Personal debt is on the rise and many individuals are worried about the high level of debt they are carrying. If a person has accumulated a lot of debt, this can significantly affect their financial future.
All debts are not created equal. There is, in the most simplest of terms, what is referred to as ‘good debt’ and ‘bad debt’. While all debt is money owed which must be repaid, there are distinct differences between the two types of debt.
Generally good debt leads to future wealth, and consequently, value, while bad debt leads to becoming a heavy financial burden that could be difficult to emerge from; it also offers no long term benefits.
In order to protect yourself from amassing a significant amount of the bad kind of debt it is important to gain a thorough understanding of the differentiations of each form of liability.
• Characteristics of Good Debt
According to Bankrate.com, examples of good debt are mortgages, school loans, real estate loans, business loans or, in some instances, stock or bond investments. The reasons why these are considered to be a positive form of debt is because they lead to something of tangible value. Refinancing a loan in order to reduce high interest rates is also considered a form of good debt.
Mortgages and real estate loans lead to ownership of homes and land, which is considered a valuable asset that, in many instances, can be resold in the future for a profit. This is especially true for investment properties which are strategically bought. Educational loans lead to a college degree(s), which in turn offers potential to gain a better earning income which can create more wealth.
• Characteristics of Bad Debt
Bad debt generally is a liability which will end up offering the individual no tangible or long-term value. Bankrate.com states “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.”
Credit cards, store credit, auto loans are forms of bad debt. The reason for this is because the purchases typically associated with these debts do not have long-term value or a poor resell value. With these types of purchases, the item goes down in value immediately and/or has fast depreciation. There is also no real potential to lead to anything of value. Bad debt cannot increase wealth.
It is important to understand that debt also impacts your credit rating. Borrowers of bad debt should watch what they owe and try to pay off these expenses more quickly to avoid additional interest rates, some of which might be pretty high. Better yet, pay in cash.
The general idea when borrowing money is to try and spend where you can either (a) increase your wealth or (b) save money through making the purchase. For instance, buying a car may result in lowering gas costs for a more efficient vehicle.
One of the problematic issues in society is the fact that there is too much opportunity and convenience to spend. Credit card banks and store credit financiers create appealing terms, only to raise them later or entice consumers to spend more (discounted coupons, percent off, free merchandise, etc), but in the long run this leads to bad debt.
Society has evolved into an instant gratification one and, as a result, many consumers find themselves stuck buried in debt because of the abundance of purchases made which may not be necessary buying. In order to avoid falling into the bad debt trap, it is best to make a strong effort to only buy within budget, meaning the money owed can be paid back quickly, or to simply stick to the cash rule.
This is essentially the difference between good debt and bad, however having an understanding of this can help consumers who may be at risk to stay out of financial difficulty.