Good vs. bad debt
How to distinguish between good and bad debt
Good debt is manageable and can help you achieve your goals. On the flip side, bad debt is unaffordable and can be overwhelming. Ask yourself these questions to determine what you’re dealing with and how to manage it.
1 Why? If you took on the debt for a student loan or another long term goal to help you move ahead in life you’re likely OK, as long as you don’t take on too much.
Other debts are designed to make aspects of your life easier, such as paying for a big, one-time expense without depleting your savings. These can be benign if they’re helping you manage your overall financial picture and are for a reasonable amount.
Desperation debt is when things get dangerous, such as payday loans in a pinch. A need for cash in a hurry can leave you with limited options and result in high interest costs.
“Any debt that is taken on because people don’t have any kind of choice means they are starting out in a place of disadvantage,” says Ida Rademacher, a vice president of nonprofit think tank The Aspen Institute. “That can create a spiral that can prevent people from being resilient.”
To avoid desperation debt, build an emergency fund.
2 Affordable? Comparing your debt load with your gross income can be a helpful tool.
If your debt load, excluding mortgages and student loans, is no more than 15% of your income, it’s affordable but worth addressing. A debt load of 16% to 39% of your income is increasingly difficult to pay off. You may be able to make it more affordable by reducing interest rates, such as with a balance transfer or a personal loan. But you may also want to explore a debt management plan with a nonprofit credit counselor.
A debt load of 40% or more can be insurmountable. Use a free consultation at a nonprofit credit counselor or with a bankruptcy attorney to decide the best option for you.
3 Impact? Think about how debt is impacting your life overall, says Thomas Nitzsche, of nonprofit credit counseling agency Money Management International.
“If your debt is something that is hanging over your head and you’re worrying about it constantly, that’s something you should address,” she says. Any debt that affects your mental health or significantly diminishes your quality of life is a bad debt.