Good Debt vs Bad Debt

While in the world of collection agencies, credit cards, and falling home rates, the inevitable acceptance of debt has become an everyday affair. Being able to manage the difference between Good Debt and Bad Debt will not only keep you from losing sleep at night over unpaid bills, but also will help to improve your credit score and allow you to obtain better interest rates or higher loan amounts.

There are many types of debt that one can obtain, whether it would be a Credit Card, Mortgage, Automotive Loan, Student Loans and more. None of these debts are bad. It’s all in how they’re used.

Student Loans, Automotive Loans, and Mortgages are all Installment-Based loans and are just a few that focus on one primary attribute towards good credit; The History. Paying the debt on time for the duration of the payment plan is far better than paying off the entire debt (or a large portion of it). For example, if you have a $250,000 Mortgage for a 20 year term, you may pay about $1,100 a month. Interest can make this number higher, but for this example, our interest rate is 0%. By paying at least $1,100 a month, your credit score can go up every month because you made the minimum payment per month on time. Of course, paying off more than minimum is always good, but you don’t have to go overboard. Putting $10,000 down one month may raise your score slightly more than paying minimum, but you score will go up more if you pay, say, $1,250 for 8 months.

Of course, that’s without interest rates. Paying off more at one time means you pay less interest later. So it’s really a matter of whether you need your score to go up more over time or if you need to get that interest out of the way.

The same holds true for all Installment-based accounts. These primarily focus on the History rather than the current amount owed. Installment-based accounts are typically larger, higher debt loans to be paid over time and for a set amount, in which case the affect on your credit score is more over months or years rather than the major hitter of debt; Credit Cards.

Credit Cards are a Revolving Debt. That means that the balance owed can change at any time, as well as other factors (such as interest rate or maximum limit). Credit Scores for Revolving Accounts focus on two things; Balance to Debt Ratio, and Payment History. While it’s good with any account to pay on time, Credit Cards are more about the balance. If you have a credit card with a $1,000 limit and you have $100 on it, the only thing you worry about is the interest rate and paying it on time.

However, if you have all $1,000 used on that card, you are now considered “high risk” because the card is maxed. This will drop your credit score dramatically. Ironically, if you have the card maxed out, paying it off completely will also hurt your score. Paying it down to a very low balance and leaving it report for a month will increase your score better than paying the entire card off at once.

In practice, it’s usually never good to use more than 30-40% of your available balance on your credit card and to not have more than 2 or 3 open credit cards at once.

The Good Debt in this is not having more debt out there than you can handle. If you have a large Mortgage along with Student Loans, an Auto Loan, and Credit Cards, it may be best to keep the Credit Cards below even 10% so as not to overwhelm your payment plans between all the accounts. Good Debt is debt you pay on time, don’t sweat over, and can still have money left over to save or use on other bills (Don’t forget that electric bill!).

Bad debt is when things start getting maxed out, or payments are missed. You start incurring higher and higher interest rates to the point where the interest alone is almost more than the minimum payment.

In general, no type debt is ever bad. It’s missing the payments or getting swamped by interest that’s bad.