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Good debt versus bad debt

Financial Planning

Financial educators generally divide debt into two distinct camps: bad debt, which consists of high-interest credit cards and car loans (a depreciating asset), and so-called good debt, which are loans tied to an investment that may build wealth or generate income over time, such as real estate or student loans. In truth, car loans straddle the line, as they can potentially provide the transportation to apply for a higher-paying job farther away.

Paul Golden, a spokesperson for the National Endowment for Financial Education, however, argues that any loan can become “bad debt” if you don’t borrow responsibly.

“Any debt has the potential to be bad, especially if you don’t understand the product,” he said in a phone interview. “Even student loans can be bad if you overborrow or take on more [pricey] private loans than public loans. Or, if you borrow all this money for college but never finish your degree, then that’s a double negative.”

Some lenders also charge higher interest rates than the industry average or assess prepayment penalties, which puts consumers at a disadvantage, said Golden.

For anyone managing debt, he said, the key is to understand what you’re borrowing, shop around for the lowest rates and, above all else, keep your debt level firmly in check.

“You need to know your credit score and understand your financial identity before you go shopping for a loan, which can help you be more thoughtful with your budgeting and borrowing,” said Golden.

How much debt is too much?

So what’s a reasonable amount of debt? That varies depending on your unique financial picture, but most lenders like to see a debt-to-income ratio of anywhere from 28 percent to 36 percent.

Golden reminds consumers, though, that debt-to-income ratios are based on gross income and do not include such expenses as childcare, health care, groceries, or utilities.

“That’s why budgets become so important, so you can really get a sense of the full scope of your expenses,” he said. “And it’s not a one-time deal. You need to review your budget regularly because while some of those expenses, including your mortgage, may be static, others, like your grocery bill and entertainment costs, will fluctuate.”

Five red flags that suggest you may have taken on too much debt include:

  • Missing payments.
  • Only being able to afford to make minimum payments.
  • Borrowing money to pay bills.
  • One or more credit cards maxed out.
  • A new credit card or loan denied.

Solutions for paying down debt

If you’re in over your head financially or simply wish to rid yourself of debt, financial experts suggest you start by paying down your highest-interest credit cards first while continuing to make the minimum payments on your other debt obligations. After the first card is paid off, apply those extra payments toward the next highest-interest debt and continue until your balance is zero.

You can rid yourself of debt faster if you take a part-time job, lower your monthly living expenses, and above all else, stop making new purchases with your credit cards.

A credit counselor may also be able to help you create a budget for a debt-free lifestyle and stick with it, such as those available through the nonprofits National Foundation for Credit Counseling or the Financial Counseling Association of America.

The Consumer Financial Protection Bureau, however, cautions borrowers to beware of debt settlement companies, which are different from nonprofit groups, especially those that charge up-front fees, guarantee they can make your debt disappear, or tell you to stop communicating with your creditors.7

“It’s very easy to get into debt, and it takes so long to dig out,” said Golden, noting that those who struggle with debt should do some thoughtful introspection about their saving and spending choices. “Consider not just how you’ll pay off your debt but how you got into this situation in the first place.”

Debt isn’t all bad, especially if managed responsibly. But if you’re spending more than you should on monthly debt obligations or you’re unable to save for other financial goals, it may be time to put a debt reduction plan in place.

1 WalletHub, “Credit Card Debt Study,” Aug. 18, 2022

2, “Minimum Payment Calculator.”

3 Black Knight, “Tappable Equity at Another All Time High, But Declines In West May Mark Inflection Point," Aug. 2, 2022.

4 College Board, “Average Published Undergraduate Charges by Sector and by Carnegie Classification, 2021," 2022.

5 Pew Research Center, “5 facts about student loans,” Aug. 13, 2019.

6 Georgetown University, “The College Payoff: Education, Occupations, Lifetime Earnings.”

7 Consumer Financial Protection Bureau, “How to get a handle on your debt,” Oct. 23, 2017.

The information provided is not written or intended as specific tax or legal advice. Lenox Advisors, Inc. (Lenox), its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own and do not necessarily represent the views of Lenox Advisors.