As I mentioned in last week’s post, over the next few weeks we’ll look at the steps necessary to get out of debt, how to become better money managers, and begin living a debt-free lifestyle. This week I’m going to dive a little deeper into the concept of consumer debt.
Good Debt vs. Bad Debt
For the sake of this discussion on debt, we’re going to assume that all money you owe to anyone is called debt, regardless of your ability to repay your loan obligations.
According to Bankrate.com, “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 (on credit) 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 debt that is tax-deductible and debt that produces more wealth in the long run.
These general rules of thumb set some clear delineations — buying a home or refinancing to get rid of excessively high interest rates is usually good debt.
Most financial experts believe that the best type of debt is debt that builds wealth over the long run, and the No. 1 example of that is mortgage debt. ‘About 40 percent of Americans are renters,’ says David 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.'”
“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 Eric 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 David Bach. ‘So if you borrowed to pay for them, that’s bad 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.” The moment a new car is purchased and driven off the lot, it looses about 25 percent of it’s value!
The Ugly Credit Rating Effect
“It’s also important to understand 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.'”
Poor credit ratings, due to slow or non-payment of loans and/or credit cards, will scare other lenders away from considering your future credit and loan requests. Improving your credit score is a critically important piece of the puzzle when working towards financial freedom. Higher credit scores insure lower interest rates.
I hope this review on debt was helpful in encouraging you to think twice before pulling out those credit cards or signing for a loan without first considering the ramifications of good debt verses bad debt.
Short of buying a house or car, if you can’t pay cash for your purchases, or you know you won’t be able to pay off your monthly credit card bills in full, then like David Bach’s grandma used to say, “you can’t afford it!” I’ll admit it’s easier said than done, but it’s a great first step in working towards a debt-free lifestyle.
See you next week for more Wisdom Matters on working towards financial freedom.