according to Federal Reserve Bank of New YorkUS household debt totaled $16.51 trillion in the third quarter of 2022, an increase of 2.2% from the second quarter of the year. But while debt often gets a bad rap in personal finance circles, it isn’t always detrimental to personal finances.
“Debt can be a very powerful tool when used correctly,” says Michael Taney, senior managing director of New York-based Magnus Financial Group.
But like most powerful tools, if you use them incorrectly, they can hurt you. He says that it is necessary to take on debts for the right reasons and under the right guidance.
When you use debt responsibly, it can help you gain economic security and build your net worth. Keep reading to learn how.
How is good debt different from bad debt?
Financial experts say there is good debt and bad debt. Good debt includes loans – eg MortgagesStudent loans and Small business loans – that enables you to purchase an asset that is likely to gain value over time. (In the case of student loans, you can get into a career that is more likely to offer you higher earning potential.)
Bad debt usually involves high-interest financial products — such as credit cards — that you use to buy items that are depreciating in value or that you wear out quickly. This type of debt can become a burden on your finances and prevent you from achieving other financial goals.
When we hear about bad debt, it’s usually about credit cards with high interest rates, says Grant Sabatier, creator of the personal finance blog Millennial Money and author of “Financial Freedom.”
When you only make the minimum payments on credit card accounts, the amount you owe continues to grow, accumulate rapidly, and can plunge you into debt before you know it.. It also includes bad debts Payday loans and other predatory loansSabatier says.
How to build wealth when you are in debt
When you use a debt property, it shouldn’t stop you from increasing your net worth over time. Follow these steps to take control of your debt and move forward financially.
Pay off high-interest debt first
If you are carrying balances on your credit cards, stop using them for a while. Direct your money toward paying off those balances each month, starting with the highest-interest card first.
Credit cards can be a great tool for improving your credit score, increasing your cash flow and Collect reward points. But if you carry a monthly balance, the interest cost will usually outweigh any of these benefits. Switch to using a debit card or cash until you pay off your cards.
Setting aside three to six months of savings will help prevent you from falling back into debt should an emergency arise—such as an unexpected home repair or job loss. Aim to put some money into your emergency fund each month and at least that much retirement account To take advantage of the employer match.
“You don’t want to use an all-or-nothing approach to paying down debt that would alienate your other financial goals,” says John McCafferty, director of financial planning at Edelman Financial Engines.
Only take on extra debt if you have a plan to pay it off
Whether it is a small business loan, Student loan Or a mortgage, think carefully about how much money you want to borrow and whether you have the resources to pay it back. For example, if you’re going back to school and taking out a loan, make sure that your expected salary after graduation will enable you to make payments comfortably.
Don’t eliminate your “good debt” too quickly
If you are one of the millions of Americans who have taken advantage of record low interest rates in the past decade and secured a mortgage at a very low rate, don’t be in a rush to pay it off.
Instead, put the money you might use to pay off your mortgage into a high-yield savings account. You can earn up to 4% interest this way, which will be a higher return than you would get paying off a 3% mortgage. Or invest money in the stock market. Although it’s unpredictable right now, if you don’t need the funds in the near future, it might be a good place to put some cash.
“The stock market has historically produced an average of 8% to 10% annually, depending on the time period you look at,” says Paul Dietrich, chief investment strategist at B Riley Wealth. “If your debt is less than that, you can focus on investing instead.”