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Good vs. bad debt: Know the difference

Good or bad debt is determined, in part, by whether your financial situation is set up to take it on.

Tags: Debt, Planning, Credit, Personal loans
Published: October 25, 2019

Debt is a common part of American life. U.S. household debt reached $14.3 trillion in Q1 2020.1  But how do you differentiate between debt that will help you move toward your financial goals and debt that will set you back?

 

Ask yourself these questions. 

 

1.  What is the purpose of the debt you’re considering?

  • It will be used to purchase an asset that increases in value or to potentially expand your future income. For example, a mortgage may help you buy a home that can appreciate in value. Student loans may help you increase your future income. If that’s the case, the debt you’re considering might be right for you.
  • It will be used to purchase a depreciating item, such as a car or furniture. Going into debt for depreciating items will cause you to pay more in interest for something that is worth less. You may want to reconsider taking on debt for these types of purchases. 

 

2.  What is your debt-to-income ratio?

Your debt-to-income ratio is calculated by taking your monthly debt payments (car, mortgage/rent, credit card, loans, etc.) and dividing that number by your gross monthly income.

  • Generally, a debt-to-income ratio below 36 percent indicates a healthy balance sheet. If that’s the case, the debt you’re considering might be right for you. 

  • A debt-to-income ratio above 36 percent could indicate added risk. You may have a harder time repaying the debt if you face an unexpected financial challenge. You may want to reconsider taking on additional debt. 

 

3.  How does the debt fit into your overall financial plan? 

  • If you have a sense of how the debt will impact your other obligations, income, and savings, you likely have the information you need to move ahead. 

  • If you haven’t fully considered how debt fits into your financial plan, it may be wise to get advice about creating an overall financial strategy. Consider the different affects taking on debt can have on your finances.

 

4.  What are the specifics of the debt you’re considering? 

  • Finding an interest rate that is a fraction of a percent lower can save you thousands of dollars over the course of a loan. Research interest rates to see what your options are.

  • Some investors have benefited from using low-interest debt to purchase assets such as stocks that could earn a higher return. However, all investments have a risk of declining in value, which means there’s a chance you could lose money. Talk to a financial professional to review your options.

  • A growing business might use debt to finance the purchase of a new building, or an investor may buy a rental property and use the rental income to help repay the debt. It’s important to consider the risk of a downturn that could make it harder to cover the debt payments. Talk to a financial professional to help determine what’s best for you.

 

Learn more about using debt to build wealth, or how to manage it along with saving, investing and having fun

 

1 Household Debt and Credit Report. Federal Reserve Bank of New York's Center for Microeconomic Data. Q1 2020.