Good Debt versus Bad Debt
You probably often hear financial experts discuss the importance of keeping bad debt low, while effectively managing good debt. In fact, creditors assess the balance of your good debt versus bad debt when determining whether or not you are a good candidate for a loan or a line of credit.
So how can you determine what is good debt or bad debt? While the answer to this question can vary to a certain extent, the following are a few different types of debt that are consider either good or bad:
What Is Good Debt?
“Good debt is investment debt that creates value; for example, student loans, real-estate loans, home mortgages and business loans,” explains Eric Gelb, author of Getting Started in Asset Allocation and CEO of Gateway Financial Advisors.
Generally, debts that are related to investments are considered ‘good debt.’ People are often surprised that debt can be considered an investment, but there are actually many different types of debt that are deemed investments.
For example:
- Buying a Home: Since houses generally go up in value over time, buying a home is actually a great investment! While it often represents most people’s largest debt, a home purchase can actually be great for your financial well-being.
- Paying for College: Attaining an advanced degree ultimately leads to higher pay, which means that while going to school may incur some debt, it eventually leads to higher income over a lifetime.
What Is Bad Debt?
While bad debt is not always avoidable, your goals should be to keep these financial obligations as much as possible. Bad debts are essentially anything that creates an unbalance in your financial health. Consumable products, for example, are a prime example of bad debt. In many cases, people do not begin paying them off until well after the purchased item has been used or consumed.
For example:
- Credit Card Debt: Credit cards can be a useful tool – as long as you are sure to pay off the FULL balance each month. Allowing bad debt to build and only making the minimum monthly payments can lead to financial problems and a debt spiral that can last for years to come. Avoid this problem by using your credit card judiciously.
- Buying a New Car: It’s a harsh truth, but financing a new car is one of the worst financial choices you can make. In addition to losing a large portion of its value once you drive it off the lot, the impact of depreciation can mean that much of your car’s value is depleted before you even pay off the debt. If you must buy new, make a down payment of at least 20 to 30 percent of the car’s value. The best choice is to purchase a used car from a reputable dealer that is offering to certify the vehicle and provide some type of warranty.
- Paying for a Vacation on Credit: If you are planning a vacation, be sure to save money to cover your travel costs rather than putting it on credit. Never go into debt to finance a vacation. Not only will you be paying for your trip long after you return, the vacation will actually end up costing much more due to interest.
Cleaning Up the Bad Debt in Your Life
Now that you’ve learned a bit more about the differences between good debt and bad debt, make an assessment of your debt. How much good debt do you have? How much bad debt? After sorting your debts into the two categories, start thinking about ways that you can reduce your bad debts.
One of the best ways to lower your bad debts is to set aside a specific amount of cash each month to pay off credit cards, auto loans and other bills. Some people are tempted to leverage their good debts (such as home equity) to pay off bad debts (such as credit cards). This is generally a bad idea and should be avoided. Instead, focus on paying your good debts faithfully while progressively working on lowering your bad debt. While it may take some time to accomplish, even small steps can make a big different in your overall financial health.
Debt Reduction Tools:
