When you go to the doctor for a routine checkup, your doctor checks your vital health signs by taking your blood pressure and checking your heart rate and respiratory rate. Unfortunately, we don't have such widely available diagnostic tools to check your financial health. But that doesn't mean you can't give yourself a financial health checkup.

In our prior post, What Is Financial Health?, we provided an overview of the six vital signs of financial health. Today, we're taking a deeper dive into the fourth vital sign: debt.

What is debt?

Debt is something (typically money) owed to another person or entity. And Americans have a lot of it.

According to Experian's annual Consumer Debt Study, in 2018 the average American consumer had total debt of more than $94,000, including mortgages, auto loans, student loans, credit cards, and other types of debt.

While that number might seem high to some (and low to others), not all debt is "bad." In fact, certain types of debt can provide opportunities to improve your financial health. The key is knowing how to make smart decisions about if, when, and how much you borrow.

"Good debt" vs. "bad debt"

 Good debt is generally something that helps you increase your net worth or save money in the long run. A few examples of good debt can be:

• Mortgages.  Few people can afford to pay cash for a home, so taking out a mortgage allows them to purchase property that may gain value over time. Plus, the homeowner may save money on rent in the long term, and the interest (and property taxes) may be tax-deductible.
• Student loans. Some student loans have lower interest rates than other types of debt, and the interest may be tax-deductible. The student loans help you pay for an education, leading to more career opportunities and potentially increasing your income. 
• Auto loans. Owning a car can help you get or keep a job, which increases your earning potential.

However, even "good debt" can have negative consequences if the interest rate is too high or if you take on more debt than you can afford to repay.

Bad debt does not increase your net worth or create future value. It includes debt you take on to purchase goods and services that don't have lasting value. 

Some examples of bad debt can be:

• Credit cards. Credit cards tend to have higher interest rates than other types of debt. As of October 2020, the average credit card interest rate in the U.S. was 14.58%, according to information from the Federal Reserve. If you pay for a product with a credit card and don't pay your credit card bill in full every month, the interest payments may wind up costing you far more than the product was worth.
• Payday loans. Payday loans are typically high-cost, short-term loans. The lender may charge a percentage of the loan's face value or a fee based on increments of the amount borrowed, such as $15 for every $100 borrowed. That might not seem like much, but when you consider that the loans are usually two weeks or less, that $15 equates to an APR of nearly 400%. Making matters worse, a study from the Consumer Financial Protection Bureau found that 80% of payday loan borrowers roll their debt into another loan or reborrow within 30 days, trapping borrowers in a cycle of high-cost debt.

Some debt doesn't neatly fall into either the "good" or "bad" category. 

• Medical debt. Medical debt can be good, bad, or neutral. It's unique from other types of debt because it's connected to health-related circumstances that most people cannot predict or control.
• Personal loans. Personal loans can be used for any purpose – from paying for emergency home repairs to gambling. Using a personal loan to refinance high-interest credit card debt can help you lower the cost of borrowing and get out of debt faster. However, using a personal loan to finance something like a vacation or consumer products you don't need isn't a wise way to use debt.

Measuring debt as a component of financial health

Metrics can be helpful tools for measuring how well you manage debt, your progress toward financial goals, and your overall financial health.

In Financial Health Vital Sign #1: Income, we covered the debt-to-income ratio, which measures the total amount you pay in debt payments monthly as a percentage of your monthly gross income.

Here is another debt-related metrics you might track:

Debt service ratio

Debt to-income calculates debt payment as a percentage of your gross income, but your debt service ratio measures your monthly debt and housing payments as a percentage of your disposable income.

Your disposable income is what is left over from your paycheck after taxes and other payroll deductions have been taken out. In other words, your take-home pay.

Debt service ratio = monthly debt and housing payments ÷ monthly disposable income

For example, let's say your total debt payments, including your rent, car loan, and credit cards is $1,000 per month. Your take-home pay is $6,000 per month. Your debt service ratio would be:

$1,000 ÷ $6,500 = 0.1538 or 15.38%

Your debt service ratio impacts how much of your income you can spend or save for future needs. When your debt service ratio is high, the percentage of your income you have available to save is low.

How to improve your debt vital sign

The best way to improve your debt vital sign is to avoid bad debt. Before borrowing money to buy a home or car, pay for college, or make another purchase, ask yourself how the purchase will benefit you – not just today, but in the long-term. Will the purchase provide a lasting benefit, or is it something you don't actually need and really can't afford?

Finally, shop around for a competitive interest rate and make sure you can afford to make the payments. Carrying debt without a plan to pay it off makes it difficult to pay your bills on time, cover other necessary costs of living, and save for the future.