In 2022, the average American owed almost $102,000 and paid more than 9.5% of their disposable income on debt. That same year, American households owed approximately $17 trillion in total debt, up $2.75 trillion from 2019.
Let's face it: America has a debt problem. I believe that bad debt habits persist due to our country's financial illiteracy. This guide is aimed to help you understand the differences between good and bad debt and give you basic techniques and recommendations for managing and paying off your debt.
Good vs. bad debt
Good debt can help your long-term finances, whereas bad debt hurts or ruins it. Good debt examples include:
Mortgages: Whether for your home or an investment property, mortgages buy assets. As a mortgage is paid down, equity (the difference between the property’s fair market value and the loan total) builds and can be used to sell or borrow from.
Student loans: Data shows that a college degree can significantly boost a graduate's lifetime wages, making student loans acceptable debt.
Home equity loans and lines of credit: If you own real estate, you can borrow against your equity for long-term financial gain. Home equity debt can be used to upgrade a home, buy another property or pay off higher-interest debt.
It’s important to note that good debt is still debt, so use it wisely. A few helpful tips include:
- Keep mortgage payments below 36% of income.
- Keep student loan payments below 10% of estimated monthly after-tax income.
- Home equity loans and lines of credit often require a minimum loan-to-value ratio of 80%.
The idea is to ensure you still pay off good debt over time and manage it cash flow-wise.
Bad debt should be avoided or used with good financial habits. Bad debt includes:
Credit cards: Credit cards allow you to spend money you don’t have and carry hefty interest rates. Credit cards can simplify cash flow management, but you should use them only if you can pay them off every month.
Personal loans: Personal loans are a good alternative for consolidating and paying off high-interest debt because they have a fixed duration and payment and lower interest rates than credit cards. Avoid using them for unnecessary things such as pricey vacations or new outfits.
Buy now, pay later loans: Online retailers provide BNPL loans at the moment of sale. These loans let you make numerous interest-free payments for a charge. This idea seems great in theory, but if you make many BNPL purchases through different services or merchants in a short time, that could result in more debt than you initially meant or can afford.
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Healthy debt management
Before taking on debt, plan ahead. What is your debt goal? Will it help or hurt your finances?
A debt-to-income ratio under 35% is considered healthy. Keeping your debt-to-income ratio in this range ensures your monthly income can meet your debts. If your debt-to-income ratio is higher than that, then now’s a good time to plan repayment.
Here are some generally healthy habits and best practices to establish with your debt:
- Budget your household to understand your cash flow.
- Pay credit cards off in full every month.
- Autopay recurring debt installments to avoid late payments.
- Plan to repay high-interest debt.
- Avoid using debt for lifestyle expenses.
- Always have three to six months of living expenses in financial reserves for emergencies.
- Track your loan balances, interest rates and minimum payments, and refinance to a cheaper rate when possible.
Strategies to pay off debt
Life happens, and we sometimes get into lousy debt despite our best efforts. A plan helps discipline these situations. Three main debt payment strategies include:
Debt snowball method: This method prioritizes smaller balances over interest rates. Mathematically, this strategy is not the most cost-effective or time-saving, but it might feel simpler to attain psychologically with smaller wins gained earlier on and can often free up cash flow faster by removing those lowest sums.
Debt avalanche method: This method promotes paying off highest-interest-rate balances first regardless of balance size. By paying off the higher-interest-rate balances, debt is paid down faster, and more costs are saved on interest.
Debt consolidation method: Managing various loans, credit cards and other debt can be difficult with all the different payments and due dates. For these situations, debt consolidation may be the most preferable option.
The most typical debt consolidation technique is to use a personal or home equity loan to pay down higher-interest debt. In general, the goal of debt consolidation is to lower your monthly payment to free up cash, convert your variable-interest debt to a fixed rate and/or lower your interest rate to simplify repayment and get out of debt faster.
Wrapping up
Debt might help or hurt your long-term finances and can have serious implications, so be mindful of its use. In today's world, it's tempting to utilize debt to finance purchases or make investments, but it's important to assess the pros and cons to avoid any long-term damage. Debt can help you reach your financial objectives, but only if you understand its implications and make informed decisions first.
