THE GOOD, THE BAD, THE UGLY: THE TYPES OF DEBT AND THE KEY TO MANAGING THEM
I recently read “The Faces of Americans Living in Debt.”
Which led me to think about all the nameless people I see every day. What are their stories? Are they worried about their finances, their debt?
If I could say one thing to them: They are not alone.
The average personal debt per person in the U.S. grew from $21,800 in 2023 to $22,713 in 2024, excluding mortgages, according to research from financial services company Northwestern Mutual.
Bright spots exist, however. They begin here, with a simple primer on good debt versus bad debt, and how to best manage both so they don’t spiral out of control.
Let’s get started.
GOOD DEBT BUILDS WEALTH. You responsibly manage it and pay it off.
Good debt is debt that you’re able to repay responsibly based on the loan agreement and is used to finance something that will offer a return on the investment.
The tried-and-true example of a good debt is your home mortgage. Many of us can’t buy a home with all cash, so we go into debt to carry a mortgage with a monthly payment. The mortgage debt, in turn, helps build wealth via a growing real estate asset, your home.
Another example is student loans. More education (past high school) raises your potential for a future higher income. Typical earnings for bachelor’s degree holders are $40,500 or 86% higher than those whose highest degree is a high school diploma, according to the Association of Public Land-Grant Universities.
Interesting side note: Most of us would associate student loan debt with young adults, but the numbers tell us something totally different. Twenty-five to 34-year-olds, on average, incur almost $33,000 in debt. Thirty-five to 49-year-olds hold about $44,440 in debt. Those 62 and older acquire just over $49,000.
One reason for the higher student debt load as we age? Increased college costs mean that many are taking out loans to help their children or grandchildren pay for an education.
BAD DEBT HARMS YOUR FINANCIAL HEALTH. It’s usually put toward depreciating assets.
Bad debt finances purchases that will quickly depreciate or are used solely for consumption, like dining out on credit cards or borrowing at a high interest rate for a top-of-the-line car.
It’s also “bad” when it negatively impacts your credit score.
Well-known examples of bad debt are credit cards that carry a high interest on balances (as high as 36% right now on the First PREMIER® Bank Mastercard credit card). Other examples: department store credit cards (which are well-known for high interest rates), auto loans, vacation loans.
Like a home loan, many of us carry an auto loan … or two … or three. The good news is that cars purchased with a large down payment and shorter-term loan are classified as good debt. That’s because large down payments usually mean lower interest rates, and a shorter loan term means you’ll pay less interest over the life of the loan.
Think it through before taking on any type of debt.
Use these guidelines to steer your thoughts—and curb your “gotta-have-it-now!” urge, so that the debt you take on today doesn’t hurt you tomorrow.
Potential Return on Investment: Consider the potential long-term gain in wealth building for taking on a short-term debt. For example, when you buy real estate or take out an affordable mortgage on a home, the chances of the return being higher than what you pay is most likely in your favor.
Affordability: Can you afford to make more than the required minimum payment so that you’re paying off the debt instead of making only interest payments?
Personal Need: This is perhaps the toughest one to tackle. But ask yourself this to distill the real source of want versus need: Do you need what you are purchasing to put yourself in a better financial position?
Time to Payoff: You should know how long it will take to pay off a debt before taking it on.
Key to managing any debt—and a high credit score—is paying on time and having a credit mix.
The amount of your outstanding debt doesn’t always have a direct impact on your credit score, as in lowering it, but your ability to pay it off does.
Pay every bill on time, every month, and you’ll enjoy a healthy credit score.
A “good” credit mix also is key.
An ideal credit mix includes both revolving accounts, like credit cards, and installment accounts, like loans.
Commonly used FICO® Scores count your credit mix as 10% of your overall score. Through this mix, lenders gain proof that you can manage repayment on various types of debts.
When it comes to managing debt like credit cards, a low balance keeps your credit utilization rate, or how much credit you use, at a reasonable level as well. This also assures lenders that you don’t spend beyond your means.
TODAY’S TAKEAWAYS
· Good debt builds wealth. You responsibly manage it and pay it off.
· Bad debt harms your financial health. It’s usually put toward depreciating assets.
· Having a lot of debt won’t necessarily hurt your credit score.
· Not making payments on time will.
· A “good” mix of credit can boost your credit score.
· A low credit card balance assures lenders you don’t spend beyond your means.
WE’RE HERE TO HELP
Talking about debt as part of a larger financial-planning goal should never be stressful or shameful. There’s always a way forward, and we can make that possibility a reality. Let’s connect today.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
