Laura reviews how to identify good and bad debts and tips for paying off the right ones faster.
Laura reviews how to identify good and bad debts and tips for paying off the right ones faster.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Many people and money experts believe all debt is bad and should be avoided or paid off quickly. I'm in a different camp that believes debt is more nuanced and specific types, called "good" debts, can improve your finances by building wealth.
This post will review the differences between "good" and "bad" debts so you eliminate the bad ones and leverage the good ones to increase your net worth. I'll also review five steps for paying off the right debts faster so you save money and create more financial security.
Welcome back to episode 924 of Money Girl! I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, founder of The Money Stack, a Substack newsletter, and host of this podcast with over 43 million downloads.
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What are examples of "good" debts?
One way to know if a debt is good or bad is to ask yourself if it pays for something that appreciates or depreciates. If you use debt to finance an asset that should be worth more in the future or will allow you to earn more, it's typically good. Debt that finances something that has already lost value or will be worth less in the future is bad.
A home mortgage is one of the most popular good debts, which allows you to purchase an asset that typically appreciates over time. While there's no guarantee that a home or investment property will be worth more in five or ten years than today, real estate generally appreciates several percentage points annually on average.
Plus, a limited amount of mortgage interest you pay to finance a primary or second home is tax-deductible. That includes home equity lines of credit (HELOCs) or loans used to buy, build, or renovate a primary or second home.
Therefore, a mortgage costs less than its stated interest rate on an after-tax basis. The combination of appreciation and tax benefits makes getting a mortgage for an affordable home one of the best possible debts you might have.
But how much is an affordable home? A good guideline is keeping your total housing cost, including a mortgage, property taxes, homeowners insurance, and any homeowners association dues no more than 25% of your gross monthly income.
For example, if you earn $10,000 a month, your housing expenses should ideally be no more than $2,500. I've always targeted 20% or less for my maximum housing expense to have plenty of financial breathing room.
But these are guidelines, not hard rules. You must set your own housing budget based on your needs, total debt obligations, lifestyle, and financial goals.
Housing costs vary significantly depending on where you live. Spending 25% of your income on housing in expensive cities could be challenging. That means you may need to cut back on other budget areas.
Another example of a good debt is an education loan. While it isn't backed by an asset, like a home, it can help you earn more over your lifetime.
A college degree is required for many jobs and industries, such as health care, law, and engineering. So, depending on the career you want, taking out a reasonable amount of education debt can make you more employable. Plus, a limited amount of interest paid on education loans is tax-deductible.
A good rule of thumb is to limit federal or private student loans to your expected annual salary after graduation. For instance, if you believe you'll earn $100,000 in your first year as an attorney, consider borrowing no more than $100,000 for your education.
LISTEN ALSO: Is buying an affordable home still possible?
What are examples of "bad" debts?
As I mentioned, bad debts finance items that lose value. For example, a car loan allows you to buy a vehicle, which typically loses half its value within a few years. Of course, the depreciation rate depends on a vehicle's make and model and how well it's maintained.
While a car loan is a bad debt, most of us need vehicles. So, borrowing as little as possible, financing used vehicles, or buying new cars that hold their value over time is wise.
Credit card balances are typically one of the worst debts you can have. But it does depend on what you buy with them. For instance, if you make charges that you can't pay in full for clothes, furniture, or restaurants, you don't have anything with real value.
Plus, cards charge incredibly high interest rates. If you have a $1,500 balance on a competitive card charging 18% and can only make minimum monthly payments, it would take about five years to pay off. In that scenario, you'd pay almost $1,000 in interest! And the stuff you bought with the card would be worth nothing or pennies on the dollar.
RELATED: How to pay off credit card debt faster
5 steps to create a debt payoff plan
Carrying too much debt for your income level damages your credit scores and quality of life. Consider the following five steps for creating a debt elimination plan.
1. List your debts.
Knowing how much money you owe is the first step to paying it off. Make a list of your debts, their interest rates, and balances in a spreadsheet or on paper.
Identify your good debts, such as mortgages, student loans, and low-rate auto loans, and bad debts, such as credit cards, high-rate personal loans, and high-rate auto loans.
2. Choose a debt payoff method.
Some debt payoff strategies include the avalanche, snowball, and landslide methods.
While these are common debt elimination strategies, there isn't a right or wrong way to pay off debt. Any method you can use to make steady progress is good.
However, I always recommend the avalanche method or starting with your highest-rate debt because if you plow your savings back into your debt balance, you can reduce it faster. Plus, most people have multiple credit cards with high rates. If so, start with your most expensive card and move to the next most costly card or loan you have.
For instance, if you have a card charging 26% with a $6,000 balance and another charging 20% with $3,000, tackle the larger balance first.
After you pay off your bad debts, consider eliminating good ones—unless you have a better use for your money. For instance, if you can invest your money for a higher rate of return than a debt's after-tax interest rate, you're usually better off investing instead.
3. Pay more than the minimum.
Now that you've created a game plan for your debt and know which one to tackle first, it's time to throw everything you've got at it while making minimum payments on your other debts.
Once you pay off the highest-rate debt, take all the money you sent to it and put it towards your next highest-rate balance.
4. Find ways to increase your cash flow.
An excellent way to get out of debt faster is to increase your income, cut your expenses, or both. You might reduce spending on dining out, clothes, or subscription services.
Also, shop for cheaper car insurance, phone coverage, and internet service. Maybe you can start a side hustle to pay off debt. If you get a cash windfall, like a tax refund, raise, bonus, or gift, use it to accelerate your debt payoff plan.
5. Consider a debt consolidation strategy.
If you have multiple credit cards or high-rate loans, a couple of consolidation strategies could drastically reduce or eliminate your interest expense. For instance, a balance transfer credit card typically charges 0% interest during a promotional period, such as 12 to 18 months.
You can temporarily cut your interest expense by paying off some or all of a high-rate debt with a 0% card. However, if you don't pay off your balance by the end of the card's promotion, your interest rate could be higher than before you made the transfer.
Other downsides to making a balance transfer are that:
Another option is getting a lower-rate personal loan to pay off higher-rate debt. Personal loans have monthly payments that depend on your chosen term, such as three to five years.
While a personal loan doesn't temporarily suspend interest accrual, like a balance transfer offer, it does charge a relatively low, fixed interest rate, making it easier to include in your budget. However, the shorter your repayment term on a personal loan, the higher your monthly payments will be.
Paying off debt is a marathon, not a sprint. Your debt-elimination journey should always begin with bad debts, saving the good ones for last. You should only pay off the best debts, like mortgages if your savings and investments for retirement are in great shape and you have extra money to spare.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast, and I want to thank our fantastic team! Steve Riekeberg audio-engineers the show. Brannan Goetschius is our director of podcasts, Holly Hutchings is our digital operations specialist, Morgan Christianson is our advertising operations specialist, and Nathaniel Hoopes is our marketing contractor.