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It can be difficult to pay for everything in cash. Buying a home and paying for college, for example, are hefty investments that will likely require you to take on debt by borrowing money now and paying it back later.
Your borrowing history—the type of debt you’ve acquired and how you’ve paid it back over time—is listed in your credit report and impacts your credit score, but not all debt is created equal. By understanding the distinction of good debt vs. bad debt, you will be on your way to using credit responsibly and improving your creditworthiness over time.
What is good debt?
Good debt is often considered to be an investment in something that creates value. A mortgage or student loan, for example, can be considered good debt—especially if your home’s market value increases over time or your college education helps you land a good job that pays the bills.
Generally, any debt can be classified as good debt as long as you are able to pay it back on time each month, making at least the minimum payment. Your payment history is the largest factor that influences your credit score—accounting for about 35 percent of your score. As a result, consistently keeping up with your payments can help you raise your credit score over time.
This means you might have to make some tough decisions about how much debt to take on and where to most economically use it. Taking out a home equity line of credit to add another bathroom to your house, for example, may be a better investment than running up your credit card debt to pay for fancy dinners and lavish vacations.
What is bad debt?
In general, bad debt is any debt you take on to fund a lifestyle you can’t afford, and it usually causes you to sacrifice long-term financial health for short-term gratification. Any debt can quickly become bad debt if you overextend yourself or fall behind on your payments.
You can quickly rack up bad debt if you are using a high-interest credit card and not paying the monthly balance in full or if you take out a loan with monthly payments you can’t meet. If are able to comfortably afford the monthly payments on a $15,000 auto loan, for example, be cautious of overextending yourself by taking out a larger loan.
Debt that uses up too much of your available credit can also be considered bad debt. About 30 percent of your credit score is determined by the amount you owe on your credit cards and loans or your ratio of debt to available credit.
Keeping your ratio of debt to available credit as low as possible can usually reflect positively on your credit history and credit score. If you carry a balance of more than 30 percent of your credit limit, lenders may consider it excessive debt and view you less favorably.
How can I turn my bad debt into good debt?
In order to get your credit accounts under control and to improve your creditworthiness, consider minimizing the amount of new debt you take on while you work on paying off the debt you currently have. By paying down your debt gradually over time, you may positively impact your credit score.
In addition, responsibly using the credit you’ve already been extended and applying for new credit only when necessary can help you show lenders that you are a creditworthy consumer.
You can’t improve your credit history and credit score overnight, but if you create a budget to pay down your debt—and you stick to it—your bad debt may start to look like good debt.
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