— Recent headlines notwithstanding, debt in and of itself is not all bad. There are things most Americans wouldn’t be able to do without borrowing: Buy a house, a car, get a college education. That’s how you can tell the difference between good debt and bad debt. Good debt is debt that actually gets you somewhere. It’s the mortgage that puts a roof (one you can actually afford, mind you) over your head, the car loan that gets you back and forth to work, the student loan that helps fund the college education that increases your lifetime earning potential by $1 million.
Bad debt is debt that you take on to buy things that you don’t necessarily need, but rather that you want — and can’t really afford. There’s a difference between replacing your refrigerator because you need a new one and replacing the refrigerator because you prefer the look of stainless-steel appliances. If the former takes you a few months to pay off on a credit card, that’s OK in my book; the latter, not so much. You can usually tell good debt from bad debt by the interest rate. Good debt is cheaper — and sometimes even tax deductible. Bad debt tends to run in the double digits.
There’s an in-between type of debt also, that I call convenience debt. This is the monthly credit card bill you accrue — and preferably pay off — because it’s easier to swipe a piece of plastic to pay for things than it is to pay cash. As long as you don’t incur interest on those charges on a regular basis, it’s OK to use your credit cards as a convenience tool. You can often earn cash back or frequent-flier miles while you’re at it. (No, they’re not worth what they once were, but they’re worth something.) If you find yourself racking up balances you can’t pay off each month, credit is not a good vehicle for you. Use a debit card instead.
To avoid debt, understand it
Understanding two basic debt concepts can prevent you from drowning in it over your lifetime. The first is that you will get yourself out of debt the fastest by focusing on the most expensive — i.e., highest interest rate — debts in your portfolio first. That means putting all your extra money toward that most expensive card and paying the minimum on the rest; when it’s paid off you move to the next expensive card on your list. Let’s say you have three credit cards:
There’s a 2 percent minimum payment requirement on all the cards. And you can come up with an extra $200 above and beyond your minimums to throw at your credit cards.
If you pay off the card with highest balance first, it will cost you $2,517 in total interest.
If you pay off the lowest balance first, it will cost you $1,969 in total interest.
But if you pay them off highest interest rate first, it will cost you $1,818 in interest to pay off all the cards. In other words, you can save yourself $700 by doing this the right way.
Keep your credit score high
Secondly, the way to keep your debt costs manageable now and in the future is to protect your credit score and your credit report. If you haven’t seen a copy of your credit report recently, visit www.annualcreditreport.com and pull one from each of the three major credit bureaus for free. Your credit score is a numerical translation of the information in your credit reports. The one most lenders use is called your FICO score (FICO stands for Fair Isaac and Company, the developer of those scores). You have one FICO score that corresponds to each credit bureau report. Unfortunately, scores aren’t free. But I’d suggest that six months to a year before you apply for a big loan — like a mortgage or a car loan — you spend $15 to find out what yours is. Meanwhile, doing the following five things will help keep your score as high as possible:
1. Pay your bills on time.
2. Pay down the debt you’re carrying on credit cards until it is at or below 10 percent of your credit limits overall and on each particular card.
3. Don’t apply for more credit cards. (The exception to this rule is if you don’t have a credit card at all or if you have only one. In this case, adding another card will help your score.)
4. Don’t close credit card accounts — even if you’re not using them. Closing them reduces the amount of credit you have available to you and hurts your score.
5. Make sure you have a history of being responsible repaying a variety of creditors — not just credit card companies, but phone companies, utility companies, etc.
And that’s it. Using this system along with that advice should be enough to help you get your debt under control.
What if that doesn’t work?
What if you feel so overloaded that you’re unable to pay the debts you’ve taken on? What if you know you’ve overdone it?
Call your creditors and let them know what’s happening. If you’ve lost a job or suffered an illness or had some other event in your life that is preventing you from paying your bills, call your creditors and fill them in, preferably before you go delinquent and start paying late. If you’re already paying late, call them anyway. They may be willing to help you by lowering your interest rate, waiving late fees, extending the term of your loan, even reducing the amount you owe them. But they can’t do that if you don’t let them into the conversation.
And if you can’t — or don’t want to — go it alone, know that a not-for-profit credit counseling agency might be able to help. You’ll want one that is a member of the National Foundation of Credit Counselors (NFCC.org) or the Independent Association of Credit Counselors (IACC.org). Both use only certified credit counselors. Be sure the organization is also recognized by the Better Business Bureau and that there is no history of complaints.