Not all debt is bad
Anytime you borrow money, you’re taking on debt, but that doesn’t mean it’s always a bad thing.
Debt can be good when you use the money to invest in your future or in an asset that you expect to increase in value. For example, student loans help you afford an education that broadens your job prospects and helps you earn higher wages throughout your career—so that can be good debt.
Buying an unnecessary new television with a credit card because you don’t have the cash is considered bad debt—you’re using money you don’t have for something you don’t need. Buying a new television isn’t inherently bad, but if you can’t pay the bill in full, using a high-interest-rate credit card may not be wise.
What to consider before taking on new debt
There are many things to consider, depending on your situation, but three important points float to the top:
- Only use debt you’re comfortable managing—If you spend the full amount you’re given, how much is the minimum payment? If you’re uncomfortable paying that amount, then it’s probably too much to handle.
- Know how the interest rate works—Read the fine print to understand if the rate can change over time and by how much. If it’s flexible, make sure you know the highest rate you could be charged and decide if you’re comfortable making a payment that large.
- Understand the impact to your credit score—The amount of debt, type of debt, and frequency of taking on new debt all factor into your credit score at varying levels. Another important factor is whether your payments are on time. Consider your existing debt, your ability to make monthly payments, and what new debt could mean for your score.
When do you pay down debt, and when do you save or invest?
You only have so much money to spread among your bills and financial goals, so how do you balance reducing your debt and saving for your future?
Why you’d focus on debt reduction
- To avoid paying excessive interest—Most debt comes at a cost—interest, as well as potential fees, such as late payment charges. If your interest rate is high, you can end up paying quite a bit over time if you don’t pay it off quickly.
- To invest sooner—Once you pay down your debt, you have the amount of those monthly payments available to invest in other areas, such as increasing your retirement savings.
- To create financial flexibility—If you have too much debt, you might not get approved for a loan when you need it. Banks look at how much debt you have compared to your income when they’re reviewing your loan application.
- To reduce your stress—Having debt can stress people out. If you’re one of these people, reducing your debt may be worth it to keep your blood pressure down.
Why you’d focus on saving or investing
- To save for emergencies—Without money set aside for an emergency, you may need to borrow from family or use credit cards if you have an unexpected medical emergency or lose your job.
- To get your company’s 401(k) match—If your company matches a percentage of your retirement savings, you’re missing out when you don’t contribute to your retirement plan.
- Outearn debt interest—If you can earn more money than the interest rate you pay on your debt, it may make financial sense to allocate your money that way.
- To help safeguard against inflation—When inflation is greater than zero, the value of your money declines over time. This means $100 today is worth more than $100 in 10 years. For your money to not lose its purchasing power—the amount of goods or services you can buy—the return on your investment needs to be greater than the rate of inflation.
Three strategies to help you manage your debt
Many people choose to reduce—or eliminate—their debt with one of these three common approaches:
Pay down the debt with the highest interest rates first
When you pay down your debt with the highest interest rate first, you’re minimizing the amount of interest you’ll pay over time. The downside is that you’ll still have to manage all your other accounts until you can start paying them down.
Pay down the smallest balances first
If you’re not as concerned about the interest cost but don’t like having many different accounts to manage, you may want to start by tackling the smallest balance. Once you eliminate that debt, you gain the satisfaction of “checking one off the list” and having fewer to worry about.
Consolidate your debt
By consolidating your debt, you can tackle both—you use debt with a lower interest rate to pay off your higher-interest debt, reducing the number of outstanding balances and leaving you with lower-interest ones. If you use a personal loan, for example, with an interest rate of 5% and have three credit cards with interest rates of around 20%, consider using the personal loan to pay off the credit cards in full.
Reduce your stress with your debt under control
How people manage their debt can vary drastically. You may know people who are adamant about paying off their credit cards in full each month and others who have a dozen credit cards in their wallets. Let them do what they do—but you should only take on debt you know you can pay off. Understand the interest rate you’re charged and whether it can change over time. Know when to spend within your means and when new debt will benefit your long-term finances (i.e., good debt). And if you’re constantly stressed because of the debt you have, it may be time to look in the mirror and reevaluate your financial priorities to lessen that burden.
The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.
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