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Good Debt vs. Bad Debt: What’s the Difference?

Good Debt vs. Bad Debt: What's the Difference? | Brown & Joseph, LLC

What is the difference between good debt and bad debt?

Isn’t all debt bad?

Although it’s always better to be debt-free, all debt isn’t necessarily bad.

Some debts are actually considered investments that generate long-term income or value. This type of debt is referred to as good debt.

For example, student loans are a type of good debt because it’s an investment in your future and you anticipate being able to pay back those loans using the education you acquired.

Another example of good debt is a mortgage.

With a mortgage, also known as a home loan, you can increase the value of your home over time through various improvements and gain money if you decide to sell someday.

On the other hand, bad debt is debt that doesn’t increase your net worth, has no future value and that you don’t have money to pay for.

Examples of bad debt include credit cards, auto loans and store credit cards.

How much bad debt is too much?

While any amount of bad debt is too much, sometimes it’s a necessary evil.

You can figure out if you’re living within your means by calculating your debt-to-income ratio.

Calculating Debt to Income Ratio | Good Debt vs. Bad Debt: What's the Difference? | Brown & Joseph, LLC

To find your debt-to-income ratio, add up all your monthly debt payments and divide that by your monthly gross income.

Ideally, your debt-to-income ratio will be below 10-15%.

Anything over a 43% debt-to-income ratio is a red flag to potential lenders and shows that you are living beyond your means.

Good Debt vs. Bad Debt: What's the Difference? | Brown & Joseph, LLC

How do I get rid of bad debt?

Getting rid of bad debt takes time and commitment, but it can be done.

Here are some steps you can take to reduce your bad debt:

1. Prioritize your bills.

Prioritize your bills by paying off secured debts first, like auto loans and mortgages.

Then pay off unsecured debts like student loans, child support and taxes.

Next, pay off unsecured debts that are likely to appear on your credit report, and finally, unsecured debts that are least likely to go into collections.

However, remember that while some agencies don’t bother with smaller amounts, others specialize in collecting smaller amounts of debt.

There’s no way to tell if debt will go into collections or not, so it’s best to just pay what you owe.

Another good thing to do to make sure you don’t miss any payments is to set up automatic payments through your bank or through the creditor.

This way, all your payments are scheduled in advance and there’s no worry about missing a payment and causing further damage to your credit score.

2. Create a budget.

Creating a budget not only let you know where your money is going, but it can also help you curb any unnecessary expenses.

HiCharlie offers some great advice on what to cut first: eating out, shopping, travel, and entertainment like going to the movies.

If there are things you can’t cut completely, find hacks to spend less. Use gift cards, skip the expensive cocktail at dinner, or shop thrift stores.

6 Steps to Ditching Your Debt

Another good rule of thumb to use is the 50/30/20 rule.

The 50/30/20 rule was first coined by Harvard bankruptcy expert Elizabeth Warren as a way to spend and save money.

The idea is to spend 50% on your needs, 30% on your wants and put 20% into your savings account or toward debt repayment.

3. Make more, spend less.

See if you can increase your income to cover your debt.

Consider putting in more hours at work or getting a part-time job. With the rise of ridesharing and delivery services, all you have to do is have a car and a clean driving record!

Some of the most popular part-time jobs can be applied to through an app on your phone:

The side hustle is becoming mainstream, and it’s easy to do. Why not try to earn some extra money to pay off that debt?

4. Don’t ignore collection calls.

Ignoring collection calls won’t make the debt go away and could make the situation worse by further damaging your credit score.

It’s best to acknowledge the debt and explain why you can’t pay it.

The collector or the credit card company may be able to help you out by with the interest rate and payment due dates.

You could also get on a repayment plan.

5. Educate yourself.

There are many resources and programs that can help if you look for them, like repayment plans or loan modification plans.

You should also be educated on the more serious options for debt repayment, like consolidation and bankruptcy.

Always read the fine print and understand your responsibilities as a borrower/debtor and what the consequences are for failing to repay what you owe.

Additionally, be sure you understand the components used to determine your credit score and how it is impacted.

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