Do you know the difference between good and bad debt? Laura explains why it's a critical concept for saving money, building wealth, and creating more financial security. Plus, she covers a simple 7-step plan for paying off debt fast.
Many people think that all debt is bad and should be avoided or paid down as quickly as possible. However, you should break down debt into two types: good and bad. It’s essential to understand their differences so you stay away from bad debt as much as possible and leverage good debt when it can help you.
This post will cover the differences between good and bad debt and some practical examples. Plus, I’ll review seven simple steps for paying off your debt as quickly as possible. Understanding these concepts will help you save money, build your net worth, and create more financial security for the future.
Examples of good debt
One way to know if a debt is good or bad is to ask yourself if it pays for something that will appreciate or depreciate over time. If you use debt to finance an asset that can or should increase in value, it’s typically good. And debt that finances something that loses value is terrible.
Good debt is good because it can increase your net worth or wealth over time. One example is a home mortgage, which allows you to purchase an asset that typically appreciates over time. While there’s no guarantee that your home will be worth more in five years than today, in general, real estate appreciates about 3% to 5% per year.
In 2021, there are parts of the country that have seen home prices rise 20%! But it depends on where you live and the features of your property. Plus, mortgage rates are at historic lows, making them one of the least inexpensive debts to repay.
A certain amount of interest you pay on mortgages and home equity loans is tax-deductible, making them cost even less on an after-tax basis. The combination of benefits makes getting a mortgage for an affordable home one of the best possible debts.
Another good debt is a loan for a college education. While a student loan isn’t backed by an asset, such as 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 computer engineering. So, depending on the career you want, taking out a reasonable amount of education debt can make you more employable. Plus, some amount of interest paid on education loans is tax-deductible.
A good rule of thumb is to limit your student loans to your expected annual salary after graduation. For instance, if you believe that you’ll earn $80,000 in your first year as a registered nurse, consider borrowing no more than $80,000 for your education.
Use a Morgage Affordability Calculator to know how much home you can afford.
Examples of bad debt
As I mentioned, bad debts finance items that lose value over time. 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 bad debt, many people need vehicles for their businesses, jobs, or to handle everyday chores. So it’s wise to borrow as little as possible or finance cars that hold their values over time.
Credit cards are one of the worst debts you can have. For instance, let’s say you rack up a $1,500 balance on a card charging 18% interest. If you spent the money on dinner with friends, new clothes, and a TV, those items have no or very little future value.
If you only make the card’s minimum payment, it would take you about five years to pay off, and you’d pay almost $1,000 in interest! And the stuff you bought with the card would be worth pennies on the dollar.
Use a Credit Card Payoff Calculator to find out how long it will take to pay off your debt.
How to pay off debt faster
Carrying a lot of debt damages both your credit scores and quality of life. Now that you know the difference between good debt and bad debt, what’s the fastest way to pay it off?
Use these steps to create a debt elimination plan:
1. Make a list of your debts.
Knowing how much money you owe is the first step to paying it off. If you haven’t already, make a list of your debts, their interest rates, and balances. Put it all in a spreadsheet or write it down on paper.
Identify your good debts, such as mortgages, student loans, and low-rate auto loans, and your bad debts, such as credit cards, high-rate personal loans, and high-rate auto loans.
2. Choose a method to tackle your debts.
Some debt payoff strategies include the snowball, avalanche, and landslide methods.
Debt snowball is paying off debts in order of the smallest to largest balances. It’s an excellent method for anyone who wants to experience some small wins.
Debt avalanche is paying off debts in order of the highest to lowest interest rates. This method saves you the most interest, which may allow you to pay off your principal debt balances faster.
Debt landslide is paying off debts in order of newest to oldest. This method can help you improve your credit while you whittle down your debt.
While these are common debt elimination strategies, there isn’t a right or wrong way to pay off debt. Any method you can stick with and make steady progress will be a good one.
However, I always recommend the avalanche method or starting with your highest-rate debt because it saves you the most money over the long run. Plus, if you plow your savings back into your debt balance, you can reduce it faster. Since most people have high-rate credit cards, consider starting with your most expensive card and then moving to the next most costly card or loan you have.
After you pay off your bad debts, then you can consider tackling the 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 interest rate, you’re usually better off investing instead.
If you have a mortgage, don’t be in a rush to pay it off. Mortgages have meager interest rates and some amount of tax-deductible interest.
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 that first debt, take all the money you were throwing at it and put it towards your next debt. Rinse and repeat this process until you’re debt-free.
Not sure how much extra money you can put toward your debt each month? Keep reading.
4. Create a budget.
Creating a budget or a spending plan is always important, but it’s critical when you’re paying off debt. There’s no way to know how much money you have to put toward extra payments each month without one.
You can start by listing your income and expenses in a simple spreadsheet. Or, you can use a budgeting tool that automates the process. Try different budgeting methods until you find a system that works for you.
5. Look for ways to increase your cash flow.
Everyone wants to pay off their debt as quickly as possible. An excellent way to get out of debt faster is to increase your income, cut your expenses, or both. So, once you’ve established your budget or spending plan, look for ways to trim your expenses and free up more cash.
You might reduce spending on dining out, clothes, or subscription services. Also, shop around for cheaper car insurance, phone coverage, and internet service. Maybe you can start a side hustle to pay off debt.
Expecting a bonus or tax refund this year? Use your cash windfall to accelerate your debt payoff.
6. Consider a balance transfer offer.
If you have multiple credit cards or high-rate loans, using a balance transfer credit card may make sense. They typically charge 0% interest during a promotional period, such as 12 to 18 months. This strategy can drastically cut your interest expense. However, if you don’t pay off your balance by the end of the promotion, your interest rate could end up being higher than before you made the transfer.
7. Celebrate small wins!
Paying off debt is a marathon, not a sprint. Prevent fatigue and burnout by celebrating small wins along the way. For example, if you have a $5,000 debt to pay down, break it up into $500 mini-goals. Each time you pay off $500, treat yourself to something you enjoy, like a morning latte or a bottle of wine. That way, you can enjoy life along the way.
What questions do you have about paying off good vs bad debt? Please leave me a voicemail by calling 302-364-0308. And if you want to keep in touch, follow me on Instagram or sign up for my weekly newsletter at LauraDAdams.com.