Good Debt vs Bad Debt
You may be surprised to find that not all debt is the same. Whether debt is a good or bad thing can depend on the circumstances surrounding it. The type of debt also affects your credit score in different ways.
Basically, good debt is something that gives you access to an asset that should become more valuable over time. A mortgage is the prime example. Although it is usually a person’s largest chunk of debt, it falls into the good debt category because it gives that person control over a very large asset-their home. A home’s value usually rises over time, and could eventually make that person more money than their original mortgage loan. This is also one of the reasons that people like to invest in real estate. The difference between what a person pays for a house and what they rent it out for each month or what they eventually sell it for can be significant over time. Many people have made their fortunes in real estate by taking advantage of this. Of course, it isn’t a sure bet. Nothing really ever is when it comes to investing. Anyone who paid attention during the 2008-2009 mortgage crash knows this. If you buy a house that is over priced or values in the area drop significantly and it becomes worth less than you owe, you can become “upside down” in your mortgage. That debt would then become negative, at least until the market changed again. Luckily, it usually does if you wait long enough.
Examples of bad debt are debts that show a pattern of spending more than you make, or buying things that do not grow in value. Car payment debt is bad debt. A new car loses significant value immediately after being bought, and used cars continue to lose value over time in most cases. While it may be a necessary debt given the cost of cars these days, it is not considered a positive debt. Paying it off as quickly as possible should be a priority.
Credit card debt that is not paid off every month is also bad debt. If you don’t pay credit cards off every month, they accrue interest. That interest accrues more interest the next month and so on, until people can get quite overwhelmed with credit card debt. Many people fall victim to the ease of credit card use and do not pay attention to the balance as it rises each month. It is very easy to lose track of spending and find yourself in a situation where it is extremely difficult to pay off your balance. Always pay close attention to your credit card balance, and do your best to pay it off every month.
Mixed Good and Bad Type Debt
If credit cards are paid off every month, they can be considered positive debt, as this shows a pattern of strong financial management. This helps build your credit if you have a high limit and very low or no balance at the end of each month. This is called rolling credit. A couple accounts of rolling credit in good standing are major players in building a person’s credit score.
Student loans are an example of a mixed type of debt. While you are paying on them, if you do so every month and pay as agreed, they help to build your credit. However, their often substantial size counts against you, as it affects your debt to income ratio, which is important for your credit score.
If you default on your student loans, it will have a massive impact on your credit score. Take great pains to make sure this never happens. Always contact your loan holder if you anticipate having difficulty paying your payments on time. They may have options to help decrease or defer payments. Once your student loans are paid off, however, they help your credit because they show that you have met a significant financial obligation over a long period, assuming you did not have any late payments or defaults. Consolidating student loans can often help people lower their payments and simplify how they pay their loans, thus enabling them to benefit eventually from paying the loans off. If your payments are high each month due to several loans or you are having trouble keeping track of them all, consolidation may be a good option for you. It may even have a lower interest rate, which can save you a significant amount of money over time.
Debt To Income Ratio
Someone who owes a ton of money each month or overall, but does not make a lot of money has a high debt to income ratio. Banks and credit bureaus do not like this at all. It looks like you can barely make your payments on paper. Banks and other credit companies will be less likely to offer you loans, and more likely to give you steeper interest rates if they do offer you credit. You want to do whatever you can to not take out loans that you do not need, including credit card debt (which is a rolling loan). Paying on time and keeping loan balances low helps your credit.
Take Aways
Some types of debt are worse than others when it comes to their effect on your credit score. A mortgage, while a large debt, will not be looked at as negatively as a credit card balance. Student loans with high monthly payments hurt your debt to income ratio, but paying them off helps your credit score in the end. Car payments are always bad debt and should be paid off as quickly as one can manage.
Always pay your debts on time, every time. If you are having a hardship, contact the company, as they almost all have programs to help under these circumstances. Contacting them before you miss a payment can save your credit. Not doing so can hurt you for years to come.