You may have heard that not all debt is created equally. You may have even heard that certain kinds of debt can be a good thing. But, you may have also been told that it’s the devil in disguise.
Regardless of what you may have heard about debt, it exists. Sometimes, whether you like it or not, you may need it. And that’s not always a bad thing (as long as you manage it).
As a former banker and financial advisor, I’ve seen firsthand how debt affects people. I’ve seen them scrape by, living paycheck to paycheck, always needing more but never able to obtain it. I’ve had to tell people no, they couldn’t buy a car or build an addition on their house. I’ve also had to tell people yes, even when I know it wasn’t in their best interest.
Debt can be a scary thing for many people, but it can also be liberating. It can be an opportunity, but you have to be ready to take the proverbial bull by the horns. The first step to dealing with debt is understanding it.
The difference between good debt and bad debt
Some people claim that there are two different types of debt: good debt and bad debt. Good debt is often categorized as debt used to buy necessary items, like a home. Student loans can also be categorized as “good debt.” In theory, good debt allows you to earn a return on your investment. For example, homes typically appreciate in value over time. An education allows you to get a better job or earn a higher income.
“Bad debt,” on the other hand, is often credit card debt, auto loans, or other personal loans. Bad debt often has higher interest rates than good debt.
While you can accumulate large amounts of good or bad debt, bad debt is typically viewed as “frivolous” or “unnecessary.” In reality, too much of anything, even good debt, can be a bad thing, though.
Why you may need or want debt
There are times in life where you may need to take on additional debt. No, I don’t recommend taking out a personal loan to buy a new TV. I love and use credit cards for all of my everyday purchases (read why here), but I don’t recommend making unnecessary purchases, like a new TV, on a credit card unless you can treat it like cash and pay it off at the end of the month. That said, there are some legitimate reasons to have debt, even “bad debt.”
If you’re going to further your education, explore every option for funding your degree, including student loans. Also, if you are tired of paying for high rent, look into purchasing your first home and getting a mortgage.
Sometimes, it makes sense to purchase something with a loan or with a credit card. For example, when my husband and I remodeled our kitchen, we put the bulk of our purchases on a store credit card. We had a year to pay off the card at zero percent interest. Each month, we saved 1/12 of the balance in a savings account, and then we paid the credit card off at the end of the year.
Even if you decide to take out a loan, you should still be planning ahead for those purchases. Try to save as much as you can ahead of time, and take out as small of a loan as possible. For example, if you know you’ll need a new car in a few years, start saving now. When you do buy your car, check all interest rate, both new and used, from both the auto dealer, banks, and credit unions.Try to make as large of a down payment as possible, and read the fine print on your loan. Make sure you check the following:
- What is the interest rate, and is it variable or fixed? If the interest rate is variable, is there an option to lock it in at a certain rate?
- Will you need to make monthly payments or is the balance due on a certain date?
- Is there a fee to pay the balance off early?
- What are the new terms if you make a late payment?
- Are you charged a higher interest rate?
- Will you have to pay the interest that already accrued?
How to get rid of debt
If you end up taking out a loan for a purchase or even a student loan, you’ll need to have a game plan for paying it off. Make sure you know the terms of your loan and compare that to your budget. Figure out exactly how long it’ll take to repay your loan and then determine if you can make extra payments. (Bankrate.com has a great online calculator. You can even click on “amortization schedule” to see what would happen if you made extra payments.)
One simple way to make an extra loan payment every year is to pay half the monthly payment every two weeks. This is especially easy if you receive your paycheck every other week. At the end of the year, you’ll have made 26 half payments, or 13 full payments, instead of the 12 payments you would typically make every year if you paid once a month.
Another way to pay off your debt is to use the avalanche method. We used this method to pay off my husband’s student loans. We had two loans, one with a low, fixed interest rate and one with a higher, variable interest rate. We focused on paying off the variable interest rate loan first. We often made double payments on the higher interest rate loan while making minimum payments on the fixed loan. We also paid extra on the principal when we had leftover money in our budget. Once we paid off the higher interest loan, we used the money that we had previously paid on the variable loan to make larger payments on the fixed rate loan.
Debt isn’t the end of the world, and it’s not always the devil that people make it out to be. If you use it sensibly and have a plan to pay it off, it can help you reach your dreams. The trick to having debt, both “good debt” and “bad debt” is to understand it and treat it with care.