What’s the Worst Kind of Debt?

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This post comes from Gerri Detweiler at partner site Credit.com.

What is the worst kind of debt to carry? Is it student loan debt, credit cards, a mortgage — or something else? Even the experts don’t always agree on which debts are “good debt” and which ones are “bad,” so imagine how confusing it can be to consumers who are dealing with debt.

Student loan debt

Why student loan debt is the worst: The loans are often given to young people with no credit experience and no clue how they will pay them back. Balances are often high, and the jobs borrowers counted on to make payments may be nonexistent. (Some borrowers never graduate, which means they have debt but no degree to increase their earning power.) Finally, unlike every other type of consumer debt, it is very difficult to discharge balances in bankruptcy.

And why it may not be: College graduates, on average, still earn significantly more over their lifetimes than those without a college degree. In that sense, student loan debt can be considered an investment that pays off in future earning power. In addition, students may be able to defer payments on their student loans during times of economic hardship (albeit, usually at a cost), which makes them more flexible than other types of loans. In addition, borrowers may be eligible for reduced payments and loan forgiveness under the Income-Based Repayment Program or other loan forgiveness programs.

How does student debt affect credit scores? Even large balances typically don’t hurt credit scores as long as the payments are made on time.

Credit card debt

Why credit card debt is the worst: With interest rates hovering around 15 percent on average — and more than 20 percent for some borrowers — credit card debt is often the most expensive kind of debt consumers carry. And with the low minimum monthly payments that issuers offer, cardholders can find themselves in debt for decades if they aren’t careful.

And why it may not be: While making minimum payments on credit cards is not a great idea over the long run, having that option can come in handy in a financial pinch. It can give cardholders time to get back on their feet without ruining their credit.

And when consumers can’t pay back credit cards, they don’t have that much to lose — at least when compared with falling behind on a home or auto loan. Sure, a credit card issuer may be able to sue a cardholder to collect, but that usually happens only after months or years of not paying, and after there’s been an opportunity to work out some kind of settlement on the debt.

As far as credit scores are concerned, as long as cardholders keep balances low (usually below 10 percent to 20 percent of their available credit) and make minimum payments on time, credit card debt should not hurt credit scores.

Mortgage debt

Why mortgage debt is the worst: If you wonder how bad mortgage debt can be, just ask the owners of some 8.8 million homes that CoreLogic said had negative or near-negative equity as of the second quarter of 2013. That means those owners owe close to, or more than, what the property is worth.

That also means they can’t sell those houses without shelling out money to pay off their mortgage or doing a short sale that damages their credit scores. Even for those who aren’t underwater, rising taxes and/or insurance premiums, the cost of maintenance, and loans that typically take 30 years to pay off can make one’s home feel like a financial prison at times.

And why it may not be: Over time, homeownership remains one of the key ways average Americans build wealth. If you are able to keep up with your home loan payments, eventually the home will be paid off and provide inexpensive housing or rental income. Equity that has built up can be accessed through a reverse mortgage or by selling the house, or it can be passed along to heirs — sometimes tax-free.

When it comes to credit scores, this type of loan will generally help, as long as payments are made on time. Even large mortgages shouldn’t depress credit scores, unless there are multiple mortgages with balances. That’s usually a problem that affects real estate investors, though — not homeowners with one or two homes.

Tax debt

Why tax debt is the worst: If you owe the Internal Revenue Service or your state taxing authority for taxes you can’t pay, you can suffer a variety of painful consequences. If a tax lien is filed, your credit scores will likely plummet. In addition, those government agencies usually have strong collection powers, including the ability to seize money in bank accounts or other property, or to intercept future tax refunds.

And why it may not be: The IRS offers repayment options that may allow a tax debt to be paid off over time at a fairly low interest rate. (Similar programs are available for state tax debt in many states.) And unlike applying for a loan, you don’t have to have good credit to get approved for an installment agreement.

The good news when it comes to credit scores is that tax debt itself isn’t reported to credit reporting agencies; a tax lien is the only way that it may show up. By entering into an installment agreement, you may be able to get a tax lien removed from your credit reports, even before you’ve paid off what you owe.

Auto loan debt

Why auto debt is the worst: The average auto loan now lasts 5½ years, and some 12 percent last six to seven years, according to Edmunds.com. That means payments will last long after that new car smell has worn off, and well into the years when maintenance and repair costs start creeping up. Even more troubling, these borrowers may be stuck if they need to sell their vehicles since they may be “upside down,” owing more than what they can sell their car or truck for.

And why it may not be: Many consumers budget for a car payment, and as long as they aren’t hit with unexpected expenses, they are able to make that payment a priority. In addition, borrowers may be able to refinance their auto loans and lower their monthly payments. Plus cars often get people to work, where they can earn the money they need to pay off debt.

Vehicle loans that are paid on time can help credit scores, and are rarely a problem unless someone has several car loans outstanding at once, or misses a payment.

The worst kind of debt

When it comes down to it, the worst type of debt is … (drumroll please) the one you can’t pay back on time. If that happens, your credit scores will suffer, your balances may grow larger due to fees and interest, and you may find yourself borrowing even more as you try to keep up with your payments.

You can find out how your debt affects your credit using Credit.com’s free Credit Report Card. In addition to your credit score, you’ll find out whether your debt is lowering your credit score.

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