Debt affects you, me, and everyone else in ways that could be unexpected. Unfortunately, younger generations are racking up consumer debt more than ever without fully understanding the weight it may carry. Being a recent college graduate in finance, I get a lot of questions about debt from my 20-something year old friends and acquaintances when they hear I work for a financial planning firm. They often want to know which debt to pay off and how quickly. In particular, they ask about student loan debt, credit cards and auto loans. I often begin to explain it by asking – is it good debt or bad? Knowing the difference is essential to your financial health, and it’s not as daunting as it may seem.
Good Debt vs Bad Debt
It is important to understand the difference between what we classify as good debt and bad debt, which is a slight oversimplification, but it helps to phrase the conversation when deciding how to approach debt repayment. Good debt can be thought of as an investment and should be paid off in approachable monthly payments allowing additional money to go towards other expenses or savings. Bad debt should be aggressively paid off in order of interest rate, from highest to lowest, and should be a top priority.
Examples of good debt include a home mortgage, home equity line of credit, small business loan, or student loan. Examples of bad debt are credit cards, a personal loan, or a payday loan. Car loans might fall somewhere in the middle, depending on the terms of the loan, but are often seen as bad debt.
Refinancing and Consolidation
While student loans fall under the “good debt” category for the most part, they can add up to a sizable amount and monthly payment. In addition, managing multiple student loans administered by several different loan servicers can be cumbersome. There may be advantages to loan consolidation or refinancing in order to simplify loan payments into one payment with one fixed interest rate, with possibilities of additional repayment options. However, for both loan consolidation and refinancing, there are several factors to consider, such as the type of loan (private or federal), possible benefits lost, and the viability of the company who is refinancing the loan. It is important to review the pros and cons of consolidation or refinancing to see if they are practical options for you.
Consolidating student loans involves combining multiple federal loans into one. It cannot lower interest rates; however, it may lower monthly payments and make repayments easier to manage. There are multiple repayment plans available through consolidation, including fixed payments, graduated (starting low and increasing every two years), and Income-based. Some disadvantages of consolidation include paying more in interest over time due to a longer repayment schedule and restarting the clock on qualifying for Public Service Loan Forgiveness and other programs.
Refinancing student loans involves combining private and/or federal loans into one private loan. This method can help make repayments easier to manage and may lower interest rates. However, there is more to consider in working with a private company to refinance student loans. Financial history is important in determining the benefits of refinancing. To qualify requires a credit score of 690 or higher, sufficient income, proof of some on-time repayments, or a co-signer who fulfills those requirements. Refinancing allows modification of repayment plans including fixed and variable rates but does not include income-based repayment plans. It is often not recommended to refinance federal loans as doing so gives up access to potential loan forgiveness, flexible repayment plans, loan discharge options, and other federal protections. Though refinancing can save money by lowering interest rates and possibly monthly payments, it is important to research the benefits and disadvantages as well as the viability of the company participating.
Public Service Loan Forgiveness
The Public Service Loan Forgiveness program (PSLF) forgives remaining federal student loans after making 10 years of payments while working for the government or a nonprofit. This program is a great option for those who plan to have a career in public service anyway but is not recommended as a way to simply get out of student debt. There are qualification rules for PSLF that include working for a government agency or certain types of nonprofits, working full-time for that agency or organization, having Direct Loans or consolidated other federal student loans, paying your loans on an income-driven repayment plan, and making 120 qualifying payments. There is more information for PSLF on the Federal Student Aid Website.
Credit Card Debt
Credit card debt can be extremely harmful as it has high interest rates that can overrun principle repayments, with the compounding resulting in feeling like you will never get it paid off, causing an extreme level of stress and despair. The typical recommendation is to prioritize paying off debt with an interest rate above 5%. With rates upward of 10-15%, credit card debt should be at the top of the list for aggressive repayment. In most cases, aside from a reasonable emergency fund, it is better to put all available funds towards credit cards, prioritizing this debt over extra savings. If the rate seems irrationally higher, it is worth it to call the card issuer and attempt to negotiate. Another option is balance transfer which may offer a lower rate and some cards even offer a year free of interest after transfer. However, it is important to be aware of any fees or other unfavorable conditions. While burdened by debt, it is a good idea to maintain a low budget and repay as much as possible. Once it is paid off make sure to stay out of credit card debt and only spend what fits within budget.
Auto loans can be considered good or bad debt, depending on the interest rate and term length. As I mentioned above, a 5% interest rate might be a useful benchmark in determining whether to pay off a loan immediately or simply meet the minimum required payments. Generally, because vehicles depreciate quickly, beware of the term of the loan so you are not under water on the value of the vehicle compared to the remaining debt. However, there are certainly other factors involved. For example, using an auto loan to build your credit score to eventually purchase a home, may be a benefit of taking a 3-year loan on a vehicle even if you could pay cash. When purchasing a car, depending on your credit and ideal repayment plan, look for a lower, easily maintained interest rate and term length. If you currently have a loan with a higher interest rate, consider paying it off more quickly, as long as you are not making significant financial sacrificing to do so.
My advice is don’t rush to pay off good debt, your money is better spent elsewhere. It’s important to maintain an emergency fund and savings as well as invest in your future by contributing to a 401k or IRA plan. When repaying debt, pay it off in the order of highest to lowest interest rate to ensure that you are getting the most out of your money. We live in a debt burdened society but with some determination and planning, you can strive for financial heath and peace of mind.