Debt 101: A guide on dangers to avoid, how to pay it off & protections for your wallet
The word “debt” typically carries a negative connotation — which makes sense when you consider all the debt Americans owe these days.
To give you an idea, about 43 million Americans owe a combined $1.2 trillion in student loan debt, and the typical U.S. household now owes more than $16,000 in credit card debt.
So it’s not surprising that you probably hear a lot of talk about how bad debt is and how it will ruin your life and so on. But it’s actually not that simple.
Yes, certain types of debt can “ruin” your life when it causes you financial problems for a long time and prevents you from reaching any of your big goals.
But here’s the key: that scenario is caused by certain types of debt and how you handle it.
It may sound crazy at first, but debt isn’t necessarily a bad thing — it’s how you use it that’s good or bad. And if you use it the right way, debt can have a lot of benefits.
It sounds complicated, but it doesn’t have to be.
You just need to know a few things about how debt works and how to use it in your favor.
With a little Common Cents, you can stay out of trouble and take advantage of all the ways debt can improve your financial life!
What exactly is debt?
Before we get into the different types of debt and good debt vs. bad debt, it’s important to first understand exactly what debt is.
Debt is money that you borrow and promise to pay back. The company that loans you money is the lender, because they give you the loan. A lender could be a bank, credit union, credit card company, or even the government.
When you take on debt, you promise to pay it back within a certain period of time, typically with interest.
Here’s an easy example:
You agree to loan me $1,000 if I promise to pay it back in one month with 20 percent interest.
So in one month, I’ll owe you $1,000 plus 20 percent — so a total of $1,200.
What are some common types of debt?
There are a lot of different types of debt out there, but when it comes to your personal finances, there are a few common types of debt that you may come across at some or another:
Credit card debt
Student loan debt
Again, these are just a few of the most common types of debt that individuals may take on at some point in life. And each of them works differently — from how much money you can borrow to how much it’ll cost you in interest. Each one also has a different impact on your credit score.
Impact of debt on your credit score
Here’s where debt can start to get tricky, and why many people choose to just ignore it altogether.
Don’t do that! Ignoring any type of debt is a bad idea — that not only causes the debt to increase and will cost you more over time, but it also damages your credit score.
Your credit score is at the center of your entire financial life — think of it as your financial score card, because that three-digit number is what lenders use to determine a variety of things, including how much money you can borrow for big loans, like a car loan or mortgage, and how much interest you’ll pay on those loans. Your credit score also affects your insurance rates, and in some cases, it can even impact your ability to get a job.
So ignoring debt and the impact it has on your credit score will just make things worse down the road — in many cases, a lot worse.
And the good news is that you don’t have to memorize phrases and definitions you don’t understand — this isn’t a test. If you take a little time to grasp just a few important basics, you can protect your credit from the potential dangers of debt.
Here are some things to keep in mind about debt:
Most people have to borrow money to buy big things — like a house — because that’s a lot of cash that most people don’t have lying around. But before a lender will give you that much money, you have to prove to them that you’re trustworthy. And the way you do that is by building a good credit history and good credit score.
Basically, your credit score represents how well you’ve managed all of your financial obligations in the past (credit card debt, loans etc.), as well as the likelihood that you’ll pay back a new loan.
To have a good credit score, you have to take on smaller amounts of debt and show that you can handle it responsibly. If you can, lenders will be more willing to give you a better deal on those bigger loans — which means you could get more money, a lower interest rate and lower monthly payments.
If you have a bad credit score, your options will be very limited, if you have any at all. So you’ll either have to pay a lot more each month or you won’t be able to get a loan at all, because the payments will be higher than you can afford.
There are several steps you can take to improve your credit score, but one of the best ways to build a good credit score is by taking on smaller debt and proving that you can handle it and pay it back — meaning you pay off the balance in full each month, so it’s back at $0 before the due date.
Paying attention to how debt will affect your credit score will not only help you maintain your overall financial health, but it will also help keep you on track to reach your long-term money goals.
Now let’s look at how each type of debt affects your credit score. This is where the difference between good debt and bad debt comes in.
Good debt vs. bad debt
In a nutshell, here’s the difference: good debt offers you some type of return that will improve your financial life in the future; bad debt is just money you owe that gives you nothing in return, not now and not in the future.
Let’s say you go on a shopping spree and you find a great deal on some shoes you really can’t afford, so you just charge it on a credit card (“It was a great deal; I’ll just pay it off with my next paycheck!”). Then the bill comes, and you can’t afford to pay it off. The balance then rolls over to the next month and interest charges kick in, which are added to the total balance. So that means that “deal” just got more expensive, and what did you get in return for the shoes? Just a big credit card bill — because, sorry, looking good doesn’t count.
Examples like this are why you probably hear a lot more about bad debt than good debt, but there is a big difference. And you need to understand that difference, because the way you handle your debts will determine the your overall financial health, both now and over time.
What’s good debt?
Good debt is when you use the money lent to you to buy something that offers a return on your investment.
A mortgage is considered good debt. Assuming the value of the house will go up over time, you’ll be able to make money when you sell it. You can also rent out the house and use the money to pay off the monthly mortgage payments, allowing you the opportunity to actually profit.
Student loans are also considered good debt. That may sound crazy town — but the reason it’s considered good debt is because you’re investing in your education so you can get a better, higher paying job in the future.
Credit cards can also be good debt — but in a different way.
When you use a credit card and pay it off in full and on time each month, it helps you build your credit history and credit score. It shows lenders that you can take on debt and handle it responsibly, which will help you get a better deal on other, bigger loans, like a mortgage, down the road.
It also improves your credit score, which makes lenders more likely to consider you a trustworthy borrower.
What’s bad debt?
Bad debt is basically when you use a loan to buy something that loses value over time or doesn’t offer you any return on the investment — so no way for you to make money on the purchase.
A loan to buy a new car is considered bad debt, because the car loses value the second you drive it off the lot. That’s why buying a used car is a better deal, unless you plan to keep a new car for at least 8 to 10 years.
Also, the debt on a car doesn’t help you buy more car down the road, because you won’t profit when you sell it.
Credit card debt
Credit card debt can also be bad debt — and it’s likely the kind of bad debt you hear about the most, because credit card debt can easily go from being good to very bad.
When you charge a bunch of stuff on a credit card and can’t pay it off each month — that damages your credit score.
Credit cards also have really high interest rates — so when you can’t pay your balance in full each month, the interest charges are added to the total balance. And the longer you carry a balance on the card, the more interest you’ll pay on your interest, which is when credit card balances can quickly start to get out of control.
Bottom line: The credit card isn’t really the problem, it’s how you use it that matters.
So whether your credit card debt is good or bad is up to you!
Using a credit card can have a lot of benefits — rewards, fraud protection and it can help you increase your credit score. But all of the benefits get canceled out if you don’t remember this one golden rule:
Only charge what you KNOW you can pay off in full, before the due date. Otherwise, that credit card debt can quickly spiral out of control and cause you big problems for a long time.
The dangers of credit card debt
So now you know the responsible way to use a credit card.
Easy enough, right? Not so much.
There are a few hidden dangers of debt that end up causing people big problems because they simply don’t understand how it all works.
But how would you know? The lender hands you a card with access to a bunch of money and then it’s up to you to read all the little tiny fine print and figure out how it all works.
And it’s not quite so intuitive either.
So let’s look at some of the dangers you need to understand about credit cards, in order to avoid getting yourself into a situation you can’t get out of, which could end up causing long-term damage to your overall financial life and prevent you from reaching your goals.
If you know how these factors work, it makes handling your debt much easier (ideally).
When you get a loan — it’s not just free cash, which we touched on earlier. But what many people don’t understand is just how damaging interest can be.
It probably wasn’t a topic you learned about in school, but maybe you’ve picked up on a few things and you understand the basic idea of interest.
But credit card interest is a totally different beast.
To make the best and most informed decisions in your own personal financial life, you just need to understand a few key elements of how interest works and how it can cause credit card debt to spiral out of control.
The basics of credit card interest: How it’s calculated
Interest is how lenders make a big chunk of their money, so the deeper in debt you get, the more money the bank makes. Here’s how it works.
Your credit card comes with an annual percentage rate — or APR (that’s your interest rate). A single credit card can actually have several APRs that are used for different types of transactions — one for cash advances, one for purchases etc. Lenders may also offer promotional periods, and when the period is over, the interest rate jumps — which means if you carry a balance from one month to the next after the period is over, you’ll pay more in interest — typically a lot more.
In general, credit card interest rates are typically pretty high — the average right now is around 15 percent, and some cards can carry a rate as high as 25 percent — in some cases, even higher. To give you some context, the average rate on a 30-year mortgage right now is about 3.4 percent.
The term APR is also a little misleading for new credit card users, because you don’t pay interest on an annual basis.
Let’s say your card has an APR of 15 percent. You don’t pay interest just once a year based on that 15 percent annual rate. Interest charges are actually calculated on a monthly basis, but since the total number of days in a month varies, most lenders calculate the interest daily.
Here’s how to figure out that daily rate (again, this seems complicated, but below we’ll tell you how to avoid even worrying about this!).
To get the daily rate, divide your APR by 365. Then to figure out how much interest you’ll owe, multiply that daily rate by your average daily account balance and by the number of days in the billing cycle. (You can get all this information from your credit card statement or account. You can also call the bank or credit card company and ask for these details on your account.)
The charges on your credit card will accrue interest over the course of the month. Let’s say you charge $1,000 on the first day of the billing cycle and you make no payments before the due date. That would mean your average daily account balance is $1,000.
15 (APR) / 365 = 0.041% (daily interest rate)
0.041% x $1,000 x 30 = $12.30
That may not seem like much, but the bigger the balance, the higher the interest charge. And when you don’t pay any of it off, the interest is added to the balance, which makes the next month’s interest charges even higher.
How to avoid paying interest
The high interest rate is a big part of why credit card debt is bad — or how it can turn into bad debt.
When you pay the bill in full each month — meaning you get the balance to $0 before the due date, the lender will usually waive the interest charges that accumulated over the month — so you wouldn’t owe any more than your total balance.
Using the same example from above: if you charge $1,000 on your credit card on the first day of the billing cycle and pay off the full $1,000 before the due date, you won’t get charged interest and the on-time payment helps improve your credit score.
So as long as you can pay the full bill every month, the high interest rate doesn’t really matter. The key though, is being able to pay the full balance on time every month!
Because remember, on the other hand, when you carry a balance on a credit card from one month to the next — you’re charged interest fees — and those quickly start to add up — thanks to the high interest rate.
2. Low minimum payments
One BIG misconception about the minimum monthly payments on credit cards is that if you pay the minimum each month, you avoid paying interest.
That is NOT how it works.
The minimum payment is the absolute minimum amount you are required to pay each month to avoid other fees, in addition to interest.
The minimum payments are also typically pretty low, which is good for the bank, not for you.
Here’s why: if you’re just making the minimum payments, interest is added each month and so those payments don’t reduce the total balance by as much as you think. And the longer you only pay the minimums, assuming you don’t charge anything else on the card, the longer it’ll take you to pay off the total balance and the more money you’ll pay in interest — which is just more profit for the bank.
Plus, when you carry a balance, it harms your credit score. (We have more details on this in our Credit Score guide.)
What happens when can’t make the minimum payments
Let’s say your credit card balance is $500 and your minimum payment is $25. If you don’t pay $25 before the due date, you’ll get charged interest and other types of fees — like a late payment fee. So that not only increases the total balance, but it also damages your credit. On-time payments account for 35% of your credit score, so late payments can cause your score to drop significantly.
If you do pay the $25, you’ll avoid late payment fees and late payments showing up on your credit report, but you still get charged interest on the total amount you owe.
How to handle minimum payments each month
The only way to avoid paying interest is to pay off the total balance, in full, before the due date. If you owe a total of $500 — you would need to pay off that $500 before the due date to avoid any interest charges.
But if you can’t pay the bill in full, try to at least pay more than the minimum payment — and really as much as you can afford each month — to get that balance down.
Although small fees and charges may not seem like a big deal, they do add up and they’re harmful to your credit score, which can prevent you from getting bigger loans down the road. And when your credit card balance starts to creep up — very easily getting into the thousands — it becomes more and more difficult every month to reduce that total amount you owe.
3. Learn not to rely on credit cards
Just because a credit card company gives you a card and access to a bunch of money, it doesn’t mean you should use it.
When you start using credit cards to maintain a lifestyle that you can’t afford, and you can’t pay the bills each month, that’s when the debt can quickly become a long-term burden on not just your financial life, but on many other aspects of your life as well.
4. Do not underestimate the power of credit cards
Many people make the mistake of telling themselves, “Oh I won’t spend too much” or “I can always pay it off later.” And that’s exactly why the average American family owes more than $16,000 in credit card debt.
I told myself the same thing — then maxed out a credit card. It took me about five years to dig out and also caused me to miss payments on other debts. So not only did I pay for it, in interest and fees, but I also damaged my credit score — damage that took me years to repair.
To get on a path to financial success, you have to start developing sustainable habits and living a lifestyle that you can afford. And believe me, it’s worth it, because things like debt may not seem like a big deal at the time — until it prevents you from living the life you want and reaching your goals when you want to reach them.
How to avoid the dangers of credit cards
1. Live below your means
If you reach the end of the month and:
can’t pay off your credit card bill in full
and/or don’t have money left over for savings
that means you are NOT living below your means — and actually, you aren’t even living within your means — and it’s time to make some changes.
2. Spend less than you make
To live below your means, you have to spend less than you make! It’s one of the most important fundamentals of money management.
It’s the only way you will get ahead and learn not to rely on credit cards. Don’t use a credit card to get you through the month if you can’t pay the bill when it’s due.
When you realize you’ve reached a point when you can’t pay your bills in full, stick the card in the freezer and start reevaluating your budget.
If you’re having a hard time controlling your spending — which is the case if you can’t pay your bills — then try sticking to cash. Using cash will force you to start spending only what you have and prevent you from just swiping your credit card any time you feel like it.
When you start spending less than you make, you’ll be able to pay off any debt you have and save more money each month.
3. Know when to say “no”
“Only this once” can be a very slippery slope, because “this once” is never just once — and it can turn into thousands of dollars in credit card debt before you even realize it’s happening.
Little expenses do add up over time — and we’ve already seen how interest can turn small expenses into huge debt.
You have to prioritize your spending — so those little expenses don’t prevent you from reaching your bigger goals.
Putting off a vacation may suck — but to keep your money on track, sometimes you have to pick and choose, or maybe just tweak your plans.
Bottom line: figure out what’s important to you and keep those things in mind at all times. Making sacrifices now is worth the long-term benefits to your wallet and your life.
Sometimes debt can feel like it’s not even real — until you totally run out of money or that debt prevents you from doing something big in life. So I promise you, it is real, and the sooner you pay attention to it, the sooner you’ll get ahead financially.
How to start paying off credit card debt
If you get into trouble with credit card debt, here’s how to start paying it off.
1. Make a plan
Depending on how much you owe, give yourself a timeline of 5 years or less — any longer can make it really difficult to stay on track.
Reevaluate your budget so you can put as much money toward your credit card debt as you can — while still setting aside money for savings.
One general rule of thumb is for every $2 you put toward debt, put $1 into savings — until your high-interest debt is completely paid off.
2. Which card to pay off first
If you have more than one credit card carrying a balance, start with the card that has the highest interest rate.
That one is costing you the most money.
Put as much money as you can toward that card each month, while still paying the minimums on the other cards — and saving, too.
When that card reaches a zero balance, then move on to the card with the next highest interest rate, and so on.
Important note: any time you pay off a card in full, don’t close the account — that will hurt your credit score. Just let it sit at a balance of $0.
3. Find extra money to put toward debt
Paying off debt, while saving and paying your other bills, can be tough — so finding ways to both reduce your expenses and increase your monthly income can be a huge help.
If you want to avoid credit card debt spiraling out of control, you have to take a step back and be honest with yourself.
The key to using debt in your favor is to never charge or buy more than you can afford. It’s extremely tempting , and that’s why it causes so many people so many problems, me included.
Diligence isn’t easy, but it can change your life — and it will strengthen your relationship with money over time. It’s like ignoring a call from your ex: Every time you do it, you feel a little more powerful!
The key is to make sure debt doesn’t prevent you from reaching your big goals in life — because that’s when you’ll regret those frivolous credit card purchases and kick yourself for ignoring your budget.
A shopping spree and a couple vacations can turn into years of debt — so start preparing for things by saving up ahead of time, that way they won’t become regrets down the road.
And you don’t have to do it alone! Make it a team effort – find a family member or friend, whoever, to help keep you in check. A little support can really go a long way!