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About Debt
Good Debt vs. Bad Debt
Debt Management
"Good" debt and "Bad" debt
There is a great deal of confusion about these two concepts. It is very
important that people understand the difference between the two, as
only then can they make intelligent, informed financial decisions. There
are situations where it can make a lot of sense to borrow money, and there
are others where borrowing is a bad idea.
Borrowing money when you have a poor credit rating is
always a bad idea. A bad credit history means that you will pay a lot more
for the privilege of borrowing money, as well as the 'privilege' of buying
anything, whether it be a car, a house, or even a new outfit.
Learn how your poor
credit history costs you money - a great deal of money.
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The reality is that most people have debt of some sort. The vast majority
of people cannot afford to pay cash for their home or for their kid's
college education. Having said that, the average American carries between
$7-10,000 of debt on their credit cards, often only paying monthly minimum
fees. As well, personal bankruptcies are on the rise. Before considering
any debt, and when understanding the debt load you already face,
understand that financial experts generally agree that any person's debt
load should never exceed 35% of their monthly income.
Important to these considerations is your cash reserve. Experts advise all
of us to have between 3-6 months worth of income in a cash reserve,
available in case of emergency. This helps consumers to avoid assuming
more debt due to job loss, sickness or other emergencies.
When you do decide to borrow, get the best rates. Understand why you are
borrowing, how much interest you will pay over the course of the loan and
how much you can afford to pay down the principle every month. Any debt
assumed that has high interest rates will generally fall into the category
of "bad" debt.
Some examples of "good" debt.
1) Buying a home.
Purchasing a home can often be considered assuming good debt. It only
falls into the "good" debt category, however, if the debt assumed is
manageable and can be paid off over a period of time. The most important
point in buying a home is not to over extend your finances. Buy what you
can afford. Only assume mortgage payments that you can afford to make and
include some percentage of the principle. Always try to put a reasonable
amount of money down.
2) College Education
We all know how important an education is today. For this reason, assuming
debt for the purposes of education is often considered "good" debt. Having
said that, always research what loans and scholarships your kid's are able
to obtain to help pay for college. The same goes for adults wishing to
further their education. It's often a better idea for your kids to borrow
than for parents to borrow, particularly against their home. As well,
depleting retirement funds is almost never a good idea.
3) Financing an automobile.
Not all experts agree that this is "good" debt. Much depends on the
financial situation of the borrower. Most experts generally agree that it
is a bad idea to borrow against a home to finance an automobile. As well,
unless you've decided to drive the car for many years - certainly long
after payments have been completed - borrowing for an automobile can be a
poor decision. The goal should always be to put down as much as possible
on the car, and only finance a car that has reasonable monthly payments.
Always research the best deals for automobile financing, whether it be for
a loan or a lease.
KEY: Always consider "good" debt as debt that will eventually contribute
to assets.
Some examples of "bad" debt.
1) Vacations
If you cannot afford to pay for the vacation ahead of time, you cannot
afford to take the vacation.
2) Furniture
Again, only purchase furniture that you can afford to pay for. Avoid
falling into the common trap that you will pay monthly for furniture over
a period of time. These are the types of things that pull people into bad
debt and credit situations.
3) Appliances
Appliances are like furniture - only buy what you can afford. Appliances
can be a trickier item, however. There are some appliances that are very
necessary. For this reason, you should have your 'cash cushion' in good
shape, so that if a furnace goes or a washing machine fails, you can use
cash from your emergency fund.
4) Meals out and Entertainment
Never use borrowed money for either of these in any situation. There is
never a good reason to do so.
5) Any debt, regardless of why it was acquired, that sits on a credit
card and costs ANY interest.
KEY: Many experts simply refer to "bad" debt as any debt incurred
unnecessarily. Many experts believe that even credit card debt that is
paid off monthly should be considered "bad" debt. The reason for this is that
so often people spend money without thinking, on things they don't really
need, instead of using that money for savings, investments and the
building of other assets. The key in these situations is making your money
work for you. When you invest money wisely, you're not just spending it
well, you're actually making more money.
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