Good Debt, Bad Debt?
“Debt” is a fancy way to say for “borrowed with a promise to repay.” We incur student debt going to college, for a house we’ll have a mortgage—and we’re all certainly familiar with credit card debt. Certain kinds of debt can be good—but most kinds, under most circumstances, aren’t.
In many cases, we’ve been encouraged to take on more ability to borrow than is good for us without being clearly shown the risk. Credit card companies, mortgage providers and other financial firms are great at encouraging us to take on more debt by marketing to our hopes and dreams—and it works. But however deep we’re in debt, we can get out. Doing so requires discipline. But becoming debt-free is liberating.
When considering your debt, you should figure out if it’s helping or hurting you. Some argue that all debt is bad. If you’re paying more than a few percentage points in interest for your debt, it’s probably not good for you. Others think that debt with low fees can help. Some mortgages can be considered “good debt.” For instance, if you have a good credit rating, equity in your home, and the purchase price is modest in comparison to your income, you’re considered a good bet and can be eligible for a low-rate mortgage.
If a family has a 30-year fixed-rate $200,000 mortgage on a $300,000 house at 5 percent, then that family would pay about $1,325 per month (including taxes and insurance). Over the course of 30 years, for the right to borrow $200,000, the family would end up paying back about $400,000. That’s “good” debt.
Imagine that a family racks up $10,000 in credit card debt at a 30 percent interest charge. If the family pays the minimum, the debts won’t be squared away for 21 and a half years. All-in-all the family will have paid $26,250 or so for the right to borrow $10,000. This, due to its astronomically high interest rate, is considered bad debt.
Having debt is a normal part of life in America—and so is working to reduce it. If we just keep adding debt without working to reduce it, eventually we end up with more than we can handle. If something unexpected happened, we could quickly end up bankrupt, evicted or otherwise financially devastated.
We can avoid being constantly on the edge by reducing what we owe to a manageable amount—even though that’s easier said than done. If you’re in debt, the reduction will require diligence and discipline. But you can do it.
There are two approaches; both work. Which is best is up to you to decide.
“The Debt Snowball”
The first approach is to pay off the debt with the smallest balance first. When you do, immediately begin on the next account with the lowest balance. As you knock debts off your list, the sense of accomplishment will feel great and encourage you in your next step. Your monthly surplus will grow, and every month you will have a little bit more money to pay down what debt’s left. This approach is called “the debt snowball” because your quick wins create momentum, like a snowball rolling down a hill. Keep at it, and you’ll be debt free and can use the surplus for building a future.
Slow and Steady
The second approach is to pay off the highest—cost debt first—highest cost meaning highest interest rate charged. This strategy is based on the idea that in the long run, the highest debt grows the most quickly—so it’s wisest to start there. Though it has a solid mathematical foundation as its basis, this approach can be overwhelming. If you have the discipline to pull this approach off, you’ll end up paying fewer dollars over time.
Both strategies can work. If you have the dedication to grind through it, then slow and steady is probably best—but it could be more emotionally daunting. If you want the reinforcement of the quick wins, or if you’re not sure of your dedication to something long term, then the snowball strategy is the best way to start.
Regardless of which strategy you choose, it’s important to know that getting out of debt is doable. It doesn’t require fancy thinking, just consistent action. As long as you stay on the path and remain diligent, you’ll get to a debt-free (or debt-reduced) life. There will be countless distractions, special occasions and opportunities to relapse into old patterns—but anticipate them and be creative in your thinking to avoid them. Do be sure to avoid them as best you can, though—once we make a single exception, we’ll get back to where we started before we know it.
Everyone has debt; the difference is how you manage it. It doesn't need to be a burden.
Here's a great article about debt reduction at Get Rich Slowly.