While too much debt is never a good thing, some debt is necessary. Financial Advisors typically put debt into two categories: good debt and bad debt. While these categories can get complicated, the basic point is that good debt is debt that helps you make money, while bad debt is debt that makes you poorer. If the scales aren't currently tipped in your favor, there's good news for you: there are specific steps you can take to reduce bad debt.
Examples of Good Debt
Buying a home is one of the best examples of good debt. For the most part, homes will appreciate in value over time, so the price you pay for a home today will likely be less than you'd be able to sell it for in ten years. College is another example of a good debt. While the specifics will vary based on the degree obtained, the average employee with a degree will make roughly a million dollars more in their lifetime compared to someone without a degree.
Financing a car can be a good debt as well. The more reliable your transportation is, the more reliable you can be as an employee or a student, and the greater your current and future earning potential. If you make your payments on time, you can see significant increases in your credit score – which can mean lower interest rates and more opportunities for good debt in the future.
Paying Down Your Mortgage May Not Be the Wise Move You Think It Is
Many people assume that if they have a little extra cash, paying down their mortgage is the smartest investment. Typically this belief comes from the fact that, for most people, the debt they owe on their home is much higher than their other debts. However, interest rates for mortgages tend to be much lower than on your typical credit card, and the interest on the first million dollars of a mortgage is tax-deductible.
Focus on Your Higher Interest, Lower Balance Debts
The first step in reducing your bad debt is to decide on a plan and stick with it. The ideal option is to pay as much as possible toward your debt with the highest interest rate – usually a credit card – and pay the minimum payment on all your other debts. Once that highest rate debt is paid, move on to your next highest interest rate debt and pay as much as possible on it. Continue until all your high interest debts are paid and you'll be left with only good debt.
There are a few exceptions to this rule, though. If you have a credit card with a $500 balance and a personal loan with a $15,000 balance, then it makes more sense to pay the credit card off first – even if the interest rate is lower than on the personal loan. Why? Because you can pay off $500 much more quickly, and reduce the number of monthly payments you must make per month.
Reducing your bad debt is simple but that doesn't mean it's easy. The key is to know which debts to tackle first. If you don't think you can afford to make higher payments than the monthly minimums, try this trick for a month: write down every cent you spend. You just might be surprised by the cuts you can make.
In the end, it is all up to you how your financial future goes. With these tips you will be able to cut down debt, build a great credit score, and save for the things that you truly need.
Readers: How are you reducing your debt?