Debt Differences (& What To Pay off First)

Jan 11 2021

Debt has become a bit of a 4-letter word when it comes to financial planning, but not all debt is created equal. Our article explains.

Debt Difference

Is Your Debt Healthy or Unhealthy?

If you’re trying to get your financial health in order, debt is a big factor. If your financial obligations are tied up in credit card bills, for example, it can be harder to focus on your long-term financial goals and find the financial peace that can come with intentional planning.

But not all debt is inherently “bad.” Some types of debt can actually be considered healthy.


What Makes Debt ‘Healthy’?

Healthy debt is any kind of investment that will grow in value or provide long-term income.
A mortgage, whether for a home or a business, could be considered healthy debt. Along those same lines, student loans can be considered healthy debt if you use the degree to find a job that produces a higher income, and small-business loans can be considered healthy debt if they lead toward income production.

Interest rates are usually lower and terms are typically more favorable for loans that might be considered healthy debt. They can sometimes offer tax advantages, too.

A home equity loan used to improve your home can be considered healthy – especially if the rates are favorable – because it would add value to your property.

But keep in mind, even with “healthy” debt, it’s important to make good choices. If you make yourself house-poor buying a home outside of your means, or if you take out student loans but don’t end up using the degree (or even finishing it), then you could be taking on debt that doesn’t provide value.


What Makes Debt ‘Unhealthy’?

Unhealthy debt is typically used for things you want, not necessarily what you need …
and it often comes with a higher interest rate.

Credit card purchases, payday loans, cash advance loans and other high-interest loans can all be types of unhealthy debt if you let them accumulate. That can be harmful, luring you into a debt trap you have a hard time escaping.

Americans average thousands of dollars in credit card debt with interest rates well into the double-digits. If you’re focused on paying off purchases you made in the past, it can be difficult to work toward your financial goals and save for the future.


What About Other Kinds of Debt?

Some types of debt fall into a gray area – not necessarily healthy or unhealthy.
This includes debt such as vehicle loans, 401(k) loans, debt consolidation and medical debt.

A vehicle depreciates in value, but it might be necessary to get to work or do your job. Making smart decisions about the vehicle you buy, how your debt is structured and your ability to pay it off can determine whether this type of debt would be considered healthy or unhealthy. Car loans with especially high interest rates (over 6 %) would be considered unhealthy debt.

A 401(k) loan is better for your financial health than taking out a high-interest loan, but if you don’t pay it off within 5 years, it becomes taxable income. And if you’re using the loan for something you want instead of something you need, you would be borrowing on your retirement funds to get yourself into unhealthy debt.

Debt consolidation can be healthy if you’re able to find more favorable terms – such as through a home equity loan. But you also have to change the habits that lead to the debt. Sometimes people think of debt consolidation as “clearing the slate,” and they end up taking on more debt. If possible, avoid using debt to pay off debt, and instead try to earn more money and cut back on your spending.

Medical debt also falls into a gray area. It’s often unavoidable, but even if you’re on an interest-free payment plan, it doesn’t benefit you financially. When applying for jobs, make sure you consider benefits as well as salary. With rising healthcare costs, it’s especially important to pay attention to an employer’s health insurance plan.

(Learn about Bell Bank home equity loans and lines of credit here.)

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How To Get Out of Debt & What To Pay Off First

Debt – especially if it’s unhealthy debt – can feel like a heavy burden, taking a toll on your financial (and emotional) health. It also affects your credit score, and if you need a loan for something like a home or car, debt could have an effect on your interest rate and how much money you’re able to borrow.

The key to getting out of debt is to change the habits that got you there in the first place. You need to be intentional about how you spend your money, making sure to spend less than you make and focus on essentials – including savings and debt payment – before expenses that aren’t necessary.

Also, consider getting creative. If working an additional job or finding a job that pays more aren’t feasible options, could you monetize a hobby or side gig to make a little extra money doing something you enjoy when it fits into your schedule?


Pay Off This Type of Debt First

When paying down debt, focus on unhealthy debt first. Once you’ve knocked that out, put more money toward debt that falls into the gray area before tackling healthy debt.

Shoot for a debt-to-income ratio of 36% percent or less. That’s total debt (healthy, unhealthy and gray debt) divided by your monthly income before taxes and other deductions.

For example:

Optimize Debt Ratio

Be careful not to sacrifice your retirement plan in order to pay off debt. While paying down debt is important, so is building resources for future retirement income.

4 Steps for Paying Down Debt While Saving for Retirement

Many people say it is harder to plan for retirement than to stick with a diet and exercise plan. One study reports some even say winning the lottery is part of their retirement strategy!

Contrary to what some may believe, it is possible and essential to both plan for retirement and pay down debt – and it’s not as hard as many think. Also,planning – and sticking to – a strategy to dig yourself out of that debt burden can give you a sense of control over your finances and help you feel more empowered about your financial future.

Debt Difference

Here are 4 steps for paying down debt at the same time as saving for retirement:

1. Look at your budget to figure out where you have some flexibility.

Identify must-pay expenses first. From what’s left over, allocate funds toward both saving and paying down additional debt. Make sure you take out money for saving and paying down debt before spending on other things. If you wait to see what’s left at the end of the month, chances are you won’t have much, if anything.

Take advantage of tools such as apps or our handy budgeting worksheet to help with budgeting by doing the legwork for you.

2. Take full advantage of employee-sponsored retirement plans.

Put at least the amount your employer will match into a retirement plan, so you don’t leave any “free” money on the table. If you don’t have an employer-sponsored retirement plan, you can still contribute to an individual retirement account (IRA).

3. Try to pay more than the minimum balance on higher interest debts, like credit cards.

There are 2 common strategies for paying down debt: the debt snowball and the debt avalanche.

With both options, you pay the minimum balance on all but 1 debt and pay as much as possible toward that 1 debt until it’s paid off. Then you add the amount you paid on that debt to the amount you pay on your next debt until that one is paid off. Repeat the process until all debts are paid.

  • Understanding the Debt Snowball

Made popular by financial author and radio host Dave Ramsey, the debt snowball involves paying off the debt with the smallest balance first to motivate you to continue tackling your debt.

  • Understanding the Debt Avalanche

The debt avalanche involves paying the debt with the highest interest rate first to save you the most money on interest over time.

  • Which debt payment strategy is the best?

Both the debt snowball and debt avalanche will help you pay down debt, so the best strategy really depends on what will motivate you to continue. If receiving fewer bills will help you stick with your debt pay off plan, then opt for the debt snowball. If you’re more motivated by paying as little on interest as possible, then the debt avalanche might be your best bet.

4. Stick to your budget as you slowly step up debt payments and savings.

If you get a bonus, raise or any other “extra” income, instead of adding it into your budget and spending it, use some of the money to give your retirement savings a boost, and use the rest to pay off your debts faster.

Remember, while paying down debt is important, so are steps that build resources for future retirement income. If you focus only on debt repayment, you risk starting investing too late and don’t give yourself time to build your retirement assets.

Even small, regular contributions to a retirement savings plan can make a big difference over time. As the following chart shows, when you’re young, time is on your side, and the money you save has many years to grow and accumulate earnings. The longer you wait to save for retirement, the more you will need to “catch up” later to get to where you need to be.

What to Do If Your Debt Is Healthy, Unhealthy or Somewhere in Between

Many people have a combination of different types of debt.

If your debt is healthy, you’re on the right financial track. Ensure you stay there by meeting with 1 of our wealth management professionals, who can answer your finance questions and talk to you about things like insurance, investments and planning for retirement.

If your debt falls into a gray area, work on paying it down while also making sure to save for retirement as well as unexpected expenses. Building an emergency savings account can help you avoid additional “gray area” debt in the future. Our financial advisors can help guide you in the right direction.

If your debt is unhealthy, you’ll probably have to make some lifestyle changes to pay it off as soon as possible, but consider it an investment in your financial health. Bell’s financial planning experts can help you figure out how to pay down your debt, make healthier financial choices and work toward your financial goals.

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 To take the first step toward a healthier financial future, connect with a Bell Bank financial planner near you.

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