Good vs. Bad: How to Manage Your Debt

Updated June 22, 2021

Debt tends to get a bad rap – and for good reason: It can be challenging to manage and may even cripple your finances. 

But debt can also be a useful financial tool for reaching your goals, as long as you know how to manage it. We take an in-depth look at “bad debt vs. good debt” and how you can use debt to your financial advantage.

Is All Debt Bad?

Despite what some financial gurus claim, not all debt is bad. 

There are several components to determine whether debt is good or bad, including: 

  • Principal - how much you borrow in total either with a loan or charged to your account

  • Interest rate - how much you pay the lender to borrow the money 

  • Loan term - how long you must pay on the loan in order to pay it back 

  • The asset - what you’re buying with the money you borrow

An example of bad debt is credit card debt. It’s high interest debt that can take a long time to pay off. With a credit card, you’re typically only buying depreciating assets (items that lose value over time) rather than appreciating assets (items that retain and grow in value overtime). 

For most people, credit card debt doesn’t help them build wealth.

What Is Good Debt?

Good debt is when you borrow money for the purpose of building wealth over the long term. 
Good debt allows people to buy houses, invest in their business and make other purchases that provide some kind of return. 

A few key components of ‘good debt’ include: 

  • Low interest rates

  • Appreciating assets (assets that increase in value overtime) 

  • Debt that can be forgiven 

  • Debt that can provide a return on investment in some way 

While not all of these items overlap all of the time, it’s good for you to keep them in mind if you want to manage and use your debt to help grow your wealth.

2 Great Ways to Use Your Debt to Your Financial Advantage

Below are a few ways you can use debt to help you reach your financial goals.

1. Grow Your Credit History with Debt

To prove credit worthiness and build your credit score, you have to borrow money and pay it back. The key is to do so wisely and in a way that you can afford. Managing your debt-to-income ratio is an excellent way to keep track of your debt and make sure you aren’t taking on too much.

Use the Debt-to-Income Formula

To find out what your debt-to-income ratio is (and how much debt you can afford) you can use the following formula: 

Monthly Debt Payments/ Gross Monthly Income = Debt-to-Income Ratio 

For instance, if you take home $3,000 a month, and each month you pay $1,000 to your debts, your debt to income ratio would be 30%.  The general rule of thumb for lenders is 28/36- with no more than 28% of gross monthly income on housing expenses and 36% towards total debts (car loans etc). Going over this will not only severely limit your cash flow, but it may also be a red flag to future lenders. The lower your debt ratio, the better.

2. Reach Milestones with Debt

Most people can’t buy a house with cash and need to take on debt (ie. mortgage) to purchase one. If you bought a home at the right time in a growing neighborhood, it can easily be an appreciating asset that helps to build your wealth. 

Student loans are another form of debt that can help you reach a major milestone and build your wealth. While you want to take out as few student loans as possible, the right college degree can provide a return by offering you higher paying career opportunities. 

Just remember: No matter the size of the milestone, never take on more debt than you can afford. Always do your own research prior to getting into debt.

How Can I Manage my Good vs. Bad Debt?

One thing is true about both good and bad debt: You don’t want to hang onto it forever. Here are 4 simple ways to manage them.

1. Make On Time Payments

Making on-time payments reflects positively on your credit score. On top of this, paying back your debts in full can help you establish good credit. Good credit generally means you get more favorable terms for future debt (including low interest rates).

2. Pay Off the High-Interest Bad Debt First

Remember high interest debt is bad debt. You want to pay this off first before you focus on paying off the ‘good debt’. For example, you should work to pay off your credit card debt with a 21% interest rate before attempting to pay off your mortgage with a 4.5% interest rate.

3. Balance Paying off your Good Debt with Investing

Once you’ve managed to pay off your bad debt, try paying off your good debt while making wise investments. Investing allows you to prepare for retirement and build generational wealth.

4. Keep your Debt Manageable

Keep track of your debt-to-income ratio and your payment schedules. Make a budget so you can build out a debt pay off plan attacking bad debt first. Never take on more debt than you can afford.

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All of our content is verified for accuracy by Mark Herman, CFP and our team of certified financial experts. We pride ourselves on quality, research, and transparency, and we value your feedback. Below you'll find answers to some of the most common reader questions about Good vs. Bad: How to Manage Your Debt.

How Much Debt Can I Afford?

As a general rule, you don’t want to have more than 36% of your income going towards your debts and your housing expenses should not comprise more than 28% of your gross income. Debt is leverage and in this sense can help you make a good long-term investment, though building in some margin in your budget will help ensure you can continue to pay off these debts.

Is it Better to Have Savings or Pay Off Debt?

This is a hard balance to strike and everyone's situation is different. Typically, you need to have at least $1000 savings to cover emergencies. Then you’ll be able to focus on paying off bad debt (like on a high-interest rate credit card). Once you’ve paid off your bad debt, it’s a good idea to direct a portion of your funds you were using to pay off that debt towards savings and investments.

Mark Herman has been helping friends with financial questions since serving as an Army helicopter pilot. Since then, he’s gained valuable experience in the corporate world before moving on to become a Certified Financial Planner™.

If you have a question about Good vs. Bad: How to Manage Your Debt, then please ask Mark.

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