The modern world runs on debt and countless consumers find themselves tangled in debts that severely limit their financial options. One reason for this state of affairs is that basic financial education is not nearly as widespread as it should be. You can turn that situation around for yourself by learning how to tell the difference between good and bad debt.
Interest, Appreciation, And Value: Defining Good Debt
Let’s start by looking at basic terms. A debt is simply a promise to pay for something at a later time that you purchase now. Debts are usually spread out over multiple installments. The institutions that provide you with credit earn money on this service by charging you interest. That means that debts cost more over time, especially open-ended debts like credit card balances.
Generally speaking, debts and acquisitions start out equal: You take out a $20,000 loan and buy a $20,000 car. An interesting thing happens over time, though. Interest drives up the value of the debt to your creditor. What happens to the value of your acquisition? It either remains constant, appreciates, or depreciates. In three years’ time, your loan may be worth $28,000 (including the payments you make), but your car is only worth $15,000.
Financing an asset that will depreciate – like a car or day-to-day expenses – with debt that accumulates interest is what financial experts call “bad” debt.
So what’s good debt? That’s when you buy something that will increase in value over time, ideally faster than your debt accumulates interest. Real estate, investments, and student loans are all examples of purchases that produce “good” debt. (Student loans count because education enhances your future earning potential.)
Recognizing “Gimmick” Debt
It’s easy to say “don’t take on bad debt” after you’ve defined it. The problem is, of course, that many people simply don’t have the option. Emergencies, income fluctuation, or financial mismanagement may sink your financial resources below your immediate needs. In these cases, taking on bad debt is unavoidable.
What you can do is steer clear of “gimmick” debt. This is bad debt concealed with marketing tricks to make it more attractive. Store credit cards are the classic example. They offer upfront discounts that look impressive at first glance. They charge truly ruinous interest rates, though, hoping that you will carry an ongoing balance that earns the store far more money than they lose through discounts.
You should always consider a debt purchase by thinking about the appreciation potential of what you’re buying. If you are purchasing something which is not going to increase in value, avoid using debt to do it if at all possible. Put off the purchase and save up for it if you can. If you can’t, do thorough comparison shopping to ensure you are getting the absolute minimum price.
While bad debt is an unavoidable burden many people have to bear, and getting out of debt is not easy, you can take steps to lessen the impact it has on your finances. Knowing how to recognize it is an important first step. Once you understand the relationship between appreciation and debt, you will be able to use your credit wisely and reduce the amount of bad debt you take on. .