Dear Lifehacker,
Every month my paycheck gets sliced up to pay down different kinds of debt—student loans, a car loan, and a credit card balance that's almost paid off. These loans are weighing on me like a bad conscience. But I know I'm not the only one in this situation. Is my debt really that bad?
Signed,
Saddled by Debt
Dear Saddled,
You're definitely not alone—both in being in debt and thinking of debt as a harsh four-letter word. It's almost impossible not to have some kind of debt, because few of us can afford to finance a college education or pay for a house with cash. So sometimes it does makes financial sense to borrow. The problem is, it's also all too easy to fall into the bad debt trap and never get up. Two things you should find out to evaluate your debt: Can you really afford the debt you've taken on? and Is the kind of debt you're paying for worth it?
Let's take a quick look at how much debt you're carrying and what separates good debt from bad so you can sleep better at night.
Get a Quick Debt Evaluation
One way to quickly find out whether your debt should be raising red flags or not is to view it like a lender would, by checking your credit score, a number assigned to you by credit bureaus that determines your "creditworthiness." Even though credit scores aren't everything, they come in useful here because when you get your score, there's a detailed explanation of the parts that make up the score and how your particular debt history affected the score. Whether you pay the official FICO score that lenders use or just get the free non-official one that's just an estimate from CreditKarma, those detailed explanations provide valuable insights into how you're using your debt, for better or worse.
For example, the report will tell you if your balances are too high (or risky, that is) compared to your total credit limit and whether you have a history of late payments. Those would be signs that debt management is an issue, obviously, and it might be time to freeze credit cards or take other drastic measures, as well as more mundane and necessary things like setting up automatic debt payments.
CreditKarma has a very useful and telling section on its free report: debt-to-income ratio. Before lenders hand out loans like mortgages, they check the debt-to-income ratio, which is supposed to measure whether you can afford all the debt you've taken on. The general rule of thumb is that your total debt payments (including mortgages or rent, car loans, and credit payments) be no more than 36% of your gross annual salary. If your debt-to-income ratio is too high, you should work on reducing your debt commitments.
For a guideline on what your debt-to-income ratio should be, US News and World Report offerss:
36% or less: This is a healthy debt load to carry for most people.
37%-42%: Not bad, but start paring debt now before you get in real trouble.
43%-49%: Financial difficulties are probably imminent unless you take immediate action.
50% or more: Get professional help to aggressively reduce debt.
If you don't want to pull your credit score, you can calculate the ratio yourself using US News and World Report's debt-to-income ratio calculator.
Separate The Good Debt vs. Bad Debt
Now that you know whether your debt is affordable and manageable, it's time to look at the kinds of debt you have. All debts are evil, but some are necessary evils for many of us.
The main thing that separates good debt from bad debt is what it's used for, so here's what you should ask: Is this thing I'm borrowing money for an asset (something that's going to increase in value or produce income) or a liability? If it's an asset, it's good debt. Otherwise, it's the draining kind of bad debt.
Good Debt = Mortgages and Student Loans (Usually)
Good debts can include home mortgages and student loans—depending on the case. We've all heard horror stories of people underwater on their mortgages, and it seems student loans are the new debt crisis, so it's important to carefully weigh what's an affordable (see debt-to-income ratio above) and reasonable investment.
The one year salary rule, for example, can tell you whether or not a graduate degree is worth it, and some college degrees may earn more than others and therefore better justification for all that debt. (And, yes, college is probably worth the considerable cost even considering the many student loan payments.)
A nice thing about mortgage and student loans is there are often special programs people can take advantage of, such as first-time homebuyer loans, forgiveness of federal student loans for public service and other repayment plans. Interest is also tax-deductible.
Bad Debt = Frivolous Debt and Debt That Makes You a Slave
Bad debt? No benefits, really. You end up paying for things you don't really need or can't afford—like last-minute trips to Vegas—many times over. Credit card charges that you don't pay off monthly falls into this category, thanks to the high interest. (You mention a small credit card balance, so the sooner that card gets paid off the better, assuming it's the highest-interest debt.)
The ninth circle of debt hell is reserved for personal loan offers you get in the mail, payday loans, and IRS debt. (The IRS can pull money out of your bank account, garnish wages without a court order, sell your own property, and send you to jail. Don't mess with the IRS.)
In-Between Debt = Car Loans and Business Debt
A car loan isn't really awful, because a car is big expense and perhaps a necessity for you. Put a down payment on the car to reduce the financing costs and save by using car shopping smarts.
Business debt, likewise, that you might take out to pursue an entrepreneurial passion could go either way. It's risky. It could be genius or a mistake. (I'd say treat this as bad debt and tread with caution until you have your idea firmly planted.)
Being in debt is a necessary evil for most of us—a financial thing but also emotional and psychological. As long as you stay clear of the worst kinds for debt, pay down the bad debt first, and manage your reasonable good debt well, you should be fine.
Love,
Lifehacker
P.S. What are your thoughts on good debt, bad debt, and the psychological weight of being in debt?
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