Good and Bad Debts – Telling the Difference

The word debt often carries with it many negative associations. Debt is usually touted as something that you never want to have and you should do everything in your power to avoid. To some extent this is true; however, without any debt you will not be able to build a credit score. By having debt, you prove your capabilities of being able to pay back loans on time. Having a good credit score can also impact your employment eligibility and even affect if you are able to get a cell phone.

For this reason, you do need to have some kind of debt. That does not mean going out and charging up a bunch of credit cards. It means choosing debts that will look good on your credit report. Believe it or not, there is such a thing as good debt and bad debt. Obviously, you will want to try to avoid bad debt at all costs while focusing on your good debt.

What is good debt?

In order to build up your good debt, you need to fully understand what good debt is. To put it simply, good debt is something that can lead to more money long term. Good debt helps build up your personal assets. For example, a mortgage is a good debt. Sure, you have to pay interest, but over time your home will increase in value. In fact, should an emergency arise you may even be able to borrow against your home to get some extra money.

Plus, if hard times do hit your family, you can always sell your home to pay back your mortgage. Therefore, it is good debt. Not to mention the interest you pay on your mortgage is often tax deductible.
Another example of good debt is a college loan. Going to college increases your lifetime earning potential; therefore, it makes you money long term. Plus, with college loans you can get deferred payments and very low interest rates. Just make sure not to borrow more than you actually need because you do have to pay it back eventually.

Another definition of good debt is something that you need that you cannot afford to pay for upfront. Under this definition, anything can be considered good debt if it is a necessity. The hard part is really determining what a necessity is. If you literally could not live without something, it is better to take on debt to pay for it than to go without. That does not mean the latest cell phone that you cannot live without. It means the basic human needs: food, water, clothing, shelter. Use your brain. You know if you really need something or not.

What is bad debt?

Bad debt is easy to spot because it costs you more money than it is worth and it cannot be repaid by selling the items you bought. Credit cards are the epitome of bad debt. What you buy on your credit card cannot be sold to repay your loan and it most certainly will not increase in value. Not to mention, credit cards usually have the highest interest rates when it comes to debt, so the items you buy on them will cost you much more in the long run.

That being said, credit cards are also an important tool to building up your credit as long as you only charge what you can afford. Whether it is food, clothing, fuel or furniture, try to only charge items to your credit card that you can pay off as soon as you receive your statement. If you do not trust yourself with this, it is probably a good idea not to get a credit card in the first place. However, you may want to consider one just for emergencies.

What about a car loan?

Car loans are tricky because they can go either way. On one hand, cars lose value right off the lot. So in that sense, they are bad debt. Very rarely can you sell a car for more than you own on a loan. On the other hand, a car is something you need to get around. If you cannot afford a car outright it is probably a necessity to have one. So in that instance, it is considered good debt.
If you do opt to take out a car loan, be smart about it.

Only get a car loan in which you can easily afford the monthly payments. Keep in mind that as nice as the shiny new convertible looks, it will feel a lot nicer to easily be able to make your payments.

You will also want to drive a car for as long as possible if you take out a loan on it. That way, you can pay it off and still drive it once you officially own it. If you are the type of person that wants a new car all the time, you may want to consider a lease so you can avoid owing more on your car than it’s worth.

How to Make Bad Debt Good

The key to any debt is to make your payments on time. Good debt can easily turn bad if you default on your payments. On the other hand, if you make your bad debt payments on time it can actually improve your credit score. It is important to really evaluate any debt that you are considering. If you cannot make your payments on time every month, any debt is bad and your credit score will suffer. However, if you can manage your debt responsibly by only using it for items you really need and making your payments on time, debt can be very beneficial. Well-managed debt results in a higher credit score. A higher credit score means lower interest and more options available to you.

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