Good Debt Vs. Bad Debt: The Difference Matters a Lot
People tend to lump all debts together, yet they are not all equal. Knowing the distinction between a good debt and a bad one can help you make better financial decisions.
Not that long ago, when people needed extra large sums of money, their home equity was their go-to source of loans. After the housing crisis, they almost went the way of the dodo bird. Then, the new popular source to borrow from became 401(k)s, because: “What’s the harm? I’m just borrowing from myself.” (For the record, don’t borrow from your 401(k). It costs you terribly in the long run.)
Instead of getting yourself into nasty debt spiral when you need to resort to your retirement savings, you should understand the nature of your loan. The key is to know the difference of good debt, necessary debt and bad debt.
Good debt grows your value over time. A mortgage is an example of good debt. It is for an asset — your house — that serves your shelter needs, contributes to your net worth and tends to appreciate.
But this scale can get tipped into bad debt when, for example, you have a mortgage you can’t afford or you try to bet your chances to buy and sell in a short time.
There is necessary debt for things that improve your station in life. A student loan, for example, is a necessary debt to fund your education, which builds earnings potential. A car loan for transportation to get you to your job is another example — but again, borrowing excessively for a luxury car tips the scales to bad debt.
Debt for consumption is bad. Consumer goods almost always go down in value. Examples of bad debt: clothing, vacations and food. Paying months or years into the future for something you consumed yesterday is not how you get ahead financially.
If you have debts, regardless of the source, retire them as soon as you can with higher payments than an installment plan or credit card minimum calls for.
Two debt-reduction strategies are useful:
1) The snowball approach, where you pay off the smallest balance first, then move on to the largest. This saves you more on interest.
2) The roll-down method where you put extra funds toward the balance with the highest interest rate first. This gives you psychological boost as you see the number of loans dropping.
The more you pay, the sooner that monkey is off your back and the less you pay on interest. And, more important, the sooner you are debt-free, the sooner you can start saving. You can’t get ahead until you have liquid savings and investments.