| |
|
|
|
|
| The Basics | Good debt versus bad debt
|
Here's how to tell the difference -- and trust us, it makes all the difference.
By Bankrate.com
Debt is a concept as intricately intertwined with America these days as baseball, Mom and apple pie.
The amount of personal debt in this country is ever-increasing and a large part of the reason is that credit has never been easier to get. Whereas credit-card issuers previously looked for customers who could repay, today card issuers relish the chance to reel in those who'll continuously charge beyond their means at 18% or 20%.
But debt is a complex concept. Not all of it is good -- a fact a surprising number of Americans fail to realize until they're in the hole -- and yet not all of it is bad. When used intelligently, debt can be of tremendous assistance in building wealth.
One of the secrets, therefore, to being smart with your money is to differentiate between good debt and bad debt. While the differences often seem logical, it is a logic that is apparently missed by many Americans.
Related news from Bankrate.com and MSN Money
"When you buy something that goes down in value immediately, that's bad debt," says David Bach, CEO of Finish Rich Inc. and author of "The Finish Rich Workbook.
"If it has no potential to increase in value, that's bad debt."
Good debt
"Good debt is investment debt that creates value; for example, student loans, real-estate loans, home mortgages and business loans," says Eric Gelb, CEO of Gateway Financial Advisors and author of "Getting Started in Asset Allocation.
Robert D. Manning, a professor of finance at the Rochester Institute of Technology, also recommends taking on debts that are tax-deductible and debts that produce more wealth in the long run.
"If you are talking about reducing current debt, that's where it starts to get nuanced," says Manning. "If you take a home-equity loan because you have a 17% credit card, and you go with a 6% loan that's tax-deductible, that's good debt."
These general rules of thumb set some clear delineations -- buying a home or refinancing to get rid of excessively high rates is usually good debt, as is generating debt to buy high-return stocks, bonds and other investments.
Bad debt
The concept of bad debt comes in when discussing the purchase of disposable items or durable goods using high-interest credit cards and not paying the balance in full.
"The trouble is most people are not organized enough to retire the entire balance before the due date," says Gelb.
Every month that you make a partial payment on your credit account, you are charged interest. The disposable or durable item you purchased continues to lose value, and the amount you paid for it continues to increase.
"When you buy clothes, they're probably worth less than 50% what you pay for them when you walk out the door," says Bach. "So if you borrowed to pay for them, that's bad debt."
Not to mention what that debt could potentially do to your credit rating.
"Total personal debt should not exceed 36% of your total income," says Gelb.
Keeping the debt-to-income ratio in mind, it's also important not to miss payments.
"Missed payments are trouble," he says. "A representative of Citibank said if you don't pay within 30 days, they report that to the credit bureaus."
When it comes to buying durable goods that won't contribute to wealth generation, Bach offers a basic rule of thumb.
"My grandma used to say that if you're going to buy something that doesn't go up in value, and you can't afford to pay cash, then you can't afford it."
Exacerbating the bad-debt factor is that people will apply for store credit for the savings offers that say if you open a credit card account today, you can take 10% to 20% off the cost of your purchase. What people often don't realize is how much of that savings will be destroyed by the high interest rate on the card if they fail to pay for the items immediately.
"You can open a store credit card account," says Bach, "and what they're not telling you is that after the first few months, the rate jumps to 20% or greater."
Driving into debt
Another bad-debt area is auto debt. While most people need an automobile, and the ultimate cost of an auto is higher than many people can pay in one lump sum, the way people go about it -- namely, purchasing more car than they need -- turns it into bad debt.
|
|
|
|
|
|
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
|
|
