The word “debt” is commonly defined as something—usually money—owed by one party to another. In the U.S., consumer debt is typically made up of mortgages , auto loans, credit cards, and student loans.
The overall balance of consumer debt in America has been on the rise since 2012, according to the New York Federal Reserve . But that’s not necessarily a terrible thing, because not all debt is bad. So what is the difference between good debt and bad debt? And how do you avoid the latter? Here are some tips to navigating the world of debt.
1. Debt can help build your credit score.
A credit score is a number determined by a consumer’s credit history . How many credit cards you have, how many loans you have, and the total amount of money you owe help determine your score, as does whether or not you pay your bills on time. Credit scores range from 300 to 850, and the scores are compiled
by credit bureaus such as Equifax, Experian, and TransUnion.
Companies and lenders use your score to calculate risk and what interest they will charge you on a debt. If your score is higher, you will likely be offered a lower interest rate. If your credit score is low, you will probably be presented with a higher interest rate.
To build your credit score, you must establish a positive credit history, and one way consumers can do that is by borrowing responsibly—i.e., having good debt.
2. Good debt pays for things you need, and/or things that might increase your net worth or future value.
Going into debt to pay for your education or a home are considered examples of good debt. That’s because attaining a college degree or buying a house are ways to invest in yourself. A college degree might lead to a better paying job, so it has future value. And purchasing a home not only gives you something you need—a place to live—it’s also an investment that is likely to increase in worth over time. In the past year (as of April 2019), U.S. home values have gone up 7.6% in value according to Zillow. And historically, American home values appreciate over time, barring an economic downturn or crisis.
3. Bad debt pays for things you don’t need, or things you can’t afford.
Using a credit card to purchase unnecessary or extravagant items can build up bad debt. Using a credit card to buy the latest tech gadget or to book a tropical vacation may satisfy you in the moment, but they are probably not things you need and they do not add to your net worth. If you must make such a purchase, it might be wiser to save money up over time and buy them outright, rather than pay with a credit card and risk struggling to pay the bill down.
4. Using a credit card can help establish good credit, but not if you can’t afford to pay your bill and in a timely matter.
An unpaid credit card balance at the end of the month can be considered bad debt, because chances are you’re paying significant interest on that balance. In early 2019, the average credit card interest rate (or annual percentage rate, APR) was above 17 percent .
That rate can lead to a decent amount of extra money being owed. And if you let a chunk of the balance roll over month after month, you’re paying interest on top of interest. It’s easy to imagine how your bill total can climb, making it more and more challenging to eliminate the debt.
Payday loans are another example of bad debt, as the interest rate for these short-term cash advances can be incredibly high. Each state sets its own regulations for these loans. For example, in California , a consumer borrowing the maximum amount of $300 could be charged a fee of up to 15% for the loan, immediately turning their $300 to $255.
5. If you have bad debt or debt that feels unmanageable, don’t ignore it. Lessen (or reorganize) it as best you can.
Different debt challenges call for different measures.
If you find your student loans too big to pay, for example, you could consider refinancing them. In order to lower monthly payments, you might redetermine the terms of your loan so that you can pay them off over a longer period of time. Refinancing also gives you the opportunity to lower your interest rate and therefore the total paid over the life of the loan.
If credit card debt has built up to great heights—and that can happen quickly, if you’ve missed a few payments—it’s time to prioritize in a way that fits you. That might mean the “snowball method”—paying your lowest-balance debt off first, then moving onto the next lowest, thus building momentum. Conversely, you could use the “avalanche method,” paying your highest interest debt off first, then moving onto the next lowest, thus paying your debt off based on the interest rate.
At SoFi, we used our experience serving people like you to develop a proprietary debt paydown strategy called “debt fireball.” It combines the best of the two methods described above. You would separate your debt into two categories—good debt and bad debt. Then you would attack your bad debt starting with the one with the lowest balance. Then you would continue to the next lowest balance and build momentum to quickly blaze through your bad debt.
For some, consolidating credit card debt into a personal loan is a good way to go—especially if you’re feeling overwhelmed by the number of credit card bills you are keeping track of. Consolidating all of your credit card debt into one loan means you make one payment to one lender.
The additional good news is that a personal loan is likely to come with a lower interest rate than your credit card debt. Though credit card payments you are behind on can hurt your credit score, consolidating them into a personal loan that you manage and pay monthly can help build your score back up.
If you think a personal loan is a good option for you, check out personal loans with SoFi. SoFi offers personal loans with low rates and no fees. With a low-interest rate and a fixed monthly payment, an unsecured personal loan to consolidate credit cards or other high-interest debt could help you start tackling your debt.
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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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