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When good debt gets a bad rap

Despite America's penchant for debt, borrowing can be a good thing

Whether they're keeping up with the Joneses or keeping up with the Kardashians, Americans have become big spenders. And many are in over their heads in debt.

Of course, not all debt is necessarily bad. Some degree of debt can open doors and economic opportunities: paying for a college education, buying a car to get to work, obtaining a home in a nice community. The questions then become, how much debt is too much and what is the right amount of red?

Over the past 30 years, American families have taken on increasing amounts of debt, even as incomes failed to keep pace. About 80 percent of American households now hold some form of debt, according to the Pew Charitable Trusts' survey of American family finances.

Nearly 7 in 10 said that debt is a necessity, even though they would rather not have it. Almost exactly the same percentage also said that loans and credit cards have expanded their opportunities, according to the Pew report.

Here's a look at four common types of debt Americans take on and how best to manage it.

Auto debt

Given America's obsession with motor vehicles, one of the first things many people do is rack up debt when buying a car. More than 33 percent of American households are making car payments, according to Pew, with nearly $1 trillion in auto loans now outstanding.

In some cases, borrowing money to buy a car makes sense. Having a vehicle, for example, may let you commute to a job where alternative transportation may be lacking. Loan rates currently average 4.8 percent nationally, but could be as low as zero percent for those with excellent credit.

For an average auto loan, which is just over $28,000, payments are about $400 a month, according to Experian, a credit monitoring firm.

To reduce that cost, buy a 2-year-old car, advises Scott Tucker, president and founder of Tucker Solutions in Chicago. "The price drops like a rock initially," he said, "so if you have to finance it, keep the purchase price down."

"Look at it like a device, not a status symbol," he said.

Mortgages

Most Americans' largest liability is their home mortgage. Currently, a median priced house costs $222,700. With 20 percent down, a buyer would need to earn at least $51,114 just to afford the monthly payments, according to an analysis by mortgage research firm HSH.com. In many parts of the country, costs are much higher.

To ease that burden, Tucker said homebuyers should scale down their expectations. "Don't go crazy and buy a home you barely qualify for," he said. For a starter home, a "three-bedroom, two-bath is a good target."

Tucker recommends keeping your monthly home expenses (including interest, taxes and insurance) below one-third of your gross income.

Some degree of mortgage debt is not a bad thing, particularly as it becomes increasingly more affordable to buy than to rent in many markets.

"Interest rates are so low if you can get 3.5 percent over 30 years, you're better off taking that and investing your money in a higher interest investment," said Steve Lewit, CEO and co-founder of Wealth Financial Group in Buffalo Grove, Illinois.

"You can buy a conservative portfolio," he said, "those will do better than 3.5 percent and you'll do better in the long run."

Credit cards

Maintaining a good relationship with a credit-card issuer will also help build a beneficial credit score, which paves the way to lower interest loans — as long as your account remains in good standing.

Because card issuers charge much higher interest rates than other types of lenders, carrying a credit-card balance can quickly escalate. Currently, the average interest rate is 15.7 percent and the average credit-card balance is slightly more than $5,000, a number that's held steady for several years, according to CreditCards.com.

"It's very hard to back yourself out of that," Kearney said. He advises clients to think ahead to age 65 then work backward to determine the level of spending they can maintain today to get to that point in the future. "Keep in focus the end game," he said.

For those struggling to stick to a budget and pay off their credit-card bill in full at the end of every month, switch to a debit card, Tucker said. Carrying credit-card debt will ruin a perfectly good financial picture," he said. "It's too easy to bite you."

Student loans

For many young people, student loans are their greatest debt challenge. The majority of college graduates finish school with education debt. Such debt now totals $1.3 trillion nationwide, triple the amount in just the last decade.

Consider the choice of major, future starting salary and whether it's worth racking up the kind of debt it may require to attend a private college, said Tucker. While getting a degree may be the biggest single determinant of future financial success, taking on too much debt early on can set you back.

It may not make sense to take out more loans than you reasonably expect to make back within the first 10 years in the workforce. "If you get loaded up on student loans when you are young, you are going to work against yourself later on," Tucker said.

Another concern for parents who help their kids with college costs is their own cash flow as they approach retirement, said Bill Kearney, president of Integrated Financial Concepts in Huntersville, North Carolina.

"If it's not a specialized degree then maybe going to the state school is more worthwhile," he said. "It's a balance between the student being happy and what it's going to cost mom and dad."

Students should work with an advisor to maximize grants rather than loans to pay for school, Tucker said, and go in with the assumption "they'll be there for five years, not four, and a quarter of a million dollars in debt."