.

Red Flags

  • Unregulated interest rates on private student loans
  • Student loan balances that surpass your potential earnings
  • Using student loan funds to pay costs other than tuition

What is Bad Debt ?

Bad debt is described as high-interest debt that will not raise your net worth but will instead cost you more money in the long run. Any form of debt that is more than you can afford to pay is called bad debt. If you borrow beyond your means or surpass the recommended limits on your debt-to-income ratio, good debt can turn poor.

Credit Cards with a High Interest Rate

The interest rate on a credit card is calculated by your credit score. The higher your credit score, the lower your interest rate. Any credit card with an interest rate higher than the national average of 15.13 percent is considered strong. Some high-reward credit cards (miles, cashback, etc.) have high-interest rates but could be worth getting if you plan to pay off the balance on a regular basis. As a general rule, you can keep your debt-to-income ratio below 28 percent.

Possible Exceptions

  • Using a high-interest card for valuable rewards and paying it down monthly
  • Store cards for promotional savings

Payday loans

Payday loans are very short-term loans with extremely high-interest rates. Payday loans, which outnumber all other forms of debt, may have APRs of up to 400 percent, according to a Consumer Financial Protection Bureau warning (CFPB). Unfortunately, people who use payday loans often have underlying financial issues that make it difficult for them to repay this form of debt.

There are no exceptions that would make a payday loan a good debt; however, there are certain conditions that might justify the use of a payday loan in an emergency.

Exceptions for Use in Emergencies

  • Ensure your physical safety or the physical safety of someone else
  • Cover a medical emergency
  • Paying overdraft fees
  • Emergency travel

Personal Loans with Excessive Interest

High-interest personal loans meet the majority of the requirements for bad debt. They are expensive and, if mismanaged, can be detrimental to your financial health. Taking out high-interest personal loans for non-essential expenses such as holidays or new clothes is usually not a good idea.

Possible Exceptions

  • A high-interest loan with short-term and manageable monthly payments may be a reasonable choice for big-ticket items like car or appliance repairs.

Struggling with Debt?

If you have fallen behind on your mortgage payments, for whatever reason, you should know your debt reduction options. Speaking with Certified Debt Relief may be helpful. Call for a free consultation with one of our professionals to go over your options.