Credit is such an integral part of our economy that it feels completely natural to get into debt. In some instances, debt seems impossible to avoid. So how can we know if our debt is getting out of control?
If we want to diagnose our debt, we need to understand it. Not all debt is the same, and certain kinds of credit are better than others. Let us take a close look at the three types of debt.
1. Good debt.
Not all debt is alike. The best kind of debt will increase in value or generate sustainable, long-term income. What types of things fall under this umbrella?
Student loans.
While the debt load taken on by students in the twenty-first century seems to be disproportionately growing, it is still considered to be good debt (within reason). Education is still the strongest indicator of future earning power. However, student loans are not all created equal, so consider your educational and vocational goals before taking out a loan.
Real estate.
For many people, a mortgage represents the one item in their life with the most equity. Even though it represents high and long-term debt, it is considered good debt—provided you do not end up overpaying.
When you are talking about mortgages, it is probably smart to include Home Equity Lines of Credit (HELOC). This is credit based on your home’s equity. It is generally considered good credit because of lower interest rates, and you can use it to do upgrades that will ultimately increase your home’s value.
Other forms of real estate—like rental or commercial properties—can also be worthwhile credit investments.
Car loans.
A car loan is the most risky of the good debts. Vehicles depreciate fast, so you can end up owing more than the value of your purchase. If you want a car loan to remain good debt, aim to pay at least 20 percent down, ensure the loan is not higher than 20 percent of your take home pay, and keep the loan term to four years or less.
2. Bad debt.
Bad debt involves depreciating assets. These are things that you buy on credit but are worth very little by the time you end up paying them off.
As previously mentioned, cars can turn from good debt to bad debt in a hurry. Since cars are so expensive and depreciate so quickly, you can end up paying interest on something that is only losing its value.
Another key form of bad debt is using credit to buy vacations, Christmas gifts, clothes, or meals at restaurants without being able to pay off the bill each month. Even though this is how many people use their credit cards, paying interest on a consumable that is valueless after you have purchased it only hurts you.
2. Toxic debt.
Some debt is so bad that it should be avoided at all costs. This type of debt includes payday loans, rent-to-own plans, title loans, and debt with incredibly high interest. What does incredibly high interest mean? We are talking about interest exceeding 100 percent—the average interest rate on a payday loan is 400 percent.
This kind of predatory credit takes advantage of people in financial straits and offers them financial products that are easy to get but completely toxic. If you have found yourself mired in poisonous debt, please seek credit counseling immediately.
Managing your debt.
Debt does not have to be a dirty word. Take time to consider your habits around the use of credit and identify where you want to make changes. You can avoid bad debt, steer clear of toxic debt, and leverage good debt to practice good stewardship.
