When you hear the word “debt,” what is your immediate thought? That having debt is bad? That it comes from lack of using money management skills? For most people, the term debt has a negative connotation, likely derived from the fear of being in debt. However, what most people don’t realize is that some debt is actually good. To help you understand the difference between good debt and bad debt, and how to use debt to your advantage, we’ve created this blog.
Debt is defined as the obligation to pay or repay for something. It comes in many forms, such as buying a car or house, taking out a personal loan, or using a credit card. How much debt you take on, where the debt comes from, and for what reason you are taking it on determines whether your debt will be good or bad.
Bad debt comes from financing something that will not return your investment. Take purchasing a car, for example, using the following scenario:
|Person||Car Type||Monthly Income||Monthly Payment||% of Monthly Income|
In this case, Person A’s monthly car payment accounts for 40% of their income and is likely to fall into that trap of bad debt. Also, notice that Person A purchased a new car versus Person B’s used car. New cars lose value the moment you drive off the lot. Meaning when you finally pay off the vehicle, your “return on your investment” is much less than what you paid for. However, as part of your decision-making process, you may want to consider if having a car is important—something we will discuss later.
Bad debt can also come from having too many Credit Cards, or cards with high-interest rates such as retailer cards. Using your Credit Card to pay for everyday purchases is okay as long as it’s within your budget, but rethink if you’re using it to buy things you can’t afford or don’t need. Remember, if you can’t pay for it, don’t buy it! Use your money management skills to make responsible financial decisions.
Payday Loans are another example of bad debt. These loans are usually issued for a few hundred dollars and typically require repayment within a few weeks (when you get your next paycheck, for example). They also could carry interest rates of well above 300%—more than ten times higher than what you could have with a Yolo FCU Credit Card. When a borrower can’t make their payments in full, they often will find themselves forced to take out additional loans and end up stuck in a cycle of borrowing and repaying these costly debts. Break the cycle by avoiding these types of loans altogether.
Lastly, Personal Loans for discretionary purchases can lead to bad debt. Taking on debt for expenses like a vacation or paying for a wedding could lead you down a path towards bad debt. These loans are better off to be used for debt consolidation (something of value), rather than for discretionary buying.
On the opposite side, good debt is typically defined as debt used to finance something that will increase in value in the future, or help you build your credit. For those starting out, good debt would be taking out a Credit Card at your financial institution that helps establish credit. Yolo Federal’s Visa® Shared Secured Credit Card is great for those trying to build or rebuild credit. It works just like a regular Credit Card—except you’ll freeze funds in your account to be used as a credit line. To learn more about credit (re)building, visit this blog post: All About Credit.
Home Loans are also considered good debt. Having a home not only satisfies a basic need for shelter, but homes in a market with increasing property value could also have a long-lasting positive effect on your life. When it comes time to move, you’ll have a good chance of selling it for more than what you paid for it. Be sure to know how much house you can afford before shopping and limit your Home Loan payment to 35% or less of your monthly income.
As we previously discussed, an Auto Loan could be considered both good and bad debt depending on your situation. Whether you choose new or used will be contingent on what you can afford, your needs for the vehicle, and if there could be maintenance costs to consider. If you need the car to commute to work or take kids to school, then the depreciating value may be of less concern. Make an educated decision based on your situation and what you can afford.
How to Use Debt
To put it simply, a wise borrower will maximize good debt and minimize bad debt—within reason. If your budget can’t handle the good debt you take on, you will end up having the opposite effect, resulting in bad debt.
Credit Cards can also be dangerous because of high-interest rates, plus the late fees that can occur if you fall behind on your payments. However, if you can commit to paying off the card every month before the interest accrues, there really is no downside to using a Credit Card to make everyday or special purchases. Be aware of what you can and cannot afford, and use money management skills to make smart financial decisions.
A question you should ask yourself every time you do something that will increase your debt is: “Do I expect to find value in this purchase?” Think like an investor—if the purchase doesn’t provide you with anything valuable, consider waiting until you can pay cash to buy the item. When you fall into the habit of buying things you can’t afford with plastic, you might be digging yourself into a deep pit that will cost you time and money to escape.
As you review your current debt and find that you have more bad debt than good, don’t worry! There are many ways to improve your good-to-bad debt ratio. Let a Yolo Federal representative help you find a path to financial freedom. Whether it’s debt consolidation to our Visa Gold Credit Card or a refinance to a lower interest rate on your Auto or Home Loan, our team of local experts will look for the solution (or solutions) to make your life easier. Schedule an appointment to get started today.