Good Debt vs. Bad Debt: Evaluating Your Debt Ratio
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Have you ever heard someone talk about “good debt” versus “bad debt”? Those terms can be a little misleading, but the kinds of debt you have and how you manage your finances can reflect positively-or negatively-on your credit report.
Your credit report contains a story about what kind of debt you’ve taken on and how you’ve paid it back. You might think of the $20 you borrowed from a coworker to pay for lunch as a debt, and it is, except most creditors and credit-reporting agencies aren’t going to keep track of that.
Credit reporting agencies keep a file on you containing all your credit accounts and payment histories that have been reported to them by your creditors, lenders and public records.
Your credit file can contain up to four different types of accounts or categories of debt:
What Is Good Debt?
Some types of accounts reflect more positively on your credit report because of what they can reveal about your financial habits.
Sometimes you may need to take on debt as an investment in the future. A student loan is usually considered good debt. That home equity line to build another bedroom may be a better investment than running up your credit card debt to pay for nice dinners and extravagant vacations.
Overall, any debt can be considered good debt if you are able to pay it back on time each month, making at least the minimum payment due.
What Is Bad Debt?
Any debt can turn into a bad debt if you overextend yourself or get behind in your payments. The key is to apply for credit only when necessary and to use your available credit wisely. Essentially, bad debts are those you can’t pay on time or that use up too much of your available credit.
Let’s look at a car loan. Say you need to buy a car to be able to get to work. Are you going to take out a loan for $15,000 because you know that monthly payment will fit in your budget? Or are you going to take out a loan for $50,000 and overextend yourself for that high-end automotive experience?
Overall, bad debt is debt that is incurred to fund a lifestyle that you cannot afford. Sacrificing your long-term financial health for short-term gratification is not a wise use of debt.
Turning Your Bad Debt into Good Debt
It’s easy to say, “Pay down your credit card and make your monthly payment on time,” but we hear all too often from consumers that it can be very tough to get credit accounts under control.
The first step to any effort to improve your credit-worthiness is to stop incurring new debt. Then you’ll want to take action to improve your credit behavior.
When thinking about “good debt” versus “bad debt,” it’s more about how you use the credit you’ve been extended. You want to show that you’re using your credit responsibly.
Good debt can mean that you have a mix of credit accounts and you’ve established a history of paying back your debts as agreed. By paying down your debt steadily over time, it shows that you made a decision to finance a purchase and you’re managing the responsibility to repay the debt.
Getting into debt beyond what you can handle can be a frustrating and embarrassing situation, but if you create a plan to pay down your debt and stick to it, you’ll soon start to see your bad debt looking more like good debt
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