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Good Debt vs. Bad Debt: 5 Ways to Tell the Difference

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young_woman_paperworkThere's good news and bad news about debt.

The bad news is that the total amount owed by Americans continues to grow. The levels of debt outstanding for credit cards as well as for both mortgage and non-mortgage loans are at all-time highs.

The good news is that Americans are at least using debt more intelligently than in the past. The ratio of revolving debt to non-revolving debt is lower than it has been generally over the past 30 years. For reasons that will be explained below, that represents a smarter use of debt.

After all, debt is neither inherently good nor bad. It's really a question of how you use it. The distinction between revolving and non-revolving debt is just one example of how there can be good debt or bad debt. Which do you think you have?

Revolving debt vs. non-revolving debt

Let's start with an explanation of the distinction between revolving and non-revolving debt. Revolving debt is essentially credit card debt, while non-revolving debt is a loan structured to be paid down on a regular schedule. Below are three reasons why non-revolving debt (loans) is generally better than revolving debt (credit cards). Non-revolving debt is:

  1. Cheaper. Loans typically carry lower interest rates than credit card debt.
  2. More predictable. Loans usually have a schedule of fixed payments, so you know when the debt will be paid off. Credit can be stretched out indefinitely, which may cost the user more in the long run.
  3. Less impulsive. While credit cards are certainly convenient, they represent a constant temptation to go deeper into debt.

Here's where the good news comes in. According to Federal Reserve figures, last year, revolving debt dropped below 36 percent of the level of non-revolving debt for the first time since the 1980s. In fact, over the past 30 years revolving debt outstanding has been an average of 52.78 percent as high non-revolving debt, but by late last year this number had dropped to 35.48 percent.

So, while Americans are accruing a lot of debt, they are at least making smarter choices about what kind of debt to take on. This issue of loan vs. credit card debt is just one example of the distinction between good and bad debt.

How to tell the difference between good debt and bad debt:

Here are some things that indicate whether you have good debt or bad debt:

  1. Are there cheaper alternatives? As described above, credit card debt is generally more expensive than loan debt, and for any kind of debt, there are generally cheaper interest rates to be found for those who shop around.
  2. How do the payments fit into your household budget? Debt is easy to take on, but you shouldn't commit to it until you figure out how the payments fit into your household budget. Ideally, that budget should include room for long-term needs like saving for retirement.
  3. Is your debt balance growing or shrinking? Carrying a permanent balance on your credit cards is an expensive habit. Any budget that depends on repeated borrowing needs to be re-examined.
  4. Are you offsetting debt with assets or other benefits? Borrowing for something with lasting value like a car or a house at least gives you an asset to offset your debt balance. Borrowing for short-term experiences like a vacation just leaves you with the debt.
  5. Is your debt improving or damaging your credit score? Judicious use of debt helps to establish a responsible repayment history and thus can help your credit score. Over-use of debt or erratic repayment can have the opposite effect. Check your credit score regularly to see what your debt is doing to it.

The three "P"s of smart debt usage

There may be other examples that distinguish good debt from bad debt, depending on your situation. However, following these three letter "P" rules can help you to accrue debt more responsibly:

  1. Plan. Don't take on any debt without a plan for how payments on that debt will affect your household budget. Try to maintain a budget worksheet listing your expenses so you can see how debt payments might crowd out some of your normal expenditures.
  2. Prioritize. Direct any extra money for debt repayment towards your highest-interest rate debt first, and if you have to take on new debt, look for the most cost-effective way of doing so.
  3. Pay down. You should not treat debt as a permanent condition. If you are always saddled with debt payments it could interfere with future goals, like saving for retirement. Always have a finite time frame in mind to pay off debt.

Generally, the best debt is no debt, but if you have to borrow, try to take on the good kind of debt rather than the bad.


More resources on debt:

Is There Such a Thing as Good Debt?

9 Questions to Ask Before Taking on Debt

How Should I Prioritize My Debt?

How Do You Overcome Debt?

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