When the average person hears the word ‘debt’, they tend to associate it with things like bankruptcy, bills, and collections agencies. While it’s certainly better to be in the black than in the red, not all debt is inherently negative.
Here’s what you need to know about good debt vs bad debt.
Why should everyone have at least some kind of debt?
You need to have some kind of debt in order to build a credit score. Why do you need a credit score? Because it’s the only way to show potential lenders that you’re a responsible borrower. Even if you plan to pay for everything with cash and debit, there are going to be times when you need a loan.
Trying to buy a car or a home without an auto loan or a mortgage is almost impossible for the average person. And good luck renting an apartment if the landlord or property manager asks to see a copy of your credit history to confirm you’ll be able to make your payments on time.
What is Good Debt?
As we’ve established, not all debt is bad debt. While all debt can theoretically help you build your credit score, there are certain kinds of debt you should avoid and other kinds of debt that can strengthen your credit file.
- Payment history (35%)
- Credit Utilization (30%)
- Age of Credit (15%)
- Mix of Credit (10%)
- Credit Inquiries (10%)
The category that’s most relevant for this blog is the fourth one: mix of credit.
There are two main categories of credit – Installment loans (things like mortgages, auto loans, lines of credit, and student loans) and Revolving Credit (credit cards).
With an installment loan, you take out a pre-agreed upon sum of money and then you pay it back in instalments each month until the debt is paid off (with interest added, of course.)
With revolving credit, you can use as much or as little as you’d like during a billing cycle and your statement at the end of the month will reflect the total. If you pay it back during the interest free grace period, then there are no added interest charges and the billing cycle resets itself. If you can only pay back some or part of the total, then you’re still able to use your card but the amount of money you’re eligible to borrow is reduced until you’ve paid off your previous debt in full.
Having too many or too few installment loans/credit cards can negatively affect your credit score; credit bureaus want to see that you’re able to responsibly manage and handle a variety of different types of debt and that you don’t rely on just one type.
What is Bad Debt?
Loosely speaking, bad debt is any debt you’ve accrued (or are considering accruing) with repayment terms or conditions that you won’t reasonably be able to manage or pay off. Bad debt is debt that will harm your credit score without any positive benefits to offset taking out the loan.
Some common examples of bad debt are payday loans, cash advances, and any other kind of loan or revolving credit with an exorbitantly high interest rate.
If you already have bad debt, then your primary focus should be mitigating the damage. If you rely on payday loans because of a low credit score, try applying for a secured credit card. It will help you build your credit score with a reputable lender so you can borrow money directly from the bank in future.
Debt may be a part of life, but it doesn’t have to control your life. Contact us today if you need additional guidance to figure out how to get on top of your financial situation.