Your Guide to Good and Bad Debt

Debt has a bad rap. We hear constantly scenarios in which people struggle to stay afloat while trying to make minimum monthly payments, are hounded by debt collectors, and have to succumb to bankruptcy to free themselves from the grips of debt. In such scenarios, the negative connotation of debt is appropriate. In actuality, however, debt is not always a bad thing.

In fact, debt sometimes is considered a good thing. In many cases, it is absolutely necessary. In order to thrive in today’s financial environment, it is crucial for most people to incur debt – but wisely. By understanding the difference between good and bad debts, and how debt can work for you, you will able to plan your best possible financial future.

Bad Debt

In a broad sense, bad debt is described by experts as those expenses that you cannot afford to pay for in cash, and that begin to loose value immediately after their purchase or that have no potential to increase value in the future. These are disposable, short-term items, especially those that are unnecessary.

Bad debts include credit cards, store cards and auto loans on cars that are out of your price range. For example, you may use your credit card to purchase things that you cannot afford to pay for with cash, such as meals at restaurants, clothes, or vacations. Credit cards are one of the worst ways to incur bad debt because the interest rates attached usually are highest.

Meals and vacations are examples of purchases that are useful only for a short period of time. If you cannot afford to pay right away, then you will be paying for these expenses even after they no longer are of use to you.

Clothes are an example of a purchase that begins to loose its value immediately. If you put expensive clothes on a credit card and cannot afford to make the minimum payments each month, then your clothes literally will lose value as your balance due keeps rising with interest. The same situation applies to an unaffordable auto loan.


A particular type of bad debt that experts consider to be especially destructive is debt that arises from “fringe banking”. Fringe banking refers to financial services that fall outside of traditional financial institutions and services. Payday loans and unsolicited loan offers received via mail are common examples.

Fringe banking services almost always have extremely high fees and interest rates attached to them – not good if you cannot afford the original expense in the first place.

If you owe payment in line with the debts listed above and you cannot pay off the balance, then you probably have bad debt. Try to pay off your expenses with the highest interest rates first, and consider the various debt consolidation options to relieve yourself of debt.

Not all Debt is Created Equal

In opposition to bad debts that hinder your financial situation, good debts actually can build wealth and quality of life when used properly. Such debts are investments that will pay off in the future, or goods or services that you need but cannot afford to pay for all at once.

Student loans, debt consolidation loans, real estate loans, business loans, and especially mortgages are considered good debts. Such debts not only can be used to create an improved financial situation in the future, but also can help to build your credit in the first place.

Using Debt to your Advantage

It might seem daunting to actively use debt with the sometimes arbitrary distinction between good and bad, and especially with the potential to get in over your head. In reality, however, it is imperative that you build up your credit history for future protection.

Suppose you use cash to pay for everything and always have. What if an emergency or other unexpected event occurs that requires more money than you have? You most likely will need to obtain a loan, but how can a lender trust you with their money if you have not proven your responsibility?

In order to prove to lenders that you are a responsible credit user, you must use credit well to build your credit history. You will need to show that you can handle both installment and revolving credit reliably. The good debt examples above are great types of installment credit to get you started – especially mortgages.

Surprisingly, credit cards probably are the best place of departure for building up revolving credit – if and only if you make your payments, of course. Remember, if you can afford the full cost of the purchases listed in the bad debts section, then they really are not bad debts at all.


Regarding all Debt

The labeling of debts as either “bad” or “good” is very broad. Good debts are only good if you can afford them, and bad debts are only bad if you cannot afford them. To be even more confusing, too much good debt can become bad, and sometimes even bad debt can become good. For example, if you take out an auto loan on a car that has cheaper insurance than your current car, then it might turn out to be a good investment after all.

No matter what debts you incur, experts recommend that your debt load not exceed 36% of your earnings. Ideally, it should be less than 10-15% (not including a mortgage) of your income.

It is very important for you to check your credit report periodically so that you know for certain your credit and debt situation. Many people do not even realize that they owe money until long after the fact.

Conclusion

Before embarking on a new debt, consider what you want that debt to do for you. Lenders today no longer grant loans based on one’s ability to pay, so in many ways taking out debt responsibly is up to you. In short, good debts are those that are investments for your future, while bad debts are disposable items that you cannot afford to pay for in full.