Telling the Good Debt From the Bad
Written by Kasey Ng   


Debt is a complex concept. Many people have underestimated the problems of having huge debt. They fail to realize it until they are in the hole. On the other hand, if people know how to use the borrowing money effectively, it can build up their wealth at a much faster pace. This article will explain what is considered as a good debt and what is considered to be a bad debt.

Good Debt

Good debt should be anything you need- “need” being something like groceries, not of the “I need a new LV bag” variety- but can't afford to pay for up front without wiping out cash reserves or liquidating all your investments. In cases where debt makes sense, only take loans for which you can afford the monthly payments.

Another type of good debt is investment debts that create value. It is a good idea to take out loan if you are confident that you can make higher return on the loan than the interest rate. In this case, you should leverage and make a decent return.

A Mortgage is one example of a good debt that creates value- assuming your house price is rising. When you purchase a house with mortgage, you are essentially buying a house with a real-estate loan. Once you pay off the loan, you will have a full ownership of your house. In this situation, if your house’s value is increasing, you are creating value with your mortgage loan.

However, if your house price starts falling after you purchase your mortgage, the “good” debt turns into a bad one. Make sure you know your house will rise in value before getting into an unnecessary mortgage.

Student loan is another typically cited example of a good debt. Students use the loan to invest in human capital. Once they complete their education, they should be able to have higher earning power in the future. Therefore, the loan essentially creates value- assuming that your future increase in earnings can offset the total payments on the loan. Otherwise, you’ll turn into one of the cautionary tales of students with $200,000 in debt and a low-paying job.

However, if you have extra money reserves that can pay off the expenses mentioned above, it makes more sense to just pay them off rather than take on loans. It helps avoid any interest payments.

Overall, a good debt should provide more value in the purchase than that amount you are borrowing. Mortgages and student loans are two popular examples of such, but be certain that you get back more than you borrow.

Bad Debt

Bad debt includes debt you've taken on for things you don't need and can't afford. When you take on debts and spend on things that can’t create value in the future, you are taking on bad debts.

Credit cards are the most common form of bad debts among the general public. A typical example will be using your credit cards to purchase unnecessary clothing or electronics because those things will depreciate quickly in a short period of time. Also be aware not to fall into the minimum trap. If you just pay the minimum due on credit-card bills, you'll barely cover the interest you owe. It will take you years to pay off your balance, and potentially you'll end up spending thousands of dollars more than the original amount you charged.

In addition, if you take on debts that you can’t afford the monthly payments, then it is considered bad debts no matter how you use the loans. There is no faster way to fall into debt than behind your monthly payments. If there's something you really want, but it's expensive, save for it over a period of weeks or months before charging it so that you can pay the balance when it's due and avoid interest charges.  For more details, read the article on avoiding unsustainable debts.



 
Last Updated on Friday, 24 December 2010 06:13