Good and Bad Debt On Your Credit Report
Is Debt Your Friend or Foe?
For many Americans who lived through the Depression, or whose parents did, a fear of personal debt is embedded in the deepest recesses of their minds. For people like this, debt is distasteful and something to be avoided whenever possible. Younger generations, on the other hand, may consider debt a normal part of everyday life and simply can't imagine how they'd ever get by without "plastic."
The truth is, there's good debt, and there's bad debt. Bad debt can't always be avoided, and sometimes, good debt goes bad. Confused? Many are, but we'll do our best to separate the good from the bad and arm you with the debt advice you need to help you assess the impact of specific types of debt on your financial health.
What is "good debt"?
Simply stated, "good debt" could be considered an investment that grows over time, such as a home mortgage or school loan. Student loans are considered good debt because they usually offer lower interest rates than other loans and because you're making a lifetime investment in your career potential.
Mortgage debt is in fact considered one of the best types of debt, as it builds wealth over time. Good debt might also be something that generates cash flow, such as a loan for business or a rental property.
What is "bad debt"?
In contrast, "bad debt" generally refers to loans for items that lose value the minute you purchase them, such as cars. (And there's nothing more painful than making payments on a car that's already been scrapped.)
The use of high-interest credit cards for disposable items (clothing, furniture or vacations, for example) may also be considered bad debt when payment is not made in full. That's because each month you make a partial payment, you're being charged interest, so the total cost of your purchase continues to increase while its actual value doesn't. So revolving credit is generally considered bad debt if the debt is financed over a period of time. If you habitually pay off your credit card balances in full each month, credit card debt may, in your case, be considered good debt.
Debt advice to live by
Total monthly personal debt (including mortgage and credit cards) shouldn't exceed 36% of your gross monthly income.
Whatever item or service you finance should last longer than the life of the loan.
Example: Fulfilling a lifelong dream to sunbathe on the beaches of Patagonia by charging it all on your credit card is bad debt since you'll be paying off that loan long after you've recovered from your sunburn.
Whenever possible, the loan should provide leverage that helps you build wealth.
Example: Historically, homes have proven a solid value and appreciate over time. Mortgage loans also offer tax deductions on points and interest paid each year.
Question: If I always pay cash and never incur debt, wouldn't that be a good thing if I later need to apply for credit?
Answer: Unfortunately, keeping your record of personal debt a blank slate generally does more harm than good. That's because your personal credit report would lack a proven track record of responsible loan payments, leaving lenders without any means of assessing their risk in loaning you money.
Question: But if I've avoided taking out loans altogether, doesn't that show that I'm careful with my money?
Answer: Not really. Lenders want to see that you can both obtain credit and repay it responsibly. Specifically, lenders will likely focus on your debt-to-income ratio, which tells them how much available credit you have and the portion you've spent. If you have a lightweight credit report with not much credit history, you'll likely receive a low credit score. This, in turn, increases the chances you'll be turned down for credit when you need it, or conversely, could cost you more in interest than you could otherwise expect.
Even if you're wary of debt, obtain one or two credit cards, and periodically charge small purchases, then repay your balance in full each month. This will help you maintain a low debt-to-income ratio and a favorable personal credit report. People who shy away from debt will pay the piper for their credit aversion if they later require credit or a loan. It's nearly impossible to live debt-free.
Regardless of how you define debt, remember never to take on more personal debt than you need, because even so-called good debt can get you into trouble. If you cultivate good consumer credit habits, your debt report will reflect it. Your ability to obtain credit and finance debt should be considered a tool that can not only help you manage your finances but boost your wealth as well.