According to the Federal Reserve Bank of New York, total American household debt equaled $16.51 trillion in the third quarter of 2022, a 2.2% increase over 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 properly,” Michael Tanney, senior managing director of New York-based Magnus Financial Group, says.
But like most powerful tools, if you use it incorrectly it can hurt you. It’s essential to take on debt for the right reasons and under the right guidance, he says.
When you use 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’s good debt and bad debt. Good debt includes loans — like mortgages, student loans and small business loans — that enable you to purchase an asset with the potential to gain value over time. (In the case of student loans, you’re gaining access to a career that will likely afford you higher potential earnings.)
Bad debt typically includes high-interest financial products — like credit cards — you use to purchase items that decline in value or that you quickly consume. This type of debt can become a drag on your finances and prevent you from meeting other financial goals.
Grant Sabatier, creator of the personal finance blog Millennial Money and author of “Financial Freedom,” says that when we hear about bad debt, it’s usually regarding credit cards with high interest rates.
When you make only minimum payments on credit card accounts, the amount you owe continues to grow and compound rapidly and can put you deep into debt before you know it. Bad debt also includes payday and other predatory loans, Sabatier says.
How to Build Wealth When You’re in Debt
When you use debt property, it shouldn’t prevent you from increasing your net worth over time. Follow these steps to take control of your debt and get ahead financially.
Pay Down High-Interest Debt First
If you’re carrying balances on your credit cards, stop using them for a while. Direct your funds toward paying down those balances each month, starting with the highest-interest card first.
Credit cards can serve as a great tool to improve your credit score, maximize cash flow and rack up rewards points. But if you’re carrying a balance every month, the interest cost will typically outweigh any of those benefits. Switch to using a debit card or cash until you pay off your cards.
[READ: Easy Ways to Pay Off Debt.]
Set Aside Savings
Setting aside from three to six months of savings will help prevent you from going back into debt if an emergency — like an unexpected home repair or job loss — arises. Aim to put some money into your emergency fund each month and at least enough into a retirement account to take advantage of your employer’s match.
“You don’t want to use an all-or-nothing approach to paying down debt that would alienate your other financial goals,” John McCafferty, director, financial planning at Edelman Financial Engines, says.
[READ: How Your Employer Can Help You Build Emergency Savings.]
Take On Additional Debt Only 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 of money you want to borrow and whether you’ll have the resources to pay it back. For example, if you’re going back to school and taking out a loan, make sure your projected salary after graduation will enable you to comfortably make the payments.
[Read: Best Private Student Loans.]
Don’t Eliminate Your ‘Good Debt’ Too Quickly
If you were one of the millions of Americans who took advantage of record low interest rates in the past decade and secured a mortgage at a rock-bottom rate, don’t rush to pay it off.
Instead, put that money you would use to pay down your mortgage into a high-yield savings account. You could earn up to 4% interest that way, which would be a higher return than you’d get paying off a 3% mortgage. Or, invest the 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% per year, depending on the time period that you look at,” Paul Dietrich, chief investment strategist at B. Riley Wealth, says. “If your debt is less than that, you might focus on investing instead.”
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How to Use Debt to Build Wealth originally appeared on usnews.com
