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Plenty of confusion about good debt vs. bad debt

Do Americans understand the ins and outs of credit? They should. After all, they have enough of it. A 2015 NerdWallet study found that the average U.S. household with debt carries $15,310 in credit card debt and $132,086 in total debt.

Financial advisors come across many misunderstandings.

"I consistently see people with a lot of confusion surrounding credit and building a positive credit score," said Jason Reiman, certified financial planner and owner of Get Financially Fit. "The biggest issue I see is people mistakenly thinking they have to have so many different types of credit in order to improve their scores."

Reiman recommends clients have one major credit card, paid in full each month. He uses a diagram from MyFico.com to help them understand the factors that contribute the most to developing a positive score.

Credit score
Courtney Keating | E+ | Getty Images

Many consumers don't understand the costs of borrowing, said certified financial planner Kathryn Hauer of Wilson David Investment Advisors.

"They don't run the numbers and don't see what they are actually paying over time with credit cards," she said. "They don't realize how the credit costs are constantly changing."

Clients are unaware that they should keep their overall debt ratio — as well as within each credit account — below 30 percent of their credit limits, said Paul Stagias, certified financial planner with Francis Financial.

"For instance, a client who was looking to repair his credit score was planning on charging as close to his limit each month as possible," he said. "I advised him that even though he was planning on paying off the balance each month, using [a high percentage] of his credit limit was going to harm his credit further."

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Stagias added that clients are also unaware that they should not close credit-card accounts, but should instead cut up and throw away the cards if they find their spending habits out of control.

"Closing an account will shorten the length of their average credit history, which is a key but often overlooked, component of their credit health," Stagias said.

Shawn Tydlaska, CFP, founder and CEO of Ballast Point Financial Planning, debunked some common misconceptions:

  • You need to carry a balance on your credit card. The balance does not affect a credit score, but a healthy payment history does.
  • Checking your credit score will hurt your score. It is only the "hard" inquiries [e.g., applying for a new line of credit] that affect credit scores.
  • Your income affects your credit score. Income affects the ability to obtain a new line of credit or a favorable interest rate, not the FICO score.
  • Your spouse has good credit, so you don't need to worry about yours. It is important to improve one's own score, especially when applying for loans where both spouses' credit is considered
  • You don't need a credit card. By not having a credit card, you don't have any credit payment history.

"In terms of educating my clients about good versus bad debt, one thing I tell them is that good debt is deductible on your tax return," Tydlaska said. "For example, student loan interest and mortgage debt are two types of good debt.

"Bad debt consists of consumer loans to finance your lifestyle like auto loans, furniture loans, credit-card debt and payday loans," he added.

Stagias at Francis Financial educates his clients about credit both by reviewing their credit reports with them annually and by having an event for their children, aged from 12 to 30, that discusses the proper use of credit cards, good debt versus bad credit, and other topics.

Hauer of Wilson David Investment Advisors works with her clients to overcome their emotional issues around credit.

"Each individual's situation is different, and they're going to approach the topic of debt differently. I don't believe there is a general one-size-fits-all approach." -Jason Reiman, owner of Get Financially Fit

"They believe that you should never have any credit," she said. "There's an underlying guilt that it's a bad thing.

"They also fear another catastrophe like 2008," Hauer added. "I see this reaction across the board."

This guilt hurts clients in several ways, she said, causing them to feel too embarrassed to ask for professional advice. In turn, they put off dealing with the guilt. They then lose willpower and feel forced into making snap decisions that lead to higher cost.

"I explain to them that as a company only gets ahead by leveraging money, so does a family," Hauer said.

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Get Financially Fit's Reiman also attends to clients' emotional dispositions to determine whether having major debt causes them anxiety.

"Current life circumstances often dictate a particular attitude toward debt," he said. "This, of course, can and does change over time depending on what's going on in life.

"Simply put, each individual's situation is different, and they're going to approach the topic of debt differently," Reiman continued. "I don't believe there is a general one-size-fits-all approach.

"Instead, I like to focus on what ultimately makes the client tick, provide education where needed and ultimately help them save in unnecessary interest fees in the process."

— By Deborah Nason, special to CNBC.com