According to the Federal Reserve Bank of New York, total US household debt was $16.51 trillion in the third quarter of 2022, up 2.2% from the second quarter of the year. But while debt often gets a bad rap in personal finance circles, it’s not always a detriment to personal finances.
“Debt can be an extremely powerful tool when used correctly,” said Michael Tanney, senior managing director of New York-based Magnus Financial Group.
But like most powerful tools, it can hurt you if used incorrectly. It’s essential to go into debt for the right reasons and under the right guidance, he says.
When you handle debt responsibly, it can help you gain economic security and build your net worth. Keep reading to learn how.
How good debt differs from bad debt
Financial experts say there are good debts and bad debts. Good debt includes loans — such as mortgages, student loans, and small business loans — that allow you to purchase an asset with the potential to gain value over time. (In the case of student loans, you gain access to a career that is more likely to give you higher potential earnings.)
Bad debt usually includes high-interest financial products, such as credit cards, that you use to buy items that depreciate in value or that you quickly use up. This type of debt can hinder your finances and prevent you from achieving other financial goals.
Grant Sabatier, creator of the personal finance blog Millennial Money and author of “Financial Freedom,” says when we hear about bad debt, it’s usually about credit cards with high interest rates.
When you only make minimal payments on credit card bills, the amount you owe continues to grow and increase rapidly and can send you deep into debt before you know it. Bad debt also includes payday loans and other predatory loans, Sabatier says.
How To Build Wealth When You Are In Debt
When you use debt assets, it shouldn’t stop you from increasing your net worth over time. Follow these steps to get your debt under control and get ahead financially.
Pay off the high-interest debt first
If you carry credit cards with you, put them off for a while. Focus your money on paying off those balances each month, starting with the card with the highest interest rate first.
Credit cards can serve as a great tool for improving your credit score, maximizing cash flow and earning reward points. But if you carry a balance with you each month, the interest costs will typically outweigh all of these benefits. Switch to using a debit card or cash until you’ve paid for your cards.
Set aside savings
Setting aside three to six months’ worth of savings will help you avoid going 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 enough in a retirement account to take advantage of your employer’s match.
“You don’t want to take 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 back
Whether it’s a small business loan, student loan or mortgage, think carefully about the amount you want to borrow and whether you have the means to pay it back. For example, if you are going back to school and taking out a loan, make sure that your expected salary after graduation will allow you to make the payments easily.
Don’t eliminate your “good debt” too quickly
If you were one of the millions of Americans who have benefited from record-low interest rates over the past decade and have taken out a mortgage at rock bottom rates, don’t rush to pay it off.
Instead, put that money you would use to pay off your mortgage in a high-yield savings account. You can earn up to 4% interest that way, which would be a higher return than if you paid off a 3% mortgage. Or invest the money in the stock market. While unpredictable at the moment, it might be a good place to put some money aside if you don’t need the money in the near future.
“The stock market has historically produced an average of 8% to 10% per year, depending on the period you look at,” said Paul Dietrich, chief strategist at B. Riley Wealth. “If your debt is lower, you can focus on investing instead.”