Good Debt vs. Bad Debt

Believe it or not, there are some types of good debt. However, there are more types of bad debt.

For most Americans, it is nearly impossible to live debt free. We can’t afford pay for our homes, our cars and college education with cash. These items are investments in our lives, our futures, and just make sense to borrow for. The problem lies in when we let our debt get out of control.

Long-term debt payments, which include your home and credit cards, should not exceed 36% of your gross monthly income, experts say. But, when credit cards are so easily accessible and simple to use, it’s no wonder the average US household with at least one credit card carries over $10,000 in credit card balances. Hence, many families are experiencing overwhelming debt and personal bankruptcies are at record highs.

Some of this debt is unavoidable. Much of it is not. The challenge is to learn how to balance what debt makes sense and which does not, without depleting your cash reserves for emergencies. You much judge wisely and manage the money you save and borrow.

Good debt is anything that you need (not just want) but can’t afford to pay for at once without depleting your savings or liquidating your investments. If you have an item that makes sense, be sure to only borrow the minimal amount that you need and can afford to make the monthly payments. These debts would include college for yourself or your children, your mortgage or home loan, and a vehicle.

Bad debt is accrued on items you want - but don’t need and can’t afford. Rather than saving, you put the purchase on a credit card, which is the worst form of debt because they typically have the highest interest rate. These debts would include anything you don’t need and can’t afford, such as vacations, designer clothing, jewelry, etc.

Occasionally the decision to borrow doesn’t necessarily depend on how much cash you have, but whether there are ways to make your money work harder for you. For instance, if interest rates are exceptionally low, compare what you will spend on interest on a loan versus what your money could earn if it were invested. If you think you can get a higher return from investing your cash than what you’ll pay in interest on a loan, than borrowing a small amount at a low rate may make sense. Be sure you do your homework and you are confident in your decision. If the investments you are considering don’t yield a return, what kind of hit will you take?