4 Ways Bad Debt Is Stealing Your Freedom
Bad debt can have a knock-down effect on your personal finances. Learn more about how bad debt could be hurting you.
Contributing Writer at Tally
October 6, 2021
Not all debt is the same. There’s a difference between good debt and bad debt. If you’ve borrowed money or plan to in the future, it’s important to understand the difference between the two.
Even though you're borrowing money from a lender, there are some benefits to taking on good debt. On the flip side, taking on bad debt could be harming your personal finances.
In this article, we outline everything you need to know about bad debt, including how it differs from good debt and four ways it's hurting you. We also dive into why it's important to pay off bad debt and how you can go about doing so.
Comparing good debt and bad debt
Both good debts and bad debts are debts from the money you've borrowed from lenders. You're responsible for paying these debts off. Good debts are those that increase your income or your net worth. They typically have comfortable repayment schedules and favorable interest rates.
Examples of good debt
One example of good debt is a mortgage. Mortgage rates are typically low. You end up repaying the loan over a span of 15 or 30 years. When you pay off your mortgage, you've purchased a tremendous piece of equity that you can then:
Continue to live in
Sell, often for a profit
Pass along to your dependents
By buying a house, you've increased your net worth. Student loans are another example of good debts because investing in your education can increase your income.
Examples of bad debt
Bad debt, on the other hand, is the opposite. Bad debt is used to purchase depreciating assets. It comes with unfriendly repayment schedules and high interest rates.
Credit cards are an example of bad debt. The annual percentage rate (APR) on a credit card can be upward of 25%. If you don't repay your balance in full within one statement cycle, that interest begins to compound.
Uncollectible accounts receivable
It's also worth noting that there's a more technical definition of bad debts that you may see. Lenders or providers often refer to bad debt expenses as an account receivable that is uncollectible. The lender may have extended the borrower too much money, or the borrower may have misrepresented their ability to repay, perhaps by lying about their gross income.
These "doubtful debts" impact a lender's bookkeeping, as it requires them to take bad debt deductions and debt write-offs on various financial statements, such as:
For the sake of this article, we refer to bad debts more broadly as those that don’t increase your income or net worth. We're more worried about how bad debts impact you as an individual instead of technical things like accounting principles, write-off methods and accrual allowance methods.
The similarity between the general and technical definitions is that you're more likely to fall behind on these debts because of the high interest rates and poor repayment schedules. If you fall far enough behind, you won't be able to repay your debts and may need to default. Depending on the amount of bad debt you write off, you can cause considerable harm to your credit score.
4 ways bad debt is harming your personal finances
Many people take on bad debts out of necessity. Perhaps an unexpected medical bill arises and you don't have the cash flow needed to cover the expense. However, bad debts can impact your personal finances significantly, including the following four ways:
1. You pay more in interest
As mentioned, bad debts often have high interest rates. The longer you carry these balances, the more you pay in interest. Interest associated with bad debt is basically wasted money.
The interest associated with a good debt is a bit more justifiable since it should eventually increase income or net worth. However, the interest related to bad debt is money you're paying a lender without getting anything in return.
2. Too much of your income is wrapped up in debt
Lenders will look at your debt-to-income ratio when determining whether they should lend to you. Your debt-to-income ratio measures how much you borrow compared to how much you earn. Lenders typically want to see this number below 36%. If you're looking to buy a home, in most cases, the number is required to be below 43% for a Qualified Mortgage.
Borrowing money may seem helpful at the time, but it can impact your ability to secure future lending. Keeping your debt-to-income ratio low is typically something to strive for.
3. You miss out on savings and investing
By paying interest unnecessarily, you might miss out on the opportunity to save and invest. If you save and put the money into a rainy day or emergency fund, you'll reduce the likelihood of having to take on future debts.
Additionally, by paying money in interest, you can miss out on investment gains. For example:
Let's say you pay $500 in interest on a credit card one year. If you didn't have to pay this interest, you could invest it.
From there, let's estimate that the investment earns 8% a year for 10 years.
Your initial $500 would be worth $1,079 — more than double in value.
4. You put yourself at risk of future debts
Bad debt is risky because the more your income is tied up in debt, the more difficult it becomes to repay your debts. For instance:
Let's say you have 50% of your income tied up in debts.
You then have a medical emergency and open a new line of credit to pay for this expense.
Now, debts make up 55% of your income. If you happen to abide by the 50-30-20 budgeting rule, you won't have enough money to cover your most basic living expenses (or you won't have enough money to pay down your debts).
The more you borrow, the less likely you are to be able to repay. This then drives you to borrow more. It's a vicious cycle that can be difficult to escape.
Why paying off bad debt is important
The more you rely on bad debts, the more challenging it is to escape the cycle of debt. By taking on debts, you increase your credit utilization ratio and lower your available credit, both of which impact your credit score.
Fortunately, there are tools available to help you manage your personal finances and pay down your existing credit card debts. One such tool is Tally†. Tally is a credit card payoff app that offers a lower-interest line of credit to help repay your higher-interest credit card debts more quickly.
Start paying down bad debts today
If you borrow money, it's important to understand the differences between good and bad debts:
Good debts are those that can result in an increase in income or net worth.
Bad debts are those associated with depreciating assets. They don't yield any equity and often come with high interest rates and unfriendly repayment schedules.
Taking on bad debts can harm your personal finances. You pay more in interest, which not only prevents you from saving for long-term financial goals but also increases your likelihood of needing to borrow more money in the future.
If you currently carry bad debt, Tally† can help you get on the path to financial freedom. Tally rolls all your credit card debts into one monthly payment, repaying them for you using the debt avalanche method and ensuring you don't miss minimum payments.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.