Tuesday, November 11, 2014
Good Debt Versus Bad Debt - Does it Exist
Good Debt vs. Bad Debt. Many of you may be saying what is good debt and what is bad debt? Well let's start with debt. According to Webster's dictionary debt is, "something that is owed or that one is bound to pay to or perform for another or a liability or obligation to pay or render something".
Is debt really good, no it’s not but the term "good debt" will be used here for illustration purposes. Good debt is anything that you can't afford to pay for up front but have the money to pay for on a schedule such as a mortgage or home equity loan. Bad debt is anything that you can't afford to pay for up front, that is usually something you want instead of something you need, or you can't or didn't save up the money to pay for it so you apply for a loan or charge it.
The most common form of bad debt is a credit card. Credit cards should be used with discipline. The best way to establish and maintain good credit is to purchase something with a credit card and then pay off the balance when the bill arrives. This shows the credit card company that you pay your debts on time and are a responsible shopper.
Other examples of bad debt are cars and personal loans. I know you are saying, but I need a car! Yes a lot of us need a car to get around but you don't have to buy a new car. The value of a car starts to depreciate as soon as you sign the paperwork. It is better to buy a used car and finance it for one or two years or save money to buy the used car in cash. Other examples of bad debt are: personal loans, lines of credit, payday loans and installment loans.
Examples of good debt are a mortgage. Some other financial experts may disagree and include car loans with this but I believe anything that you can borrow against and that has a monetary value is a good debt. The value of a car only decreases immediately so although the car has a monetary value, that value is less than the original price paid for the car.
An exception to the above statement is student loans. Student loans are a good debt because the end result is furthering your education which results in a higher paying job (monetary value). The money from that job can be used to pay off your student loans. Some of you may say I can borrow against my credit card to get a cash advance; but it is still a bad debt because you didn't have the cash up front and you will be charged a higher interest rate and fee to get the cash advance.
Also, the value of cash does not increase unless it is in a mutual fund or investment. The best way to determine if you have good debt or bad debt is to prepare a liability statement. This statement will identify your income and all of your debts and the difference of the two equals your total liabilities (your total debt).
Bad debt has no value or the value decreases over time. Good debt has value and has the ability to increase in value over time. Keep in mind at any time a good debt can turn into a bad debt if you miss a payment or if you are living above your means. Your debt-to-income ratio should be between 28% and 36%. If you debt-to-income ratio is above 36% then you need to do a financial health check and see how to cut expenses, reduce interest rates, and increase the amount sent to pay for your monthly debt payments.