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The word "debt" causes some to quake in their boots, but depending on your financial goals, there's debt that works for you and debt that works against you—good and bad debt.
Businesses consider bad debt as debt they'll never be able to collect from a customer. But for consumers, it's types of debt you'd do best to avoid. Bad debt is used to buy things that don't add to your net worth, depreciate in value or have no lasting value to begin with. Types of bad debt include high interest loans, car title loans and debt you're consistently late on.
Good debt, on the other hand, increases your net worth, has lasting value or will appreciate in value. Common types of good debt include mortgage loans and loans used to make investments that will earn a higher rate of return than the interest on the debt.
Keep reading to learn more about bad debt, how bad debt can affect your credit score and how you can manage it.
What Is Considered Bad Debt?
Distinguishing bad debt from good debt isn't always so black and white. In general, bad debt is any type of debt that doesn't increase your net worth. But even good debt can go bad if you can't pay it off or if the payments start eating up too much of your income. (Find out how much your debt-to-income ratio should be.)
Your financial habits also affect whether debt is good, bad or neither. If you can put all your household spending on a credit card, earn lots of rewards for that spending and pay the balance off in full every month, that debt will have a positive effect on your credit and overall finances. If you spend beyond your means, pay just the minimum each month and rack up interest costs, your debt is doing more harm than good.
That said, some types of debt are bad news from the get-go. This debt may carry very high interest rates or have unrealistic payment schedules. These include:
- Payday loans: When you're in a cash crunch, these emergency loans can offer a way to tide you over until payday. But they have extremely high interest rates and fees, and you typically have to pay back the loan in full on your next payday. If you can't do that, interest on the loan keeps accruing. A payday loan quickly can lead to a vicious circle where you owe your paycheck to the payday lender before you even get paid.
- Car title loans: Title lenders use your paid-off car as collateral. You'll get cash fast, but you'll have to sign over your car title to the lender and you won't get it back until the loan is paid in full. Because title loans charge high fees and interest rates, you can easily find yourself getting deeper and deeper in debt and never be able to get your car back. Find out more about title loans.
How Bad Debt Affects Your Credit
Aside from wreaking havoc with your budget, bad debt can hurt your credit score in a couple of ways. First, it may increase your credit utilization rate, which is how much of your available revolving credit you're using relative to your total credit limits. You should keep your credit utilization rate under 30%, or in single digits for the best scores. If you have a lot of bad debt, you're probably using more than 30% of your available credit, which can hurt your credit score.
Bad debt also can affect your credit score if the debt becomes seriously past due. If your grace period is over and you still haven't made a payment, the debt is considered delinquent and the creditor might send it to collections. They'll either turn it over to an internal collections department or sell it to a collections agency to try to collect payment from you. Since paying your bills even a few days late can hurt your credit score, you can imagine how much damage having a debt go to collections can do. Debt in collections leaves a lasting impact: It can stay on your credit report for as much as seven years from the date the debt first became delinquent.
How to Deal With Bad Debt
Now that you know all the problems bad debt can cause, what can you do if you've already got bad debt? Depending on your situation, one of these two approaches may work for you.
- Consolidate your debt. If you have high interest debt or have so many different debt payments that it's hard to keep track of them all, debt consolidation might be for you. Combining different debt accounts into one monthly payment at a lower interest rate can make it easier to repay your debts.
There are several ways to consolidate debt. You can use a balance transfer credit card that offers a 0% introductory annual percentage rate (APR), get a personal loan or debt consolidation loan, borrow from your home's value using a home equity line of credit or pull money from your retirement account. Each of these options has risks, so be sure you understand what you're getting into.
- Make a budget. Poor money management often leads to bad debt, and taking charge of your finances can help you get out of it. To start eliminating bad debt, set a budget that takes into account your income and expenses. You have options when it comes to setting a budget. One common approach, the 50/30/20 method, is to put 50% of your income toward essentials (rent, groceries and car payments), 30% toward discretionary spending (eating out or new clothes) and 20% toward financial goals such as saving and paying down debt.
Tracking your spending will help you set a budget and also reveal where your money really goes. If you're surprised to see how much you're spending on eating out or retail therapy, don't beat yourself up—just redirect that money toward reducing your debt. Setting and following a realistic budget will help you make steady progress toward your goals without getting discouraged.
Know the Score
Whether you're trying to reduce your bad debt or avoid bad debt in the first place, knowing your credit score is always a smart move. Check your credit score at least once a year to keep tabs on how you're handling debt (you can get a free FICO® Score☉ from Experian). Reading your credit report will show you whether the way you use debt is helping—or hurting—your credit score.