How to be smart about debt

The aggregate level of US household debt has never been higher.¹ Many Americans have loans and many college students graduate owing tens of thousands of dollars in student debt.

While you may count yourself among the lucky if you’re debt-free, you may not want to stay that way forever. As difficult as it can be to struggle with more debt than you can afford, an aversion to taking on any debt can be challenging as well. Used prudently, some debt can be a smart financial tool. Here are three things to consider.

The key is to take on only as much debt as you can easily afford to repay. Know how much disposable income you have each month (after accounting for all regular bills and necessities) and make sure not to sign on for debt payments greater than that amount. You should always keep about three months of expenses in an emergency fund, in case your job situation takes a turn for the worse, a friend or family member needs your assistance, or you incur an unexpected expense.

Another key: Differentiate between good debt and bad debt. Obviously, bad debt is high in interest and used to buy something you don’t really need that is unlikely to retain its value. Expensive gadgets or clothes are likely culprits.

Good debt carries low interest that may even be tax-deductible. It’s used for something that is likely to appreciate in value or can help you improve your financial position. Taking out debt to buy a house, go back to school, or purchase a car you need to get to work may all fit the bill.

Here’s a checklist for determining if it’s okay to take on debt for a purchase (education included):

• You are buying something that is likely to climb in value or improve your earning ability.
  
• You can handle the monthly debt payments easily.
  
• You have an emergency fund in place.
  
• You are already saving regularly for retirement.
  
• You aren’t overpaying for the item you’re buying.

A credit card is a convenient way to make purchases, but it is a terrible way to borrow. If you use a credit card, plan to pay off the balance each month to avoid high interest rates on the unpaid balance.

Along with the convenience and potential perks, using a credit card wisely can help you build a credit history and establish a high credit score. That may help you qualify for a lower rate loan when you’re ready for a major purchase.

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. When trying to get your arms around your debt load, understand the type of debt you’re facing. Then, consider paying off high interest debt first and make a plan for low interest debt.

The source of this article, Four Keys to a Smart Approach to Debt, was originally published on May 20, 2020. The video is inspired by Morgan Stanley’s series The Playbook: Your Guide to Life and Money. Learn more about the Playbook and other resources available to help you navigate various life milestones.

1. Federal Reserve Bank of New York, Center for Microeconomic Data, Q3 2021