While living a debt-free life might be desirable, it is not very likely. In fact, it may not even be recommended. As some financial obligations can actually be considered “good debt” to have if you use it properly. While other obligations are almost universally labeled as “bad debt.” Knowing the difference between the two will improve your financial security.
Unless you’re independently wealthy, chances are that you will be in debt to some degree during some points or maybe even all of your life. The type of financial obligations you accumulate and how you manage it are keys to your overall fiscal health. Understanding when it may be helpful to borrow money as well as knowing the ways to minimize bad debt will improve your financial security.
General debt characteristics
This is a very important financial literacy term. Before covering types of debt though, with any spending you do it is always critical to know what a want and a need is. As some things in life are critical to have and others are not so much. Find examples of wants and wants.
Good debt is generally considered an investment in something that will increase in value with time, generate long-term income, have beneficial tax advantages or improve your opportunity and ability to earn greater wealth. Low-interest loans for education, mortgages and business expansion, or buying stocks on margin are usually examples of what is considered are good debt.
Bad debt includes high-interest loans, credit cards, auto loans (in most cases) and incurring financial obligations for items that quickly lose value soon after purchase. As in taking on debt to pay for “wants” will almost always be a negative. Bad debt may also generally include almost anything that negatively impacts your credit score or increases your monthly debt obligations beyond 43% of your monthly gross income. Once that percentage is reached, your credit score is likely to drop, and financiers will begin to see you as a greater credit risk.
Lenders typically examine both the income and currently outstanding debts of the borrower as part of an overall financial assessment. This is one of the main factors that is used when it comes to a credit score. The ratio of available credit to credit currently in use is important as well as the type of debts the potential borrower is currently paying. Some financial obligations are viewed as better than others. Ensuring that most of your ongoing obligations are considered good debt will make you more creditworthy.
Types of good debt
Home mortgages and equity loans. Financial experts generally agree that home mortgages are among the best kind of debt. Interest rates are comparatively low, interest payments are tax-deductible and real estate usually increases in value with time. Most markets are experiencing annual home value growth of at least 7% with many areas enjoying even higher increases.
Homeownership also creates valuable benefits for a lifetime, which is one lesson of financial literacy. Housing costs typically consume the largest portion of a person’s monthly income. Paying off a mortgage usually results in relatively low housing costs in a homeowner’s senior years, a major consideration in financial planning for retirement.
The home is also a potentially valuable income-producing asset that may serve as collateral for a reverse mortgage or as rental property to provide increased cash flow in later years. If circumstances require an eventual move to an assisted-living community, the sale of the home can supplement other retirement income to ensure funds are sufficient to obtain high-quality, long-term care.
Home equity loans, when used to improve a residence, are also considered good debt. They are generally available at low-interest rates and renovating or remodeling usually adds value to the home. But the key to this financial literacy concept is what you use the loan for – it needs to be improving the home for something that retains value. As using a home equity loan to pay for trips, cars, TV, or really any type of non-home cost will be bad debt.
Always keep in mind that mortgages may become bad debt if you buy too much home to financially maintain. Or if you try to pay for property that is risky and outside your comfort level. For example, divorce may make a home mortgage impossible for either spouse to pay alone. If annual taxes and upkeep begin to consume too much disposable income, your options may include refinancing, downsizing or relocating to an area with a lower cost of living.
Auto loans. Taking out a loan to buy a vehicle has aspects of both good and bad debt. On the good side, interest rates are generally low, and if having a car increases your ability to obtain a good-paying job or is essential to your business, the loan is good debt. That is really about the only time a car loan can be looked on favorably. The characteristic that makes an auto loan a potentially bad debt is that, unless you are buying a collector car, vehicles immediately lose significant value when driven from the car lot.
To maximize the positive aspects of an auto loan, you should make a down payment of at least 20% to minimize your monthly debt obligation and limit loans to a maximum of four years. Buy a fuel-efficient vehicle that is practical for your needs and that has reasonable maintenance costs.
Student loans. The majority of college students will require student loans as part of the financial package to cover the ever-increasing cost of higher education. While it is not uncommon for college graduates to have thousands of dollars in loans to pay off, this is generally considered good debt as it is an investment in yourself as well as future earning power.
Interest rates, particularly for federally guaranteed loans, are reasonably low, and some interest expense may be tax-deductible. The loan is being invested in your personal future presumably to help you obtain an education required to launch a well-paying career.
Students studying for careers in science, technology, engineering and math can generally expect to have a high-earning potential thus justifying taking out more in loans. Aiming for a higher paying career is one reason that kids should be taught financial literacy. However, student loans can become a bad debt if your career goals are aimed at lower-paying fields. It probably makes little sense to take out $80,000 in loans for a job that pays $29,000-35,000 a year with little opportunity for significant salary increases.
If your intended vocation is in a lower-paying field, you should minimize your student loan debt or look for a lower-cost education. A good general rule when planning future finances is to keep your expected monthly student loan debt to no more than 10% of your anticipated after-tax monthly income.
Other types of good debt can include debt consolidation loans that allow you to package multiple high-interest obligations into one lower-interest monthly payment. As using the funds in this case will lower your monthly interest costs.
Small business loans, while considered somewhat risky by lenders, are generally considered good debt as well, particularly if you have the knowledge and drive to make your business idea a success. Putting money into an existing business is also considered good debt if the goal is to increase future profits. But always keep in mind how hard it is to start as well as run a business, and keep in mind the high failure rates. Therefore a business loan tends to be a higher risk type of good debt.
Types of bad debt
Credit cards. The typically high-interest rates of most cards coupled with their frequent use to purchase items that do not increase in value virtually define bad debt. Annual interest rates from 18-24% are common. Maintaining a balance of around $1000 may easily cost you $20 a month in interest. This is in effect financial literacy 101…using credit to buy “stuff” is always bad debt and bad for your financial health.
Credit cards are often a necessity but should be used as a convenience and not as a source of increased spendable income to purchase discretionary items. Credit cards are often essential to rent cars or other equipment, and they make purchases at stores, restaurants and other establishments quick and easy.
On a positive, credit cards are also a valuable way for young people to begin establishing a positive credit history and improving their overall financial literacy skills. This is needed for employment and other financial reasons, and it may be one of the few (if only) times card can be looked on favorably. However, the responsible use of credit cards requires that you only charge as much as you can afford to pay when the bill comes due. When used responsibly, credit card purchases can have a couple positives associated with them.
Payday and cash advance loans. These are one of the worst types of bad debt, and are far worse than credit cards. The interest rates are even higher, and the chance of such loans quickly becoming unmanageable is greater. Using them will often lead to financial hardship or even bankruptcy. Payday loans are typically used to cover the cost of other bills coming due and not to invest in anything which will grow in value.
Borrowers typically postdate a check to cover the cost of the loan plus fees and interest. If the borrower is unable to cover the check, additional interest and fees accrue. Even if the initial loan is repaid, due to having paid the added interest and fees, the borrower often finds himself with even less income with which to pay recurring bills and must take out an even higher loan the next month. It becomes a cycle of bad debt that also increases in amount over time.
Almost any alternative is preferable to taking out a payday loan. Borrow from a credit union or bank. Find a friend or relative to make you a short-term advance. Get an extra job as recommended by financial literacy professionals. Just be sure to promptly repay them.
Don’t rack up vacation debt. A week in Hawaii may make you feel better in the short-term, but having several thousand dollars in bad debt requiring months, if not years, to pay will quickly erase the fond memory of basking in the sun on a sandy beach. Save until you can afford the trip. You’ll feel better both during and after your time off.
Ways to minimize bad debt
As a general financial literacy rule, before purchasing anything ask yourself if the debt you’re about to incur will benefit you in the long term. Are you paying for a need or a want? Will the debt produce a lasting benefit for you and your finances or will it satisfy an immediate desire you really could afford to put off?
Consider whether a new credit card or car loan will help to meet your financial goals. Will the debt help you make it to work or get a higher paying job? If the auto loan is for an affordable, practical car that you need for your job, once again that may be a good financial obligation to take on. When it comes to credit card debt, if your goal is to more quickly pay off existing bills, consider transferring high-interest balances to a new card with an extended period with 0% interest on transfers.
If you must incur debt, develop some buying discipline and examine less costly alternatives. Rather than buying a new car, borrow less and buy a well-maintained pre-owned vehicle that is practical, affordable, and has good mileage as well as maintenance history. If you 100% absolutely need a new television, then wait to buy a new TV set until the holiday and Super Bowl sales. The point is, financial literacy also involves spending smartly. Therefore make less expensive clothing choices.
Maintain an emergency savings account of at least $1,000 so that if the washer breaks down or you need an unexpected car repair you can pay cash rather than using a credit card. The emergency account will help reduce your need for using bad debt in a crisis.
Finally, try to prioritize your spending habits. Create a budget or household spending plan which is a great financial literacy skill to have. Work to eliminate the bad debt as quickly as possible. And if you have got into trouble with your spending, then find debt assistance programs.
The bottom line
Debt is inescapable for most people, but it does not need to be a source of constant worry. Ensuring that most of your financial obligations fall into the category of “good debt” will help you to maintain a good credit rating as well as improve your overall wealth. That can be done while allowing you to reasonably afford life’s necessities and set some money aside in savings. In addition, good debt should help you hit long term financial goals, such as owning a home or investing in your college education from student loans.
Your ability to hit long term goals as well as borrow money when truly needed will be enhanced when you have just good debt and not bad debt obligations. Knowing the difference between the too, spending smartly, and using the basics of financial literacy before you take on debt will help ensure your overall financial security will be strengthened.
By Jon McNamara