Good debt vs. bad debt

In Lesson 9

Debt Reduction Planner Glossary Take the test

Top things to know Good debt vs. bad debt Three examples of good debt Borrowing for other expenses Loans to pay credit cards Managing your debt Getting your credit reports

Money 101 Lessons

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It's almost impossible to live debt-free; most of us can't pay cash for our homes or our children's college educations. But too many of us let debt get out of hand.

Ideally, experts say, your total monthly long-term debt payments, including your mortgage and credit cards, should not exceed 36 percent of your gross monthly income. That's one metric mortgage bankers consider when assessing the creditworthiness of a potential borrower.

It's far too easy to spend more than you can afford, especially when you pay by credit card. The average U.S. household with at least one credit card carries nearly a $10,700 balance, according to CardWeb.com, and personal bankruptcies have hit record highs in recent years.

Of course, avoiding debt at any cost is not smart either if it means depleting your cash reserves for emergencies. The challenge is learning how to judge which debt makes sense and which does not and then wisely managing the money you do borrow.

Good debt includes anything you need but can't afford to pay for up front without wiping out cash reserves or liquidating all your investments. In cases where debt makes sense, only take loans for which you can afford the monthly payments.

Bad debt includes debt you've taken on for things you don't need and can't afford (that trip to Bora Bora, for instance). The worst form of debt is credit-card debt, since it usually carries the highest interest rates.

Sometimes the decision to borrow doesn't hinge on how much cash you have but on whether there are ways to make your money work harder for you. If interest rates are low, compare what you'll spend in interest on a loan versus what your money could earn if it were invested. If you think you can get a higher return from investing your cash than what you'll pay in interest on a loan, borrowing a small amount at a low rate may make sense.

NEXT: Three examples of good debt

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