By David Quilty, Special feature courtesy ofMoney Crashers
While most of us cannot live entirely debt-free, there are major differences between what is considered “good” debt and “bad” debt. Though some debt falls into a bit of a gray area, good debt is simply defined as money borrowed to pay for items you truly need or that appreciate in value, and bad debt is accrued for items you only want and that generally depreciate in value.
To help you make this distinction, it is important to be able to differentiate between wants and needs. Moreover, before borrowing money, you need to determine whether the money is going toward something that will have a positive or negative effect on your overall financial situation. Ultimately, debt is not always bad – it’s how you use it that counts.
Good Debt
1. Borrowing Money for Education
When you take on student loan debt, you are rarely making a bad decision. Generally, those with college degrees tend to earn more money over their lifetime than those without a degree.
And taking out a student loan to pay for your child’s education sure beats using your retirement money to do so. After all, you cannot borrow to pay for your own retirement. There are many government programs offering low-interest or interest-free student loans, and you can often deduct student loan interest on your taxes.
2. Paying for Medical Care
While unpaid medical bills account for more than 60% of bankruptcies in the United States, there is no amount of money not worth borrowing to help pay to keep a loved one healthy. You can always pay back money you borrow, but you cannot replace a human life. If someone needs expensive treatments or surgery to regain their health, this an acceptable debt to take on, no matter what.
3. Taking out a Mortgage on a Home
Make no mistake, taking out a loan of this size can be daunting, but buying a home builds ownership in something that not only provides a roof over your head, but also is a potential source of retirement money. And while your drive to stay out of debt may feel like encouragement to put any and all available liquid cash down as a down payment (which effectively reduces your monthly payment and interest charges), it may not be the smartest move.
Home mortgage interest is deductible on your taxes, and the interest rate is much lower on your home loan than it is on your credit card, so having cash to pay other expenses instead of using your credit is important.
While buying a house was formerly seen as a solid, future-proof investment, some homeowners are finding themselves upside down on their home mortgage loan, owing more to the banks than their homes are worth. But careful planning, buying only what you can afford, and keeping those interest rates low by having good credit enables you to buy a house that you will one day own outright.
4. Purchasing a Car
If public transportation is not available in your area, or you cannot find anyone with whom to car pool, you are probably going to need to buy a car. An auto loan can fall into that gray area between “good” and “bad,” but the key to keeping an auto loan closer to good debt rather than bad is to make sure you get the lowest possible interest rate on your loan. Also, it’s important to put as much down as possible, while making sure you still have cash on hand should you need it.
Your best bet is to buy a late-model used car rather than a brand new one, potentially saving you thousands on the sticker price and the interest paid over the life of the loan.
5. Business Loans
While this wouldn’t be considered good debt in every single case, borrowing money to start or expand a business is generally seen as a good idea, especially if business is booming. After all, it takes money to make money, right?
Sometimes you have to borrow capital in order to hire new employees, buy new equipment, pay for advertising, or just to manufacture the first run of a new widget you invented. As long as the money is borrowed with a plan in place to generate more business or income, then taking out a business loan counts as good debt.
Bad Debt
1. Credit Card Debt
The average U.S. household carries a balance of more than $10,000 on their credit cards each month. Credit card debt often piles up quicker than we realize, and is often used to pay for things we want rather than need. It’s much easier to think we can afford something using a card rather than paying with cash.
By the time credit cards are paid off, interest rates and minimum payments can turn $100 items into $200 items, and many items depreciate in value rapidly, making the loss that much more substantial. Credit card debt is without question a bad debt, and one that millions of Americans find themselves with today. It’s hard to get out of credit card debt and is best to avoid it in the first place – most Americans should not use credit cards.
2. Borrowing From a 401k
When you borrow money from your 401k plan, you have to deal with the IRS, and unless you are using the money to buy a home, you have to pay back the borrowed money within five years. If you don’t pay it back when you should, you could get hit with heavy early withdrawal penalties. Plus, the interest you’ll pay on the loan will effectively get taxed twice – first when you pay it, and again when you withdraw it during retirement.
You cannot borrow money to fund your retirement. Therefore, borrowing money from your retirement fund to pay for anything other than retirement is a bad idea. You put your retirement at risk when borrowing from a 401k, so don’t do it unless absolutely necessary.
3. Vacations, Jewelry, and Expensive Clothes
If you cannot comfortably afford to pay for these luxuries with cash on hand, don’t do it. These are not needs but wants, and thus bad debt. Wait until you have the money to pay for them. Going into debt just to pay for a vacation or a handbag is most definitely a terrible use of borrowed money.
4. Payday Loans
It may be easy to borrow money from payday loan companies, but it’s very difficult to pay them back. These companies loan out money with terrifyingly high interest rates, taking advantage of the fact that many people are desperate for cash. Even a small amount borrowed through a payday loan outlet can end up costing a small fortune when finally paid back.
Payday loans are often considered the worst kind of debt you can take on. If you are in serious need of a short-term loan, you are better off taking a cash advance on a credit card than borrowing money from these companies.
Click here for the “Final Word” on “Good Debt vs. Bad Debt”
You can afford anything you want, on even a very modest income, if you're willing to give up the things you don't need. Out of high school I joined the Navy and used my GI Bill to pay for my Master of Science degree; and I talked my first employer into covering night classes for my MBA - so two professional degrees for free. I buy a new car every two years and pay cash; I can do this because I buys cars that will hold their value, maintenance them appropriately, and keep my mileage low. Every three years I buy a new toy - three years ago it was a 4-wheel off road buggy and this year it will be a pontoon boat; again, each paid for with cash. I paid off each of my 30-year mortgages in eight years by putting 30% down and making 3 extra payments every year; I now own 3 houses outright and rent 2 out for positive income.
So, that's what I get to do for fun. On the flip side I rarely eat out, unless I'm on a date. I never go to the movies or theater, instead I use Netflix ($8/month) for movies and cable series. I don't buy video games or music, and only own 1 TV with basic cable (still 70 channels, but it cuts my Internet cost in half). Instead of donating money I volunteer for causes I want to support. I brew my own beer and bourbon (which I give as gifts to certain clients) and don't smoke. Some of the best clothes I've found have come from the Goodwill store down the street, as well as a 7-day backpack and a 3-season tent that I will use this summer when I hike Maine's 100-mile wilderness. I don't take extravagant vacations, but my work often sends me coast-to-coast several times a year. I usually try to extend the stay by a couple days on either end and go camping.
At the end of the day it's all about deciding where your priorities are.
- spam
- offensive
- disagree
- off topic
Like