Living completely debt-free is an almost impossible task. Most Americans are not able to pay for their home or childrens' education with only cash, so borrowing money is necessary. When contemplating a purchase that will add to your debt, it is important to consider whether it is good debt or bad debt.
You may be wondering how anything that adds to your debt could be considered good. Good debt is the debt that you acquire in order to finance an asset. An asset is something that has value today and is expected to increase in value over time. The increasing value of the asset can help contribute to your overall financial well-being. A mortgage is an example of good debt; your home is an asset that will most likely appreciate in value. A student loan is also considered good debt. The asset is you or your child’s future. More knowledge and education leads to a higher earning power. With both a mortgage and a student loan, you also get a tax break on the interest payments.
Of course, with the good comes the bad, and accumulating bad debt is a very easy thing to do. Bad debt is any money that you borrow that is not used to finance an asset. Credit card debt is the ultimate bad debt if not managed properly.
When you pay by credit card, it is very easy for you to spend more than you can afford. The average American household has $15,216 in credit card debt. If you use your credit card for everyday purchases, paying your balance off in full every month is very important. Avoid accumulating credit card debt that you don't pay off in a short amount of time. Other tips for the use of credit cards include:
- Use a card that does not charge an annual fee
- Make sure there is at least a 3-week grace period
- Pay the balance in full every month
- Negotiate a low interest rate, just in case you have to carry a balance
- Always make your payment on time
- Don’t charge anywhere close to your credit limit
- Avoid and understand all possible fees (late fees, over limit fees, consolidation fees, cash advance fees)
- Avoid the minimum payment trap: if you have a credit card balance of $2,500 with a rate of 16% and you’re making the minimum payments (3%), it will take you approximately 14 years to pay it off. Yes, 14 years! On top of that, you will have paid an additional $1,844 in interest — 74% more than what you originally spent.
Home equity lines of credit are categorized as bad debt if they are used to finance vacations or other items you want but do not need (the vacation to Fiji may sound nice, and you may come back refreshed and revived, but unfortunately it cannot be classified as a need). A car loan can also be bad debt to take on, as a vehicle is considered a depreciating asset. However, most of us need to take out a loan to buy a car. Try to minimize your car debt and aim to pay it off a quickly as possible, and try not to finance your car purchase for more than 3 years. In most cases, you will save money getting a car loan rather than leasing.
Not all debt is a bad. The important thing is to be wise about the debt you acquire and don’t let your debt get out of hand.