We all know that the financial crisis was brought about by people having too much debt, bad debt to be exact. With what people are going through right now, I doubt if many will ever go back to a financial institution, and borrow money again. As I have said many times, there are two types of debt, good debt and bad debt. The one characteristic that will differentiate between these two types of debt is, whether whatever you are buying on debt will increase in value over the years or reduce. When you buy an asset, for example, take a mortgage, using debt, the value of your home will increase you net worth over time, but when you purchase, for example, a car, its value will depreciate every other year, thereby eroding you net worth. The following article from Bankrate.com clearly distinguishes between good debt and bad debt.
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 percent or 20 percent.
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 apparently is missed by many Americans.
“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 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 17 percent credit card, and you go with a 6 percent 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.
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 percent 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.”
Credit Rating Effect
Not to mention what that debt could potentially do to your credit rating. “Total personal debt should not exceed 36 percent 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 percent to 20 percent 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 percent 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.
When is it worth it?
“What we would normally consider bad debt can turn into good debt in certain circumstances,” says Catie Fitzgerald, a personal finance coach and registered investment adviser in Henderson, Nev. “If you use debt to buy a car that gets better gas mileage than your old vehicle, you could end up better off financially.”
Bach considers auto debt a Catch-22. “People borrow to buy cars before homes,” says Bach, “and that’s unfortunate. For most people, their first major loan is a car loan. That’s guaranteed to go down in value. So you really want to borrow less. For example, instead of rushing out to borrow to buy a $50,000 BMW, you’d be better off buying a $25,000 car.”
The Best Debt
The best type of debt is debt that builds wealth over the long run, and the No. 1 example of that is mortgage debt.
“Home values have increased an average of 6.5 percent a year over the past 30 years,” says Bach. “So when you borrow to buy a home, chances are that’s good debt. You’ll build value.”
Bach heavily promotes the idea of homeownership, saying that everyone needs to own where they live. “About 40 percent of Americans are renters,” says Bach, “and the fastest way to wealth in America is buying where you live.”
Bach cites some shocking numbers to back this up. “The average renter has a median net worth of $4,000, and the average homeowner has a median net worth of about $150,000.”
Manning also emphasizes what a good time this is to build wealth through debt. “This is the most advantageous time ever to be in debt,” says Manning, “in terms of opportunities to get low-interest loans or to renegotiate or refinance.”
One of the reasons so many Americans seem mired in bad debt (Bach reports that the average American carries approximately $8,400 in credit card debt) is that financial education is practically nonexistent. “This type of commonsense stuff isn’t taught in school,” says Bach, “and most Americans don’t realize how bad high-rate credit cards are hurting them.”
Fitzgerald advises teaching your children the difference between good debt (debt that’s used to buy assets that grow in value over time) and bad debt (debt that’s used to buy things that will lose value) early on.
Gelb opts for a more hands-on approach. “Give your children an allowance (without strings) beginning when they’re in kindergarten and offer them the opportunity to perform extra jobs around the house for money. Stop buying them everything, and teach them how to make choices with their own money-buying decisions.” The mistakes they make will help them learn and grow.
“People are getting in debt before they have a job,” says Manning. “Education is important. We used to encourage kids to save, and that has been missed. Students now refer to their credit cards as ‘yuppie food stamps’. They see cards as entitlement, and see they will be in debt all their lives.”
Fitzgerald recommends teaching by example. Treat credit cards like emergency safety nets and your children will likely learn some money management skills. “If you have to use your credit card, immediately revise your budget, paring back on nonessential spending. Allocate the saved dollars to a pay-off plan to bring your debt balance down to zero as soon as possible,” she says.