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Credit Score Makeup: Good Debt Vs. Bad Credit

Living debt free would be ideal. However, it is almost impossible to not acquire debts.

Contrary to popular belief, not all debt is bad. But how do you determine what is good debt and what is negatively affecting your credit?

One source says that your monthly debt payments - including your credit cards and mortgage should ideally not exceed 36% of your gross monthly income. Though it may be difficult to avoid debt altogether, figuring out what debt makes the most sense can help with your financial obligations.

What is considered good debt?

Taking out a loan or using a line of credit is not always a negative thing. In fact, utilizing financing can allow you to have cash reserves in case of an emergency. Also, a history of borrowing is needed to establish an accurate credit score.

Sources of good debt include:

  • Mortgages: Investing in a home purchase can be a source of good debt, provided you do not borrow more than you can afford.
  • Student loans: Paying for college, especially with government-backed student loans, is a smart investment in your (or your child's) future.
  • Auto financing: Consider paying for a car by looking into leasing options. However, car payments can be acceptable debt when you need an automobile for your daily life.
  • Business loans: Investing in the future income of a potentially profitable business is a wise investment and is considered good debt.

The above types of debt have the potential to increase wealth or are used to purchase goods that have long-term use.

What is considered bad debt?

Unlike good debt, bad debt does not have the potential to increase your wealth through investment in a business, your home, or your education.

Some examples of bad debt include:

  • Credit cards: Although many view credit cards as necessary, many times cards are used for expendable items that lose value quickly and luxuries like vacations. Also, if you do not pay off balances each month, you may end up paying more in interest than the item is worth.
  • Store charge cards: These cards often have higher interest rates than good debt sources and the purchases (clothes, consumables, etc.) typically do not add to your long-term wealth.
  • Payday loans: A questionable financing option, payday loans charge much higher interest rates. Based on a scenario given by the FTC and the example they provide, you could pay an annual percentage rate of 391% for these loans.

Effects of your credit rating

Good credit can open various doors for you. A strong credit score (typically 680 to 850) can help you:

  • Be approved for mortgages, car loans and other lines of credit
  • Get lower interest rates on credit cards and loans
  • Remove barriers to renting a home or getting a job

Conversely, a bad credit score (usually under 580) can hurt you. Poor credit may cause you to:

  • Be denied a loan or line of credit
  • Pay higher interest rates, which potentially could cost you thousands of dollars
  • Fail the background check required to rent an apartment or to get certain jobs

Understanding your credit scores

It is important for you to know your credit scores and how it can impact future financial decisions.

Having good debt may not always mean you have good credit.