When going into debt is good (and how to avoid too much)

Be mindful of how and why you borrow money to avoid racking up too much debt. (iStock)

Not all debt is created equal, and how and why you choose to borrow money is crucial to maintaining financial health.

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Financial experts often separate debt into two categories: good debt and bad debt. The difference between the two is that one group can help improve your financial health over time while the other can cause it to deteriorate.

Even if you focus only on good debt, it’s still important to avoid taking on too much. Here’s what you need to know.

What is good debt? 

Good debt is generally characterized as a type of loan that offers a relatively low-interest rate and can help improve your financial situation. Examples include:

  • Mortgage loans: Home loans have some of the lowest interest rates you can get, and they allow you to purchase an asset (a house) that appreciates in value over time. You can compare mortgage rates to maximize your savings via Credible's free online tools.
  • Student loans: Both federal and private student loans come with mostly single-digit interest rates. And if you need them to get through college, obtaining a degree can open up opportunities to earn more income. 
  • Auto loans: Auto loan interest rates can be high for some people, but they’re still low relative to other types of consumer debt. While cars typically depreciate in value over time, having a vehicle may be essential to your ability to work or attend school. 
  • Home equity loans and lines of credit: These loan options are typically low-interest because they’re secured by your home’s equity, and you may be able to use them to consolidate debt or make improvements to your home to increase its value.
  • Debt consolidation loans: Personal loans can be used for just about anything, but when you use them to consolidate debt from credit cards and other high-interest loans, they can save you money. Shop around to get the best rates using Credible now.

GOOD DEBT VS. BAD DEBT: WHAT'S THE DIFFERENCE?

While these types of debt can be helpful, it’s still a good idea to reduce how much you borrow.

For example, put down cash on mortgages and auto loans, and if your budget allows it, opt for shorter repayment terms. With student loans, work to find other ways to pay for college that don’t require repayment, such as scholarships, grants and a part-time job.

What is bad debt?

Bad debt typically comes in the form of high-interest loans that don’t improve your financial situation in the short or long term. Examples include:

  • Credit cards: Finding the right credit card can help you take advantage of special features like rewards programs, zero percent APR promotions and more. But if you’re not planning to pay your balance in full each month to avoid interest charges—many cards charge rates upwards of 20 percent—it may be best to avoid them and credit card debt.
  • Personal loans: Using a personal loan for something other than debt consolidation or emergency expenses is easy, but it may do more harm than good to your financial situation. It’s possible to get a personal loan with a single-digit interest rate, but many lenders charge more than 30 percent to people with less-than-stellar credit.
  • Short-term loans: These loans come in the form of payday loans, auto title loans and short-term personal loans. Not only do they have sky-high interest rates—often in the triple digits—but they also have short repayment terms, making it harder to afford repayment.

For some people, it can be challenging to avoid bad debt. But, if possible, make it a goal to eliminate this type of debt and avoid it in the future.

HOW DOES DEBT CONSOLIDATION AFFECT YOUR CREDIT SCORE?

How to best manage your debt

While not all debt is bad, that doesn’t mean you want a lot of it in your life. The best way to manage your debt is to build and maintain an excellent credit history. The higher your credit score, the lower your interest rates will be, regardless of how you borrow money. Lower interest rates and payments can help keep your debt out of collections.

Also, whenever you’re planning to borrow money, take time to shop around and compare rates and other terms before you make a decision.

HOW TO GET RID OF $5,000 OF CREDIT CARD DEBT

Finally, if you can, take steps to pay off your debt faster than your scheduled repayment terms. This strategy can save you money on interest charges and open up more cash flow for other important personal finance goals.