When you first start learning about personal finance and how to deal with debt, you hear a lot of arguments about “good debt” and “bad debt.” As someone who might be drowning in bills, it can certainly feel like all debt is bad debt (and there are some financial gurus who agree with you). The reality is, though, that there truly are some debts that are good for you and that can only be afforded once you’ve cleared up all of your bad debt.
What is Good Debt? Why Should You Want It?
Good debt is an investment that you pay over time and that helps you build equity. A mortgage, for example, is considered a good debt. This is because as you pay off your mortgage, you own more of your house. As real estate tends to appreciate in value over time, this provides you with a good investment on which to fall back upon later. It also makes you seem more trustworthy to other lenders, etc.
For example, let’s say you want to buy a boat. You do your research and use a boat finance calculator to figure out how much financing you are going to need to buy that boat. If you have done the work and paid off all or even most of your bad debt and your credit report shows that you’ve been working to prove that you can use credit responsibly, you’ll have a much easier time getting your dream boat financed.
Bad Debt: Most of Us Have It
Bad debt is the debt most of us carry. Credit cards, store charge cards, personal loans, even student loans are considered bad debt. If you manage these debts responsibly and pay them off in a good amount of time, your credit should be in really good shape and you should be able to accrue good debts relatively easily.
Unfortunately, in today’s world, where wages often don’t cover even the most basic costs of living, most of us aren’t able to use credit responsibly. We use it to stay alive and keep ourselves fed and sheltered. We live right at our near our credit limits, which looks terrible on a credit report and can make getting our financial houses in order incredibly difficult.
How to Tackle Bad Debt
The first thing you should focus on in terms of your bad debt is paying down your credit accounts and loans so that your debt to income ratio improves. Be as aggressive as you can with this.
Here’s a tip: instead of paying down your biggest debts first, use the snowball method of debt payment: concentrate on paying off small debts to help you build momentum so that you’re more likely to stick to your plan as those larger debts take longer to resolve.
There are several methods of aggressive debt-tackling. The most aggressive is to sell as much of your stuff as possible and move in with friends or family until your debts are paid off. If this is an option for you and your family, great! Go for it! If it isn’t, a slightly less aggressive method is to downsize as much as possible: sell your car and take public transportation or rideshares. Move into a smaller home.
Once you’ve gotten yourself to a respectable debt to income ratio, it’s time to start working on building up some savings. Yes, savings are just as important as paying down debts. Savings aren’t just what help you retire. Your savings is also what keeps you from being one emergency away from landing right back where you started, debt-wise.
There are a lot of different approaches to building up your savings account. You can use the slowly graduated transfer method. My favorite method is to combine the graduated transfer method and pair it with this: as you pay off a debt, instead of simply allocating 100% of that monthly payment across your remaining debts, take 50% of what you’d been paying every month and tuck it away in savings. This helps your savings grow while simultaneously increasing your ability to pay off your bad debts quickly.
Not Falling Back In the Trap
It can be tempting as you pay off bad debts to go out and splurge using your recently freed up credit. Resist this urge! All this does is start you back on the slippery slope toward overwhelming debt! Instead, implement this new rule: you are only allowed to make purchases you are sure you can pay off within two months. In addition to keeping you from falling back into the debt hole, it helps you build a good payment history on your credit report.
Understanding the difference between both good debt and bad debt as well as how to approach ridding yourself of both is important. Hopefully, the information we’ve shared here will help you make smart financial decisions.