Good debt vs. bad debt

You maybe surprised to hear that living without debt is not necessarily wise. There are few people who earn enough money to pay cash for big-ticket items such as a higher education, home or a vehicle. In some cases your debt can be a smart investment, in others – a financial trap. So while shopping for a loan, you need to understand whether you are going to owe good debt or bad debt. 
   
What is debt?

Consumer debt is the amount owned by individuals to various credit organizations for funds borrowed. According to statistics, the total amount of consumer debt in the United States is nearly $2.6 trillion dollars. It means about $8,500 in debt for every person living in the US. If you think that these figures are no so bad, keep this in mind that consumer debt we are talking about does not include debt secured by real estate (mortgages, home equity loans, etc.).
Consumer debt can be divided into two main categories: 
•    Revolving credit is credit which is repeatedly available as regular repayments are made. The most common example of revolving credit is credit cards. According to statistics, in 2008 about 37% of all consumer debt was revolving.
•    Non-revolving credit is a loan with a set term made by a financial institution. You can’t use it again after payment. Non-revolving credit includes auto loans, student loans, etc. In 2008 about 63% of all consumer debt was non-revolving.
When you look at your bills each month, you may feel overwhelmed by the amount of money that you spend to make payments. However, not all debt is bad. Sometimes your balance will bring you good dividends and ensure your successful financial life in future. You think it’s not possible? Let’s see how it works. 

Good debt


Good debt is an investment that will go up in value or generate long-term income. So if you take a loan to purchase something that will cost more in future, it is good debt. 
One of the perfect examples of good debt is student loans designed to pay for higher education. They generally come with a low interest rate compared to other types of debt, so you won’t need to pay a small fortune in interest. In addition, higher education will let you find a better job and increase your income in future. Higher education will not lose its value even in the times of economic uncertainty.

Mortgages are usually considered good debt as well. Like student loans, they have moderate interest rates, and that interest is tax deductible. Even though mortgages are taken for a long time (20-30 years), the monthly payments are rather low. That allows you to build a rainy day fund or make investments.  

We mentioned the word “usually” due to the present-day mortgage crisis. The ideal situation is when your home goes up in market value over time. That difference covers your interest, so taking a mortgage loan you will lose nothing. However, nowadays we see another situation: homes values are slumping. It means that people who took mortgages several years ago need to pay for their homes much more than they cost now. 

If you are buying something for your business, for example a car or a computer, it is also good debt. In this case you will earn more than you will pay in interest (of course, it makes sense to shop around for a loan with the best terms and conditions). However, be careful if you are going to borrow money to start up new business: not everyone can become Bill Gates. You need to have good workable ideas. 

Good debt can also be a loan with low interest rates, for example a home equity loan. It has a lower APR than other types of loans, for example credit cards, so it is often used to pay off expensive debts. However, taking home equity loans has become very difficult under the dark cloud of the global credit crunch.
How to obtain a good debt and contribute to your overall financial health? The only answer to this question is think, think and think. Good debt is obtained through making smart decisions about your future. For example, if you want to expand your education and have no other way of financing it, then taking out a student loan is a valid reason for borrowing money.

Bad debt

Just like there is good debt, there is also bad debt. This kind of debt creates an unhealthy financial situation. Bad debt is obtained to purchase things that quickly lose their value and don’t generate long-term income. Bad debt is also debt that comes with a high interest rate.

The typical example of bad debt is credit card debt. Many people use their plastics to charge small items here and there and don’t pay off their balance in full at the end of the billing cycle. It means that they will end up paying much more for the items than they really cost. 

For instance, if you buy brand new $200 skinny jeans on your credit card, but make only minimal monthly payments, those jeans will cost you over $250 in the long run. In a year you can gain weight and they won’t fit you, or this model can go out of style, or you will make a large hole in the jeans, but you will still need to pay for your purchase. 

On the other hand, if you charge a necessary item on a credit card with a 0% interest rate on purchases and significant cash back rewards, and then pay off your debt within the interest-free period and get cash rebates – then it is a good debt! 

Car loans are also considered to be bad debt because they constantly decrease in value. It means that in a couple of years your car will cost less than now. That’s why it makes sense to make a large down payment to reduce your borrowing costs. If you can’t pay at least 30% of your purchase amount, it means that you can’t afford this car model and need to choose a cheaper vehicle. Or you can take advantage of public transportation. 

Payday loans (also known as cash advance loans, short term loans, bad credit loans, fast cash loans, etc.) are also bad debt. They are designed for people who want to cover their urgent financial needs. The finance charge for payday loans is $10-$30 per $100 borrowed. However, do you know that paying $10 per $100 means a 240% interest rate? If you can't pay back a payday loan in the set timeframe, the lender can extend the loan period for you. This is where you can double your high interest charges. And don’t forget to add numerous fees to your borrowing costs! 

If you take a personal loan to finance your vacation, it is also bad debt. Although it can help you feel better and be more productive when you return, a vacation is not an asset that grows in value. In several months you will forget about warm sun, a soft-sand beach and light sea breeze, but you won’t be able to forget about your debt. No doubt the bank will remind you about it. So don’t take a loan to pay for a vacation, especially if you can’t afford it. 

Final thoughts

As you see, debt is a complex concept. If you have debt, it doesn’t mean that you are in a bad financial situation. Vice versa, its may mean a good investment in your future. When used wisely, debt can help you improve your financial health.

One of the secrets of smart money management is to differentiate between good debt and bad debt. The main rule is: if you are going to buy something that doesn't go up in value or that is too expensive for you, then do not buy it. However, while this tactics seems smart and reasonable, many people don’t use it. It is always easier to say than to do, right?