The good, the bad and the ugly of debt

The economy is strong and so is our debt. When times are good, Americans typically start piling on more debt.

We take on all kinds of debt – credit cards, personal loans, auto loans, mortgages. By June of 2018, the New York Federal Reserve reported that total household debt hit $13.3 trillion, $618 billion higher than the peak in 2008 when the Great Recession was taking hold. 

Housing debt represents the biggest chunk of the debt. It’s about 2.5 times all other debt combined. Student loans lead non-housing debt, followed by auto loans. 

Keith Newcomb, founder of Full Life Financial in Nashville, Tennessee, said low interest rates on debt, particularly mortgages, has been attractive to a lot of people because of the good economy. But trouble occurs with debt that has a variable rate and moves up as interest rates increase. “That can squeeze people,” he said. 

Creating a budget helps ensure you don’t go into too much debt and helps you pay down debt if you’ve taken so much that you’re living paycheck to paycheck. 

There’s good debt, and there’s bad debt. Typically, mortgages and student loans are considered good debt. Both are investments in the hope of financial gain down the road. Student loans, while considered good debt, can be burdensome and it’s a debt you have to pay. 

The student graduating today leaves college with an average debt of more than $37,000. There are a lot of students coming out of college with three times that number. Terms run from 10 years to 20-25 years. The average monthly payment is $351.

There are loans in which the monthly payment is based on discretionary income, which can help. But the fact is, you’ll be paying for a long time. 

Newcomb said graduates coming out of college should consider paying down that debt as quickly as possible, delaying building up lifestyle expenses, such as buying a house, until it’s absolutely necessary. 

And that may mean avoiding the bad debt. Auto loans and credit cards are considered bad debt. Credit cards, in particular, can be a big budget killer. The debt becomes easy to run up and in the end, costs a lot more than if you had paid cash for whatever you bought. Consumers are projected to pay more than $100 billion in interest and fees this year, especially as that debt continues to rise.  

Credit card debt typically is the first area of your debt to deal with if you’re looking to lower your debt. Doing so helps you with obtaining the mortgage you want. It helps lower your debt utilization. 

Financial guru Dave Ramsey and a host of other experts tout the “snowball effect.” Choose the card with the lowest balance and pay that off first while making the minimum payment on the others. Then go to the next lowest balance and pay that off. You work from the smallest to the largest. 

Another method is called the “avalanche method” in which you tackle the credit cards with the highest interest rate. Then there’s the “blizzard method” that involves paying off the lowest balance first and paying off those with the highest interest rates. 

One trick to lowering the interest you pay is transferring a balance or balances to a card that has a no-interest introductory rate for a period of time. This way, you can pay off the principal quicker.

Auto loans are considered bad debt because you’re borrowing money for a depreciating asset. Many cars begin losing value as soon as you drive them off the dealer’s lot. Over five years, the value of your new car could drop by as much as 60 percent. 

That’s why a lot of financial gurus suggest buying a used car with cash. That requires saving money for the purchase. If getting a new used car is a goal and not an immediate need, you could set up a separate bank account expressly for that purpose. Budget experts are fond of this method for managing expenses.

Personal loans are another area of credit. Since they are unsecured loans, the interest rates tend to be higher than, say, a mortgage or car loan. But they may not be as high as the credit cards you already have. The better your credit score, typically the better the rates. 

Consolidating your credit card debt into a lower interest personal loan works if you have a plan for paying off the loan and can afford the payment. The key is not using the credit cards again that you’ve just zeroed the balances. That means showing strong spending discipline. If you start charging up the credit card, you’re doubling the trouble. 

A personal loan is a good way of handling medical debt. But there are other options to handle that debt before resorting to a personal loan. You could negotiate costs with the medical provider or see if the provider has a payment plan. Then, if the personal loan becomes the best option, go for it. 

Good or bad debt needs to be managed within a budget. You can go the hardcore route with a budget and itemize every bit of spending to ensure you have everything in check. Or, you could take a more laid-back approach if the word budget gives you the heebie-jeebies and use the 50/30/20 method of managing your personal finances. 

With that method, 50 percent of your income is applied to your needs, which includes debt. Your wants are covered by 30 percent of your income and the remaining 20 percent goes toward savings. No matter which route you choose in managing expenses, the goal should be to keep debt at manageable levels.