What are good Debt and Bad Debt?

 

Index

• What is Debt?
• Types of Debt
• Bad Debt
• Good Debt
• Categories of Debt
• Secured Debt
• Unsecured Debt
• Revolving Debt
• Non-Revolving Debt
• Sneaky Debt
• 8 Steps to Break Free from Debt
• Step 1: Reduce Your Card Collection to One Card
• Step 2: Keep Your Surviving Credit Card Out of Your Wallet
• Step 3: Carry a Debit Card Instead of a Credit Card
• Step 4: Prioritize Your Creditors
• Step 5: Assign a Monthly Payment to Each Creditor
• Step 6: Apply Found Money to Your Debt
• Step 7: Close Paid-Off Accounts
• Step 8: Knock Off Other Creditors One by One
• Good Debt vs. Bad Debt: A Breakdown
• Examples of Good Debt
• Examples of Bad Debt
• FAQs

A Small Part of The Article for The Introduction of “What are Good Debt and Bad Debt?”

Debt is a term most of us are familiar with, and it’s a crucial concept in personal finance. Whether you’re making payments on a car, a home, or even a new pair of shoes, debt is essentially money borrowed from another party that you need to pay back. This borrowed money allows you to purchase something you can’t afford upfront. For instance, if you bought a nice car before you had the cash to pay for it, that’s debt. Or maybe you borrowed money from a friend because no one else would lend it to you. Debt means you owe someone and are obligated to repay them, often with interest.

What is Debt?

Debt can take many forms and comes in different sizes. Essentially, it is an obligation that requires you to repay borrowed money. When you are in debt, you are not only working for yourself but also for the party you owe until the debt is repaid.

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Types of Debt

There are two primary types of debt: good debt and bad debt.

Bad Debt

Bad debt involves borrowing money for purchases that lose value quickly or are consumed immediately. It does not generate income or appreciate. Here are some examples:

1. Cars: Borrowing money to buy a car is often considered bad debt because cars depreciate rapidly. Even if you find a loan with low or no interest, the car’s value will decrease over time.

2. Clothes and Consumables: Buying clothes or other consumable goods on credit is typically bad debt. These items lose value quickly, and using borrowed money to purchase them can lead to financial strain.

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Good Debt

Good debt, on the other hand, has the potential to increase your net worth or enhance your life in meaningful ways. It often helps you generate income or appreciation. Examples include:

1. Student Loans: Investing in education can significantly increase your earning potential. While not all degrees have the same return on investment, education often pays for itself within a few years of entering the workforce.

2. Mortgages: Mortgage debt is generally considered good debt because it helps you build equity in a home. However, it’s crucial not to borrow more than you can afford and to understand the terms of your mortgage to avoid financial pitfalls.

3. Business Loans: Borrowing to start or expand a business can be a good debt if the business becomes profitable. However, it’s important to understand the risks, as many new businesses fail within the first few years.

Categories of Debt

Debt can also be categorized based on the terms and conditions attached to it.

Secured Debt

Secured debt is backed by collateral. For example, if you take out a car loan, the car serves as collateral. If you default on the loan, the lender can seize the car. Mortgages are another form of secured debt where the property is the collateral.

Unsecured Debt

Unsecured debt has no collateral backing it. Credit cards and personal loans are common examples. Because there is no asset for the lender to seize if you default, unsecured debt typically comes with higher interest rates.

Revolving Debt

Revolving debt, such as credit cards, allows you to borrow up to a certain limit and repay it over time. As long as you make the minimum payment each month, you can continue to borrow against your credit limit.

Non-Revolving Debt

Non-revolving debt, like car loans or student loans, involves borrowing a fixed amount of money and repaying it over a specified period. Once you pay off the loan, you cannot borrow more money without applying for a new loan.

Sneaky Debt

Sneaky debt refers to offers that seem appealing, like zero percent APR or 90-day same-as-cash deals, but come with high interest rates once the promotional period ends. These deals can lead to significant debt if not managed carefully.

8 Steps to Break Free from Debt

Breaking free from debt is the fastest path to financial freedom. Here are eight steps to help you achieve this goal:

Step 1: Reduce Your Card Collection to One Card

Having multiple credit cards can lead to overspending and high-interest payments. Start by pulling out all your credit cards and select the one with no annual fee and the lowest interest rate. Use a pair of scissors to cut up the rest. This may seem drastic, but it will help you gain control over your spending.

Step 2: Keep Your Surviving Credit Card Out of Your Wallet

Instead of carrying your credit card with you, hide it in a place that’s inconvenient to access. This will force you to think twice before using it. Consider keeping it in a cupboard, or drawer, or even freezing it in a water-filled container.

Step 3: Carry a Debit Card Instead of a Credit Card

A debit card works like a credit card but deducts money directly from your checking account, preventing you from accruing interest. While some banks charge a fee for debit cards, it’s often worth it to avoid the high interest on credit card balances.

Step 4: Prioritize Your Creditors

List all your debts, including names, balances, interest rates, and monthly payments. Decide which debts to pay off first based on factors like balance size, urgency, and interest rates. Prioritizing smaller debts first can provide a psychological boost and motivate you to continue.

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FAQs

What is the difference between good debt and bad debt?

Good debt helps you acquire assets that increase in value or generate income, like a mortgage or student loans. Bad debt is used to purchase items that depreciate quickly or are consumed immediately, such as cars or clothing.

How can I determine which debts to pay off first?

You can prioritize debts based on the smallest balance for an emotional boost, the highest interest rate to save money on interest, or the most urgent to avoid penalties.

Is it better to use a debit card or a credit card?

Using a debit card can help you avoid accruing debt and interest charges since it deducts money directly from your checking account. However, responsible use of a credit card can help build your credit score.

Should I keep my credit card accounts open after paying them off?

It’s generally a good idea to close credit card accounts after paying them off to prevent future use. However, keep one low-interest, no-fee credit card for emergencies.

How can I find extra money to pay off my debt?

Look for ways to save money, such as cutting unnecessary expenses, selling unused items, or using bonuses and tax refunds. Applying this “found money” to your debt can help you pay it off faster.

What should I do if I can’t make a payment on time?

If you can’t make a payment on time, contact your creditor immediately to explain the situation and possibly negotiate a new payment plan. It’s important to show good faith and maintain communication.

How can I avoid falling back into debt after paying it off?

To avoid falling back into debt, create a budget, stick to it, and build an emergency fund. Use credit responsibly and avoid unnecessary purchases.

Is it ever okay to borrow money for non-essential items?

Borrowing for non-essential items is generally not advisable as it can lead to bad debt. It’s better to save up and pay cash for such purchases to avoid interest charges and financial strain.

By understanding the differences between good and bad debt and following these steps, you can take control of your financial future and work towards becoming debt-free.

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