Debt Solutions – Good Debt vs. Bad Debt
By Michael Russell
Debt simply means that money was transferred between two parties. It implies that at a future date the loan will be repaid according to the repayment terms. Every time an item is bought we immediately go into debt. If the item is small, we can generally pay immediately and not see any long-term debt. Of course, there are many larger items that we all need but cannot pay for with cash. It causes us to go into debt for months if not years in order to repay.
Debt is not a terrible thing to avoid at all costs. Some people feel comfortable paying for everything right up front. Drive used cars, rent an apartment and pay for school once you have the money for it. All items that we buy either appreciate or deprecate in value over time. Buying a brand new car loses could lose 10% in value the second it leaves the dealership’s parking lot. At that point, if you sold the vehicle, the value of the car would not even pay for the remaining balance due on your auto loan. Even if the driver uses the vehicle for several years and finally sells it, they may still sell upside down which means they did not receive enough money from the sale to cover the loan. Perhaps you need to take out an additional loan to cover the original auto loan. This scenario is a great example of bad debt. A great financial rule is to never go into debt to buy something that loses value over time. One could make an argument that if you wait long enough the value of the car would start to appreciate again. This could happen after waiting several decades. Investing that money into bonds during that same period could result in smarter investment.
On the other hand, good debt is buying an item that appreciates over time. Upon sale, you will have money to pay off the loan and receive additional money to pocket. There are many examples of good debt including buying some homes in a buyer’s market. Working out the math on buying a home to see if you will make money in end is complicated. You can deduct many things including mortgage interest but if you are buying in a seller’s market and selling in a buyer’s market, you may turn good debt into bad debt. The alternative is renting where of course, nothing is tax deductible and you throw rent money away each month. For most people who own a home and fall in the 25% tax bracket, they throw away 75% of the interest they pay each year so there is certainly a trade off. Figuring out if taking on a house debt is more financially healthy than renting is complicated but it could help you decide which one makes more sense.
As college tuition rises, more students want to work first and then go to school so they can pay for it. Perhaps for them the sound of debt is scary but looking at your salary difference should be the reason behind the decision. For example, if you make $20,000 ($10 an hour) before college and $50,000 ($25 an hour) after college that is a difference of $30,000 a year. By waiting to go to school and make money before you go you are actually costing yourself $30,000 every year you delay graduation. You can also look at the ROI, return on investment. College could put you in the red lets say $60,000. If you make $30,000 more per year it will only take 2 years of post college employment to cover you debt. A 2 year ROI is certainly good debt and it will pay off. Simply looking at the word debt without doing some math could result in passing up an opportunity to take on good debt.
Remember to look at the long turn implications of your decision and always observe if buying will incur a debt that will pay for itself and net you a profit.
Your Independent guide to Debt Solutions
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