How to manage debt

By Roshan Pourghasemi

In this article we will cover:

What is debt and how it works
Good vs. Bad Debt
How much debt should you have
When should you take on more debt

Abstract

Pretty much everybody either has trouble with debt or knows somebody that does. From a mortgage to student loans, debt is a necessary evil for some of the most important purchases in life and for upward mobility. In this article, we go in depth on good vs. bad debt, how to know you’re ready to take on more debt, how debt works, and steps you should take, like setting up an emergency fund, before you decide to take on more debt.

All About Debt

From the $20 you owe your friend after last night's meal to crippling student loans, we all deal with all different kinds of debt. The general connotation around debt doesn’t paint it in a great light. Still, “good debt” does exist, and it is imperative you know how to differentiate it from the “bad” variety.

Key Takeaways:

Repay all high-interest debt first and foremost. This is a form of bad debt.
Don’t overextend yourself. Make sure you have six months worth of savings before taking on new debt. Only take on new debt when your budget allows for it.
Taking on debt is a common avenue to grow your net worth and improve your well-being.
Going into debt to buy assets that appreciate qualifies as good debt and going into debt to buy assets that depreciate qualifies as bad debt. If you go into debt to invest in something that is necessary or its value gets larger over time, it counts as good debt.

What is debt and how does it works?

Before we talk about good vs. bad debt, we must first understand what debt is. Debt is anything owed from one party to another. Governments, businesses, and individuals all go into debt, with the most common forms being loans (personal, auto, mortgage, etc.) and credit card debt. Interest is a percentage of the principal (the borrowed amount) that the debtor has to pay back on top of the principal, usually calculated on an annual basis.

The following table shows how the money on a $10,000 loan increases over 10 years based on a 4.75% annual percentage rate (APR):

As you can see, what might seem like an innocent 4.75% transforms to 20.6% over 5 years, and the rate of increase only speeds up as time goes on. This concept is known as compounding interest and it is a large reason that many can’t repay their debts.

Good vs. Bad Debt

Some will say that the only type of good debt is no debt, and there is an argument to be made there. Many people will take out loans to finance important purchases like homes, cars, or college. However, some will also carelessly take out debt for assets that don’t appreciate in value and only aid in their consumption.

Good Debt

“It takes money to make money” encapsulates the idea of good debt pretty well. People, generally speaking, don’t have enough capital on hand to purchase many big-ticket items, so they must take out loans to acquire the money needed to invest in the assets that improve their livelihoods.

Examples of Good Debt:

Education - In general, education exponentially increases one’s earning potential. However, there are diminishing returns, and so it’s possible to over-extend your spend on education to the point where returns don’t outweigh the costs.
Start a business - Many of the world’s richest people acquired the majority of their wealth from starting a business. This avenue also comes with its fair share of risk, but the potential returns are limitless.
Home/real estate - First and foremost, a safe home is one of the prerequisites to a high standard of living, so taking on debt to purchase a home is necessary for almost all of us. Of course, make sure to purchase a home with monthly payments that fit within your budget.

Bad Debt

Bad debt is generally seen as debt taken out to buy assets that depreciate. Sometimes this is necessary, as in the case of the car, but, from a financial perspective, it would still be considered bad debt. Also, taking out debt to buy items seen as consumables is generally a bad idea. As evidenced by the need to go into debt to purchase them, these consumables probably don’t fit into your budget.

Examples of Bad Debt:

Cars - By the time you leave the car lot, the car will have already depreciated in value. As mentioned above, cars are a necessity for a lot of us, but that still doesn’t categorize this asset under good debt.
Clothes - Similar to cars, clothing’s value plummets as soon as it’s purchased.. Of course, clothes are necessary for all of us, but, if you need to go into debt to buy a certain pair of sneakers, it probably isn’t a good idea.
Consumables - Many things can fit into this category, but the general idea is the same. If it depreciates in value, going into debt to purchase something is a bad idea.

Furthermore, it is important that we can identify and avoid predatory lending, the types of loans that are structured so that you aren’t able to pay back the borrowed money (defaulting). Common signs of predatory lending include:

Unclear pricing and terms
Aggressive/abusive broker tactics
Short-term loans
Approval is too easy
Unwilling to answer questions

Some things can’t be categorized as good or bad debt. Examples include taking out a loan to pay off other outstanding debts at a lower interest rate or taking out a loan if you have an investment opportunity. As a rule of thumb, good debt has an interest rate lower than the return rate you could get if you invested the money instead.

How much debt should I have?

To an extent, the answer to that question depends on you and your family’s financial situation. If you know you’re the type to get really anxious about any sort of debt, the zero-debt lifestyle is probably for the best. It also depends on many other factors, such as how old you are, your family’s financial health, and your professional goals, for example. If you are looking to use debt to increase your future net worth, you should evaluate your finances and budget first, which will be expanded upon in the next section. Debt is generally okay if it’s not stretching your budget thin and ruining your mental health. If it is having this effect on you, paying off your existing debt should be your first priority.

When you apply for credit, lenders take many factors into consideration, but one of the main ones is your Debt to Income ratio, or DTI. Front-end DTI is typically calculated by dividing your monthly mortgage by your monthly gross income, while back-end DTI factors in your other forms of debt as well. For example, if you earn $4,000 a month and have a mortgage of $1,000, your front end DTI would be 25%. The standard front-end limit is 28%, with the back-end limit being 36%. If we look back at our example, the highest monthly mortgage payment a lender looking at front-end DTI would generally grant to a person making $4,000 a month would be $1,120. Take a look at Wells Fargo’s DTI ranges to judge your own DTI.

When should I take on more debt?

Make sure that you have these considerations sorted out first:

The immediate priority should be to eliminate all high-interest debt, as it compounds quickly.
Once you’ve rid yourself of high-interest debt, you should aim to build a six month emergency fund. Read our article here if you need help building the proper budget to create such a fund.
Market climate is another factor that we need to consider. During a recession, the market generally slows down and assets can appreciate at a slower rate, making a loan not in your best interest (no pun intended). However, the Federal Reserve generally lowers interest rates during a recession, which makes borrowing money more appealing. Read our article here on the actions of the Federal Reserve if you’re curious behind the reasoning of such a decision.

After addressing these three issues, you can consider taking on more debt. Ask yourself the following questions:

Is the debt I want to take out good or bad debt? If it’s bad, do I have the room in my budget to allow for such a purchase?
Will I be using the borrowed capital to buy an asset that appreciates?
Is my financial situation stable enough?
Is the economy stable enough? Does the market climate allow for large asset appreciation?
Will this improve my financial health or quality of life?
Will it ruin my DTI?

If you’ve answered yes to most or all of these questions, taking on more debt may be a good idea. Of course, consult with your loved ones and financial advisor before making a decision of such magnitude. Debt is a double-edged sword – it can build one’s fortunes just as easily as it can seriously cripple one’s financial health.