Understanding the Different Types of Debt

The typical American household holds an average of $104,215 in debt.¹ Any amount of debt can pose a challenge to handling your finances in the present and planning for the future. But understanding the different kinds of debt you hold may help you better prioritize—and make the process of paying it down more manageable.

Here are some things to keep in mind:

Is There Such a Thing as "Good" Debt?

You may have heard about the concept of "good debt" versus "bad debt." While the reality of debt may not be so black and white, it’s worth exploring what’s behind this idea.

So-called good debt refers to debt that has the potential to increase your wealth. This includes housing loans like mortgages and home equity lines of credit, student loans and small business loans. All of these can be considered investments in your future, and the return on these investments could be substantial.

On the other hand, bad debt refers to high-interest, non-deductible debt used for depreciating assets. The most common example of this is credit card debt.

So, Which Debt Should You Pay Off First?

In order to keep your credit in good standing, it’s important to make at least the minimum monthly payments on all of your debts. But as you’re thinking about a game plan for getting multiple balances under control, you may want to consider some general guidance:

Address High-interest Debt

High-interest debt can be expensive to pay off—because if you’re only making minimum payments, you could end up chipping away at ever-mounting interest for months or years before getting to the principal. And if you continue to rack up new charges, that only adds to the challenge.

To take control of this type of debt, it’s a good idea to stop adding to it with new charges, if possible, and make more than the minimum payments. Moreover, aim to pay off the card with the highest interest rate first, and so on. You might also look into consolidating your balances onto a lower-interest card.

Consider Debt Repayment in Light of Your Overall Financial Picture

There is plenty of guidance out there about how to prioritize your financial activities. For instance, it’s often suggested that you save enough in a workplace retirement plan to take advantage of any matching dollars offered by your employer before putting your money toward debt repayment.

If you’re wondering whether it makes more sense to decrease debt or to save and invest instead, here are some questions to ask yourself:

• Are your debt payments going toward mounting interest, or have you paid off enough that you’re chipping away at the principal?

 

• Do you have enough cash flow to avoid going deeper into debt if you choose to invest?

 

• Do you have enough in personal savings to avoid having to borrow more in an emergency?

 

It could be a good idea to consult with a financial professional who can help you work through these questions and decide on a plan for your unique situation.

Consider Your Debt-to-income Ratio

Lastly, check on your financial health by calculating your debt-to-income (DTI) ratio. You can do this by taking inventory of your monthly expenditures and dividing that number by your monthly income. For example, if your bills total $3,000 and you make $8,000, your DTI ratio is 38%. In general, it’s suggested you aim for a at DTI ratio of 30% or lower, keeping in mind that the maximum DTI ratio you can have to qualify for a mortgage is usually 43%.²

The Bottom Line

Life can be expensive, and taking on debt is a common way to finance your needs and wants. But amassing too much can be a strain on your current situation and could derail your efforts to save for the future. That’s why it’s important to understand the kinds of debt you hold so you can make a plan for paying it back that supports your goals.