Whether you have credit card, student, car, or home loans, the debts you incur can affect your credit score.
Why is this important? Your credit score can affect your ability to get a loan or any type of credit in the future.
Below, we discuss "good debts" versus "bad debts" and why having some debt can actually help when it comes to your credit score. First, "good debts" are expenses you incur to improve your lot in life, such as a loan to further your education or deposits you make into a retirement account. On the other hand, "bad debt" is debt that sees little to no return on your investment. It can include high-interest store credit cards and payday loans.
Below, we talk about the different types of debt and which should you pay down first (in order of priority).
Credit Card Debt
Credit card debt is the most common type of debt. Today, we use credit cards to pay for everything from gas to groceries. However, many of us don't pay off our debts at the end of the month. If you don't pay in full, you could be paying interest rates as high as 20% each month.
This makes those small "on-the-spur-of-the-moment" purchases very costly. Yes, we're talking about things like picking up chocolate iced mochas on the way to work or buying cute decor items at Walmart. Let's say you picked up a breadmaker for $59.99 last week. How often do you use it? And, what about those pony figurines? Are they cluttering up your living room table? Last, but not least, your mocha habit may be costing you a small fortune each month.
Now, we're not saying that purchasing mocha lattes or pony figurines is a crime. And, breadmakers come with many benefits. The key to deciding whether you can afford these items is to take a hard look at your credit card balance: Can you pay off the balance at the end of every month? If the answer is no, you may have to reconsider your credit card habits.
In all, credit card debt is generally viewed as "bad debt." Here's the bottom line: High-interest rates and large balances make it more challenging to pay off debts in their entirety. This state of affairs can negatively affect your credit score. However, if you pay off your balances every month, your creditworthiness will increase. If you'd like an effective way to pay down credit card debt, try the debt snowball method of repayment.
We have all seen the commercials for 0% interest rates and "no money down" for cars, but not many of us can take advantage of those promotions. Many people walk into a car dealership and think of car loans in terms of monthly payments.
However, the cost of car ownership is high. Depending on the terms, car loans can be considered "bad debt." Many car loans are offered at 5% interest or more. With car loans, the interest you pay will depend on your credit score. It's important to shop around for a car loan and not just accept the rates your dealership quotes.
Also, remember that cars depreciate in value as soon as you drive them off the lot. This means that, even if you sold your car the next day, you would never recoup all of your investment. Other auto expenses to consider are regular maintenance costs, fuel, and insurance premiums. All of these add to your overall monthly auto costs. This is a loan you should pay off as quickly as you can.
To decide how much car you can afford, use the 20/4/10 rule:
- Your down payment should be at least 20%.
- Ask for a four-year loan (instead of five years or more)
- Your total monthly vehicle expense, including principal, interest, and insurance, shouldn't exceed 10% of your gross income.
Many millennials have student loan debt. For some, the amounts can be overwhelming. Depending on the interest rate and terms of the loan, student debt may either be good or bad debt.
A student loan is a "good debt" if you can pay the balance in full each month. Your credit score will improve as a result. However, a student loan can be considered bad debt if it substantially affects your income to debt ratio. While the inclination to pay this debt off quickly is natural, the reality is that it may take a while. Our best advice is to make additional payments when possible (but not at the expense of other higher interest debts).
If your federal student loans are high, consider applying for an income-driven repayment plan.
If you're a homeowner, this type of debt is considered "good debt." It allows you to accumulate wealth as you make monthly payments. Since many home mortgages last 15-30 years, this type of debt is long-term in nature. One way to bring down those payments is to refinance or make principal-only payments.
Because of the current COVID-19 crisis, many homeowners are refinancing. To decide whether refinancing is right for you, consider these two questions:
- How long do you intend to remain in your current home?
- What is the age of your loan? In other words, how many more years do you have left on your home loan?
As you think ahead, a great rule of thumb is to pay off the loans with the highest interest rates first.