Good Debt vs. Bad Debt
By Teresa Ambord
Debt is a dirty word...isn't it? We all know that debt is something we want to avoid. But the fact is, credit has never been easier to obtain. If you're like most people, you're bombarded with credit card offers of varying quality. Even teenagers and children may receive such offers. While it's true that credit card debt is costly, that doesn't mean that debt in itself is bad. There's bad debt and then there's good debt. Do you know the difference?
Bad debt is debt that purchases goods that are disposable or that depreciate in value. If you have to charge those items, you can't afford them. New clothes lose 50 percent of their value when you walk out the door with them. If you buy those clothes on credit and don't pay off the balance very shortly, you're losing money. Even while interest is added to your debt, therefore increasing the amount you owe, the value of your purchase decreases. That's bad debt. Don't fall for the lure that department stores use. They give you a discount on your purchase if you apply for a credit card and maybe they give you an initially low interest rate. But a few months later, your interest rate goes double digit, eliminating any advantage you had.
Most people go into debt to buy their cars. In fact, for many of us, that is the first big loan we seek. We see the car we drive as a status symbol, and often try to finance much more car than we can afford. And of course, everybody knows that cars, like clothes, lose value immediately. Car loans used to be three or four years. Now in order to make the payments more affordable and encourage people to buy more car than they can afford, loans are five and six years. By the time you've made all the payments, your car has lost most of its value. Of course, a hefty down payment helps, but not if it means depleting your cash reserves. One consumer scraped together an additional $1,500, assuming that a bigger down payment would lower his monthly payments. To do it, he totally exhausted his backup resources. In the end, his payments only went down by about $15 a month. He would've been better off to keep the money for reserves.
Speaking of cash reserves, it is not a good idea to avoid all "bad" debt if the result is that you have no emergency funds. But if you are going to use credit cards, financial experts advise that you only charge what you can pay off entirely within the month. Some suggest that, when you use a credit card to make a purchase, you make a note of the amount in your checkbook as a subtraction so that by the time the monthly statement comes, you will have already accounted for the funds.
So what is good debt?
Good debt finances purchases that increase in value, like a home. Not only should your home appreciate in value, but the interest you pay on it also provides a tax break. But like a car, don't buy more house than you can afford, or you'll struggle not just with the payments, but the insurance, and, if the home is too big, you'll struggle just to heat and cool it. Like a car, don't put every penny into the down payment and leave yourself without emergency funds.
Here's a rule of thumb from financial consultants: your long-term debt including credit cards and mortgage payments should not equal more than 36 percent of your gross monthly income.
Other Types of Good Debt:
Debt which produces cash flow. For example, the purchase of a small rental home. If properly done, hopefully the rental income will cover the costs of ownership and put some cash in your pocket.
Student loans, if the alternative is to take money out of your pension funds. After all, your kids have more years ahead of them to gain financial resources than you do. If you take loans from your pension and fail to pay back the money, not only do you risk your retirement, but you probably face a serious tax penalty as well.