Is there such a thing as good debt or bad debt? We’ve all been told that borrowing money helps build credit, but is this true for all debts?
It’s true that not all debts are created equally. Some debts can help you long-term if you use them properly. Other debts can lower your net worth and hurt your credit score.
Here’s what you should know about good debt and bad debt.
Debt explained
Simply put, debt is money that is owed. When you borrow money from a person or bank, you are taking on debt. As you can imagine, most people and institutions aren’t willing to lend out money to just anybody. They want to be sure their money is going to a good cause, and that they’re going to be repaid.
Lenders will want to know your loan repaying history and your relationships with other lenders. Do you make payments on time? Or do you have a tendency to borrow more than you can afford? Have other lenders had a problem trying to retrieve their money from you? This information is exactly what your credit report and credit score will show.
Borrowing money isn’t free. Lenders not only want a guarantee that you’ll pay them back, but they also want a bonus for taking the risk and lending you money in the first place. The cost of borrowing money is known as the interest rate. Almost every single type of debt comes with an interest rate.
What is good debt?
The difference between good debt and bad debt lies how the borrowed money is being spent. If you’re using borrowed money to finance something that will become an asset or you are keeping your debt to income ratio below 30% debt can actually help build credit and increase creditworthiness.
Here are some examples of good debt.
Real estate
Buying real estate, or taking out a mortgage, is a common form of good debt. In general, home and property value is expected to increase over time you own the property.
Ideally, when you sell your home you should be able to pay off what you owe on your mortgage and make some profit from the sale. Obtaining a mortgage loan requires a significant amount of financial backing in order to close the loan, because of this, mortgage loans are considered safe and have a positive impact on credit and credit mix.
Education
Education has become increasingly expensive in the United States. Many young people are struggling to pay back student loans. Nevertheless, education is still considered a good debt. By investing in your education, you’ll gain the skills and knowledge required to land a well paying job. Just make sure to do your research on the job opportunities in a given field before deciding your major.
Vehicle loan
Taking a loan to pay off a vehicle can actually boost credit after a few months, provide transportation and can be a sellable aseet once you are finished making your payments. When you are starting your vehicle search keep these financial factors in mind like resale value, insurance prices, maintenance costs and monthly loan costs.
When you are ready to make an auto purchase, be sure to check out car affordability calculators to see where you are at in your plan. Having an installment loan like an auto loan will also add credit mix to your credit profile and within a few months of making on time payments, you’ll likely see incremental score increases each month.
Keep in mind that when car shopping, dealerships will need to do a hard credit pull in order to extend you a loan. This will be a small decrease to your credit score but making payments over time will likely boost your credit.
Credit cards with low balances
Credit cards can get a bad reputation because it can make it easier to go into debt when spending unearned money. But on the contrary having a line of credit open and paid off frequently, credit cards can have a high impact on credit worthiness.
When opening your first credit card only make purchases that you know you can pay off each month. This will show the credit agencies you have a history of making on time payments and are able to pay back debt. As you become more comfortable with making credit card payments, you can add in larger purchases that would benefit you if you could pay them off over a longer period of time. Just be sure to never go over 30% of your credit limit.
For example, if your credit limit is $1,000, you should never have more than a $300 revolving balance on your credit card each month.
What is bad debt?
Debt is considered “bad” when loans are being mismanaged, late payments are reported or lines of credit are overextended. Management of bills and debt are the key component of when good debt can go bad.
Maxed out credit cards
Credit card management can be tricky. While having a credit card can give you access to funds you don’t have in a pinch, overusing that privilege can put you in a debt cycle that is hard to get out of. If credit agencies consistently see your lines of credit in the 90% or higher range your credit score can actually decrease and lines of credit will become harder to obtain.
Keep your credit utilization around 30% to avoid credit card debt becoming bad debt.
High-interest loans
High-interest loans, especially payday loans, charge up to triple-digit interest rates. While short term or payday loans might not pull your credit when applying, missing payments or rolling over a loan can get reported to credit agencies.
Overdue bills
Bills like past utilities, medical or even parking tickets can be sent to collections and show up on your credit report. Oftentimes, these bills have simply gone missed and can be found on your credit report including how to get in contact with the creditor. Be sure to call and settle these debts as soon as possible. You might even be able to create a payment plan or settle for a lowered rate.
Should I avoid debt altogether?
No! Good debt has its advantages. Plus, it’s not possible to take on good debt if you don’t have a credit report. And you need debt to build up credit. As long as your debt is going to a good cause and you’re able to make your payments on time – you’re doing just fine.
Establishing good debt with bad credit
How can you build up your credit score to take on good debt? MoneyLion’s Credit Builder Loan can help!
This is an affordable, safe option for people with poor credit and young adults just starting their financial lives. There is no hard credit pull and you could qualify for up to $1,000 at a low-cost. MoneyLion offers manageable payments, credit tracking tools, and will report your payments to top credit bureaus.
Take charge of your debts
If you’re struggling to pay off debt, trying to tackle payments with a low-income, or need help with your credit score – MoneyLion has resources. The MoneyLion mobile app can help you keep track of your spending and provide access to smart banking tools.
Need last-minute cash? MoneyLion’s Instacash is a 0% APR cash advance that gives you edge when it comes to managing unexpected expenses.
