How to be smart about debt

As of 2024, the total American household debt has risen to a whopping $17 trillion.¹ With mortgage and auto loan balances climbing,¹ the weight of student loans, and the overall rise of the cost of living, debt has become a bigger drag on the finances of many Americans.

But debt isn’t always a bad thing. When used wisely, some debt can help you reach your financial goals. The trick is taking on the right kind of debt—and in amounts that you can manage.

Here’s what to consider:

The first key to taking on debt is having a plan for paying it back —before you take out the loan. To do this, you will need to know how much you are earning and spending each month.

Ideally, your current expenses should be less than your income. Determine the payments on a new loan—whether for a car or a college education—will not push your monthly expenses higher than your take home pay. In the case of student loans, it’s important to think about making sure that your budget after graduation can incorporate your loans.

Another key is to differentiate between good debt and bad debt. Generally, “bad debt” or “inefficient debt” is high-interest debt that goes toward nonessential purchases. The classic example here is credit card debt when used to pay for things like impulse shopping, unused memberships and subscriptions, or expensive gadgets that lose value over time.

Good debt, on the other hand, may help you move closer to your goals because it typically has a lower, (often fixed), interest rate and may even be tax-deductible.

You use good debt for purchases that are likely to appreciate or can generate income that will help you improve your financial position. For example, using a mortgage to purchase a home that can build equity, or taking out a loan to start a business. Even a modest student loan for college and postgraduate studies is considered good debt as degree holders tend to earn more and may benefit from economic mobility.

It is important to understand your own risk tolerance when it comes to debt. Even if you have “good debt”, if it’s causing you stress, it might be worth paying it down simply for your own peace of mind. The amount of debt you are comfortable with may also change, depending on where you are in your life. You may be more inclined to carry a large student loan balance early in your career, while some people prefer to eliminate even their mortgage as they enter retirement.

Credit cards are a convenient way to make purchases but can be an expensive and inefficient way to borrow money because of high interest rates and fees. Paying the minimum due on a large balance could sometimes only cover the interest charges. This is why credit card balances typically fall into the "bad debt" category. Over time, carrying a high credit card balance could hurt your credit score, and tie up your cash flow, making it harder for you to reach other financial goals.

If you’re struggling to get your credit card balances under control, take it a day at a time. Itemize all your balances on each card with their accompanying rates. Then, put together a payment strategy that works best for you.

Nevertheless, when used responsibly, a credit card can be instrumental in building your credit and establishing a high credit score. If you use a credit card, plan to utilize no more than 30% of your limit and pay off the balance each month to avoid high interest charges on the outstanding amount.

You do not have to be entirely debt-free to start building wealth. Remember, 'good’ debt can be a wealth-building tool over the long-term.

Once you’re on track and paying down your balances, you can direct additional funds towards these wealth-building steps:

• Emergency Fund: The first step to building wealth is making sure that you have an emergency fund. Consider splitting your excess cash each month between debt payments (ideally more than the minimum) and saving in an emergency fund. You’ll ultimately want to have three to six months’ worth of expenses saved in a liquid account. That will keep you from turning to debt in the future for unexpected expenses like car repairs or a cell phone replacement.
• Retirement Account: After you’ve built an emergency fund, even if you’re still paying off your “bad debt,” you’ll want to make sure a habit of saving for retirement. At a minimum, that means putting enough money into your work-based retirement account to get any available employer match. When you’ve paid off your high-interest loans, you can start boosting the amount you're saving.
• Investing: Once you’re making the most of available tax-advantaged accounts, you may consider opening an additional brokerage account to grow your money further. These investments can help you progress toward more wealth building goals.

Bottom line: Not all debt is the same. Different types of debt can have different effects on your credit score, bank account, and financial future.  

Article Footnotes

1. Federal Reserve Bank of New York, Center for Microeconomic Data, Q1 2024

The source of this article, Four Keys to a Smart Approach to Debt, was originally published on May 20, 2020.

CRC# 3782614 10/2024