Good Debt vs. Bad Debt
Overall, debt is a very complex topic. To simplify, it is best to view debt as either good or bad . Good debt can be defined as debt that is obtained while making a decision about the future. It is usually used to purchase something that appreciates in value. Bad debt can be defined as debt that is used to obtain something that is disposable or depreciates in value. Understanding the differences and how to use the different forms can help you minimize the bad and will allow you to use the good wisely to accumulate real wealth.
Understanding Bad Debt
Bad debt is used to purchase things that are disposable an will never have the chance to appreciate in value. Two prime examples are high interest credit cards that are not paid in full and auto debt. When you use debt to finance things that are consumed, you can be sure that this is creating bad debt. Most things purchased with a credit card and not paid off in full by the end of the month will turn into bad debt. Auto debt is also considered bad because everyone knows that when you purchase a new car, the moment you drive off the lot the car loses value instantly. With the financing options available now, most people purchase more car than they can financially handle. The way payments are spread over such a long period of time can make almost any car affordable on a monthly basis to anyone. However, after years and years go by and the car is finally paid off, the car maintains very little value of the original amount spent. These types of debts generally carry a much higher interest rate than good debt. In general, bad debt takes money out of your pocket and keeps taking more out.
Understanding Good Debt
Good debt is usually obtained while making a decision about the future. These debts can be viewed as investments that eventually create value. A few examples are student loans, home loans and business loans. A student loan is considered good because this loan is taken out with the intent that it will increase the future earnings potential of the individual. A home loan is also a good because on average, homes appreciate in value. When the asset purchased with a home loan is paid off, the individual will be left with an asset with an equal or greater value than the original loan itself. So this ads wealth by creating greater net worth. Good debt also has a much lower carrying value than bad debt. The interest is usually less than half that of the bad. This debt also usually has many tax advantages. In short, good debt is used to eventually increase the future wealth of a person.
Understanding the difference to make future debt decisions
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Understanding the difference between good and bad debt can significantly help with future decisions about debt. There are also ways to use good debt to eliminate bad debt. For example, if an individual carried a $15,000 credit card balance paying 18% interest and also owned a home that has appreciated in value, it is possible to use the home's equity to pay off the $15,000 credit card balance and eliminate the 18% interest on it and then carry the $15,000 at the lower interest percent of around 6%. This decreases total annual interest costs as well as providing tax advantages. This may not always be an option, but understanding the differences can help in future debt decisions. If there is an option of tackling bad debt vs good debt, it is always better to eliminate the bad debt first. Please know that having too much debt is never good, even if it is good debt, always maintain an reasonable amount of debt.