How to Know If Your Debt is Good, Bad, or Ugly

How you react to the word “debt” is likely related to a bad experience you have had, or something your parents taught you; that all debt is bad. On the other hand, maybe you’ve seen someone use debt strategically with great success and explain to you how debt can be good.

Both of these can be true, but emotional reactions that leave you terrified of debt could make it harder for you to reach your lifetime goals. The key is managing your debt. What you choose to accumulate as debt can move you closer to or further from your financial goals. This is when working with an advisory firm like HCR Wealth Advisors can provide valuable guidance

In reality, debt is neutral. What makes it good or bad is not how you react to it emotionally. It depends on:

  • how and why the debt was incurred, and
  • whether you can pay it off.

So, What Exactly is Debt?

Debt is unemotionally defined by Investopedia as “… an amount of money borrowed by one party from another. Debt is used by many … individuals as a method of making large purchases that they could not afford under normal circumstances.”

Very few of us are genuinely debt-free. If you are carrying a student loan, a mortgage or a car loan, you already know what debt is. But debt also includes smaller obligations: credit cards, personal loans or loans from friends and family.

Your debt may have been incurred for a carefully analyzed major purchase, say for a home, or a college degree. Or it may have resulted from living beyond your means with the financing with credit cards or small personal loans. But even debt taken on for all the right reasons can turn bad. Again, it depends on how you manage it.

The reason you want to manage it smartly is that your credit score will influence virtually everything in your life. No one knows this better than HCR Wealth Advisors. Whether it’s the quote the insurer gives you for your car insurance, or the decisions by job interviewers or rental apartment owners, your credit score plays a role.

The insurance company, employer, apartment owner and anyone else thinking of entering into a financial arrangement with you wants to know one thing: how well do you handle your money? Yet if you have no debt, you have no credit history and credit history is what determines your credit score.

Good Debt and Bad Debt

Still, debt is often split into ‘good debt’ and ‘bad debt.’ Forbes uses this distinction: “good debt benefits your financial future, while bad debt harms it.”

Good debt usually includes:

  • Mortgages
  • Federal and private student loans
  • Loans to buy appreciating assets

Bad debt usually includes:

  • Credit card debt
  • Small, personal loans
  • Most home equity loans and HELOCs
  • Auto loans for new and used cars
  • Payday or pawnshop loans

But, the division is not that cut-and-dry. What if a family loan you can pay back comfortably lets you take advantage of an opportune purchase you’d otherwise miss? Would that family loan be ‘bad?’

Or say you have the funds you need for a major expenditure, but you decide to leave them well-invested in the stock market and take out a home equity loan instead. If the investment would bring a higher return than the cost of interest on the home equity loan, could taking on ‘bad’ debt be justified?

These debt decisions are even easier to make when they’re part of a financial strategy you’ve designed with a team like HCR’s.

Let’s look at each of the different types of debt to see how they might fit into your financial picture.


A mortgage is considered one of the best types of debt you can take on. You are purchasing an asset that generally increases in value over time, plus you have somewhere to live.

You buy your house, pay for some of its cost in down payment and finance the rest. Years later, you sell at a profit, and you calculate the return on investment based on how much you paid in, not on the cost of the house. It can be good debt and historically, it has been.

However, the 2008 housing crisis shook that belief for all who found themselves upside down — with their homes worth less than the balance on their mortgages. Over 7.7 million people lost their homes to foreclosure between 2007 and 2016. That kind of crisis does not happen in a vacuum, so the entire economy suffered. Jobs were lost and anyone who was highly leveraged with debt was in trouble. Even today, nearly 40 million U.S. households own a home they can’t easily afford.

Lenders like to see a mortgage in your debt portfolio because of the stability it signals. But a mortgage makes the most sense when it’s part of a comprehensive roadmap to financial success, like the ones HCR builds using its all-encompassing Clarity Formula.

Without a framework, the risk of defaulting on your mortgage and facing foreclosure is increased. And that would hit your credit score hard.

If you feel your mortgage payments are at risk, consider finding a local HUD-certified housing counselor right away. They know of local programs that might help, such as mortgage payment assistance programs. In the worst case, they can help you do the least possible damage to your credit with options such as approved short sales.

Home equity loans and HELOCs

A home equity loan or Home Equity Line of Credit (HELOC) is a loan against your existing property. As a second or third mortgage, it decreases your net worth and raises your risk of foreclosure.

Using your home’s equity to pay down credit cards or other short-term debt is not good debt, even if it improves the interest rate. You will have only converted unsecured credit card debt into secured mortgage debt.

But using equity to make home improvements that increase the value of your home may qualify as good debt. One suggestion: you might want to first check with local realtors to understand how much of the improvement’s cost will reflect in your home’s increased value.

Auto loans

Unless it’s near the end of the month or model year — when car dealers want to make their quota or clear out inventory — car sales associates will put extreme pressure on you to finance your purchase with them. They’re not interested in cash sales, because much of their profit is in the financing, not in the sale of the car.

If financing is that good for them, how good can it be for you? Especially when the asset you’re buying loses a hefty part of its value when you drive it off the lot. With a car loan, you are increasing the price you pay for the car — in the form of interest charges — while its value drops.

Everyone loves a new car, but if you look at the numbers, you may find that buying a well-maintained, used car may make more sense (especially if it keeps you aligned with an HCR-style plan for financial well-being). It gives you the reliable transportation you want without leaving you with an immediately-upside-down asset where you owe more on the car than it’s worth.

Student loans

College degrees have traditionally been marketed as significantly increasing your lifetime earning potential. College Board says that, compared to those without a degree, on average, people with bachelor’s degrees also move up the socioeconomic ladder more quickly, and even live a healthier lifestyle.

Yes, more income means more opportunity to invest and increase your net worth. But a college degree is no guarantee you’ll get a great job after you graduate. And with the rapidly escalating costs of higher education, taking out student loans (whether Federal or private) can no longer be the default decision, it has to be measured carefully.

Federal loans cannot be written off in bankruptcy. Unless the rules change, they are long-term loans that have replaced 30-year mortgages for many people who are early in their careers. And, as HCR Wealth Advisors will tell you, getting on the right financial path early makes the rest of the journey much easier.

Today, 45 million borrowers owe over $1.5 trillion in student loan debt. Nearly 70% of seniors graduate with debt, and, in 2019, the default rate (90+ days delinquent) was 11.4%, the majority of which were people forced to drop out for some reason.

If you find your student loans turning ugly, explore federal repayment plans that can stretch payments out or reduce them early on in your career when your salary is lower. Many income-driven hardship repayment plans are also available, and private lenders offer student loan refinancing that consolidates debts. If this is the path you decide to take, just be sure you are improving your debt situation in doing so.

Credit card debt

Having a credit card is becoming almost mandatory in our app-oriented world. Many reservations and payments require one. Car rental agencies even require credit cards to the point of not allowing debit cards. So, credit cards have their place.

If you pay off your credit cards each month, as HCR would recommend, they do not generate debt. If you are not paying off your credit cards each month, you are accumulating bad debt. Rarely do you use a credit card for anything that has any long-term appreciation and resale value and taking on debt to cover daily needs is a red flag of possible financial instability.

Even if using a card does mean you can close out this month’s expenses, you are moving that debt forward (along with interest charges) and creating a snowball effect.

Credit cards carry among the highest interest rates of any form of debt, ranging from 12% to 30%, and the appeal of ‘minimum payments’ paired with those high rates can double or triple the cost of whatever you bought.

If credit card debt is turning ugly, look for available debt relief programs. They come in two forms: debt management and debt settlement. Debt management helps you pay back everything with the least amount of credit damage, often by reducing or eliminating interest charges. With debt settlement, you pay a negotiated percentage of what you owe. It may seem fast and cheap, but it will damage your credit score. Consider professional help and research that help thoroughly.

Payday loans

Payday loans are small loans usually no more than $500 that are used to help get you to the next payday. These short-term installment loans often start a chain where the last one is paid off and another is undertaken. Fees are reported as $10 to $30 for every $100 borrowed, or the equivalent annual percentage rate (APR) of over 300%.

While a payday loan may keep a roof over your head or your car on the road, there is no circumstance under which it’s not a distress signal.

Pawnshop loans

While these loans make for good television, they cry ‘emergency’ in real life. They are collateralized loans. You take an item of assessable value to a pawnshop and they give you a loan worth about one-third of what they can sell it for, all while holding your item as collateral. If you don’t pay back the loan within a defined period, with interest and fees, they can sell the item.

Pawnshop loans may be a solution for short-term cash if you are among the 80% who reclaim their property. But the cost of the short-term loan puts the transaction in the category of financial distress.

Ugly Debt

Ugly debt isn’t a type of debt and it doesn’t necessarily result from too much ‘bad’ debt. What turns things ugly is any time you cannot keep up with debt payments. First, you fall behind and you’re assessed late fees. Then the phone calls begin. You end up in collections, then possibly facing repossession or foreclosure, and bankruptcy.

At the first sign of pressure from burdensome debt payments, your reaction should be to find out what’s causing it. It’s one of two things: either your every day, non-debt spending is out of proportion or you have too much debt, period.

So, how can you tell where the problem is coming from?

Measuring Your DTI Ratio

One way is to use a tool most banks and other lenders use to measure your debt load: your debt-to-income (DTI) ratio. DTI is part of the calculation mortgage lenders use to determine your creditworthiness, along with your credit score.

They are evaluating whether you can afford to take on another payment. A lower debt load means more borrowing power. If your DTI is too high, it could indicate that you are in financial difficulty.

In our case, we are using it to understand how much of a burden your debt load is.

Your DTI compares your total monthly debt to your total gross monthly income before taxes and comes up with a percentage. Some variations exist in what exactly makes up a DTI ratio, the main one being whether your housing costs are included in the calculation.

Let’s follow the procedure used by one major bank.

Make a list of all the monthly payments you make.

Here’s what should not be on your list:

1. Add up the total and divide by your gross monthly income (before taxes). Income sources can include:

  • Wages
  • Salaries
  • Pension
  • Social Security
  • Child support and alimony
  • Bonuses or tips
  • Any other income

2. Multiply your result by 100 to get your DTI ratio as a percentage.

A standard guideline from HCR Wealth Advisors is to keep your DTI ratio below 35–36%. The bank in question considers 35% or less to mean your debt is at a workable level. At 36–49%, it leaves room for improvement as you are likely unable to handle unforeseen expenses. Over 50%, you need to take action; you have limited funds to save or spend, much less to cover potentially unforeseen expenses.

How to Manage your Debt

If you determine that your debt payment difficulties stem from overspending on everyday expenses, get them under control by living on a tighter budget. But if they are from too much debt, your first step is to face the numbers.

Your next step should be paying down your bills. Here are steps to get your debt under control:

  1. Budget: If you don’t already have a budget, create one. Look to see where you can cut costs and save money that you can use to make inroads on lowering your debt balances. Start with the most urgent and highest-interest ones first.
  2. Know your numbers: The DTI exercise will have helped you identify the degree of danger you are facing with your debt. If it is high, consider finding a financial counselor you can talk to about your best options.
  3. Contact lenders: Talk to your lenders early, preferably while you are still paying bills on time. They might lower your interest rates. Even if you’re behind, try to negotiate better terms to avoid them, and you, having to face future collection costs.
  4. Learn your options: Debt consolidation or refinancing are options to consider. They may lower interest rates or result in simplified, one-payment billing.
  5. Exceed minimums: Every extra dollar you can pay towards debt — beyond the monthly minimums allowed — accelerates how fast your debt starts dropping.
  6. Increase income: Whether it’s a side gig or a raise at work, your DTI ratio drops the moment you have more money coming in. It’s money you can use to pay down debt faster.

Life has a way of throwing curveballs when we can least afford them. Whatever decisions got you into debt, the solution is not to waste time beating yourself up. It’s important to remember that it took you some time to get into the situation you’re in and it’ll take some time to get out of it.

In the future, before taking on new debt, ask what return you can expect. What will life look like with the new debt? How can things go wrong? Having a plan in place moving forward may not initially decrease your debt, but it can greatly decrease the negative impacts of that debt. Debt is not fatal and the sooner you start taking steps to pay it off, the sooner you can begin participating actively in the economy and reaching your financial goals.

Ask any of the financial veterans at HCR Wealth Advisors. They’ve seen just about every kind of turnaround imaginable.

Originally published at on January 27, 2020.

*This article is for informational purposes only and should not be considered investment advice.