Debt can be of two types. There can be good debt as well as bad debt.

Good Debt

Good debt can be described as debt that helps you build equity or increase your net worth. For example, education loans usually are considered good debt because in the long run more education generally translates into higher earning power. Most people borrow money for a mortgage to get a home—if the home purchase was a wise investment that increases in value and adds to your net worth, then it would be considered good debt. Another example of good debt might be loans to run a small business—for example, if you borrow money at 7% and use that money to make a 15% or 20% return, then it would be considered good debt because you are using the loan to increase your net worth. Good debt includes loans that help to build your financial future

Bad Debts

Bad debts are the ones that negatively impact your financial future. Bad debt might be described as obligations that last longer than the purchase item and ones that have no return toward increasing your net worth. Before making a purchase via a loan, ask yourself is this good debt or bad debt—will the debt help to increase my net worth or will it decrease my net worth? Avoid as much bad debt as possible. The Financial Planning Association suggests that total debt should not exceed 10–15% of your take-home pay—excluding mortgages. Many credit experts recommend that debt should not exceed 25 percent of disposable income. Over indebtedness can push you to the maximum to repay your debt while still trying to maintain daily living expenses. A sudden unexpected event such as a job downsizing, divorce, a death in the family, an uninsured accident, theft, a large tax bill, or a major medical expense can have tragic results to your finances and result in a credit crisis. A major unexpected event combined with insufficient savings and insurance can easily result in a credit crisis. Assuming credit loans is something you want to avoid if at all possible. Few things are worth borrowing for. Avoid going into debt for rewards such as vacations or fancy restaurant meals; save for them and pay cash Borrow as little money as possible and at the lowest interest rate possible.

Not all debt is bad. Good debt helps you obtain assets that produce income. If taking out a loan will eventually put you in a better financial position, chances are it is good debt. Your home, for example, was probably one of the best investments you’ve ever made.

Area of Attraction of Bad Debt

Bad debt steals your money and produces no income or cash flow. It is money borrowed for something that loses value, such as a car, clothing, and electronics, to name a few. Earlier this year, the Federal Reserve reported 2005 numbers on consumer debt: Non-mortgage consumer debt climbed to $2.1 trillion. Based on that number, the average household has more than $17,000 in bad debt. Considering that most families have at least one car loan on top of the credit card debt they might be carrying, $17,000 actually seems low to me.

The other area that attracts bad debt is money we spend on clothing, electronics and eating out. The truth is that most of this spending winds up on credit cards. One of the best ways to tackle your credit card balances is to stop using credit cards altogether and use only cash for purchases until you’ve paid off the balances in full. Studies show that consumers spend far less if they use cash versus credit. At the very least, when using cash, you can’t spend more than you have. Another solution is to get a low-interest loan, home equity line of credit, or cash-out refinance to consolidate high interest rate credit cards. My only warning is to make sure that when you use your home’s equity to pay off credit cards, you address the root spending problem so you don’t find yourself months or years later with a higher mortgage balance and credit card balances once again.

By Douglas Boncosky & Bill G. Page

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