According to most financial gurus, one of the best ways to improve your financial situation is to get rid of debt. In general, this is good advice. Owing money you can’t afford to pay back can haunt you for a long time, and it could potentially wreck your credit if you’re not careful.
Not all debt is created equal, though. Even though having too much debt is bad, there are some situations where going into debt can actually help you get ahead. So how do you tell “good debt” from “bad debt”?
When people talk about “good debt,” what they actually mean is making an investment in something that will help you generate more income and improve your net worth.
Another example of good debt is investing in real estate. Buying a house and maintaining it for a few years usually results in turning a profit when you sell it, and buying a house to rent or lease can also be a source of income that is well worth the initial price of the loan.
Starting a small business, while riskier than student loans or real estate, might also be considered good debt. If a business succeeds, the loan you took to get your business started could turn out to be the catalyst that made you very wealthy.
Even an auto loan might be a good example of getting debt, since a car is necessary for almost every aspect of your life. However, this does depend on when you’re upgrading your car and the new car you’re planning to buy. Taking out an auto loan to buy a new family car when your old family car has died is good debt, but taking out an auto loan to buy a new Porsche after watching “Fast and the Furious” is not.
While good debt is an investment in your future that will pay off over time, bad debt is debt that ultimately hurts your financial situation.
High-interest loans are the most common example of bad debt. If the interest rate on any loan is greater than 20%, you may be spending more on interest each month than you are actually paying down on your debt. This is especially common with credit cards.
Taking out loans for entertainment (or “discretionary”) purposes, like buying new clothes, taking an expensive vacation or buying a sports car is also bad debt. Granted, this isn’t always a bad thing. You might want to go into debt to finance that once-in-a-lifetime trip to Hawaii, for instance, or maybe you want to buy a new wardrobe because you just got that new job you wanted.
The final example of bad debt is a payday loan. While high-interest loans and loans used for entertainment purposes might be put to some good use, payday loans are utterly toxic. The average interest rate on these loans is around 400%, and if you, like most people, can’t repay that loan within two weeks, your interest rate rockets to 521% and keeps rising.
The key is to be aware of what debts you have, and make sure you’re constantly paying down on them.
Not all debt is created equal. When you're thinking about taking out a loan or charging an item to your credit card that will take some time to pay off, ask yourself if that debt is going to ultimately help your financial situation or hurt it. If the debt will hurt your financial situation, you'll want to rethink taking it on.
If you do find yourself saddled with bad debt, you should know that when you become a member of First Alliance Credit Union, you get access to several tools that will let you get debt free. You can transfer your credit card balance to a card with a lower interest rate to consolidating your debt or refinancing an existing loan at a lower interest rate. You can even download our free debt organizer that will help you organize your debts, find extra money in your budget to pay them off, and walk you through the whole process with an easy-to-follow checklist.