Defining Differences between Bad Debt and Good Debt - dummies

Defining Differences between Bad Debt and Good Debt

By John Ventura, Mary Reed

Whether your debt is good or bad depends on the type of debt, the reason you owe it, and whether you can afford to repay it. When used the right way, debt can help you manage your finances more effectively, leverage your wealth, buy things you need, and handle emergencies.

Debt can be a positive force in your life when it helps you

  • Build your family’s net worth — the difference between the current value of your assets and the amount of debt you owe. A mortgage is a perfect example. Good debt is even better debt when the value of the asset you finance increases over time.

  • Buy something that will save your family money for years to come. For example, you get a loan so you can weatherize your home and lower your utility bills.

  • Purchase something important or essential to your life that you could never afford to buy if you had to pay for it with cash. Examples of this kind of debt include a car loan and a mortgage.

  • Invest in yourself in order to increase your earnings potential. For example, you borrow money to return to college or to upgrade your skills so you can make more money in your current field of work or move into a more lucrative career. Student loans are a common example of this kind of debt.

  • Pay for an unexpected emergency when you don’t have the cash to cover it. For example, your car breaks down far from home and you need to have it towed; or you have no health insurance and your child needs expensive medicine.

However, debt can be a negative force in your life when you

  • Go into debt to buy nonessential goods or services that do not increase your wealth and have no lasting value. Examples include restaurant meals, groceries, clothing, personal items, and vacations. The longer you take to repay the debt and the higher the interest rate on the debt, the worse the debt. Credit card debt is the most common example of this kind of debt.

    Credit card debt is not bad if you pay it in full as soon as you receive your statement, or if you pay the debt in full within a very few months and you don’t charge more on the card until you’ve paid off the outstanding balance on your account.

  • Secure the debt with your home or with another asset you don’t want to lose when you’re not sure that you can afford to repay the debt.

  • Have a high interest rate and make low monthly payments. By the time you pay off the debt, the amount you pay in interest exceeds the value of the product or service you financed.

  • Borrow money from dangerous lenders like advance fee lenders, payday lenders, and finance companies.