Kimberly Palmer

The new rules of debt management are more complicated than "good" and "bad" debt

In the wake of the recession and mortgage crisis, it's easy to forget that all debt isn't bad. In fact, in certain situations, taking on debt can be a good thing. Student loans and, in some cases, using credit cards, can catapult a person into the next stage of her career.

Meanwhile, exposure to the dark side of debt, including fees and interest payments, can be limited through careful management. Making debt work for you instead of against you just requires some advance planning and a little research.

Here's a guide to figuring out how much debt to hold onto to -- and when to get it off your back:

How much is your debt costing you?

Make a list of all your debt, along with the interest rates you're paying. For each entry, multiply the total debt by the rate to figure out how much it's costing you each year. If you have $30,000 in student loans with a 3 percent interest rate, you're paying about $900 a year. For a $10,000 car loan with a 6 percent interest rate, you're paying about $600.

Next, take a look at the rest of your money. Given the relatively low interest rates on savings accounts and even money market funds, you can probably save money by paying off any high-interest rate debt with savings. For example, paying off that car loan gives you an automatic 6 percent return on your money.

The decision to pay off debt is also influenced by other goals. If you plan to make a major career change or buy a house soon, then you probably want to have more cash in the bank. Holding onto the lower-interest debt, such as the student loan debt, might allow you to save more for those goals.

What kind of debt should you have?

While student loan debt tends to come with lower interest rates than credit card debt, generalizations don't always hold up: Not all student loan debt is "good" debt, and not all credit card debt is "bad" debt. Even Carmen Wong Ulrich, author of Generation Debt and the forthcoming The Real Cost of Living, says credit card debt is what allowed her to support herself after she graduated from college. "Money for the futon had to come from somewhere ... I had to start my career and I couldn't live at home, so I needed a place to sleep, and a couple good outfits to go on job interviews," she says, adding, "As much as I write about debt, I don't think it's a monstrosity. It can be a tool."

Student loans are also more complicated than they appear at first glance. They can be some of the cheapest forms of debt, especially when they're subsidized by the federal government. But the growth of the private loan industry in recent years means that many students graduate with some of their loans locked into interest rates that are over 10 percent, which can make them as toxic as credit card debt.

To make matters even more complicated, explains Zac Bissonnette, author of Debt-Free U, loans with the lowest rates right now are often the private ones because they're variable-rate loans, which means those rates can quickly shoot upward. "They have massive amounts of interest-rate risk, and the current low-rate environment makes them look a lot friendlier than they are," he warns. Plus, private loans come with none of the forgiveness or hardship repayment flexibility that federal loans sometimes offer, which is why they should be a priority for paying off -- even if they currently feature a low interest rate.

When should you pay it off?

Forget the old rules about what's "good" debt or "bad" debt, and look at each of your loans separately. How much are they costing you? Could the interest rate suddenly spike? Pay off the expensive ones -- or the ones that could become expensive -- as soon as possible. While Ulrich's credit card debt helped get her started in the workforce, she paid it off as soon as she could by focusing on the highest interest-rate debt first.

Living a debt-free life

Gregory Go, 33, co-founder of the personal finance site wisebread.com, started living debt-free after paying off the $10,000 of credit card debt he had accumulated during college. It took him three years of making small payments while working a $10-an-hour, help-desk technician job, but it felt so good that he's avoided taking on any new debt since.

He makes do with a 15-year-old Honda Civic and lives with a roommate outside of Los Angeles -- but he says he doesn't feel like he's sacrificing. When he compares his situation to that of friends with new cars and homes, he says, "I look at them and I don't want to be in their shoes. Some friends bought homes at their peak, and now are regretting it."

While he's had inklings of jealousy in the past, he says he'd still rather live debt-free than be in their situation. For Go, calculating his optimal debt level is easy: It's zero.

This article is adapted with permission from Kimberly Palmer's new book Generation Earn: The Young Professional's Guide to Spending, Investing, and Giving Back .

Available at Amazon.com:

Lifecycle Investing: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio

Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals

Spend 'Til the End: The Revolutionary Guide to Raising Your Living Standard--Today and When You Retire

The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work, and Living

Generation Earn: The Young Professional's Guide to Spending, Investing, and Giving Back

 

Personal Finance - How to Find Your Optimal Debt Level

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