Part 4 of the Financial New Year's Resolution Series is about something almost all of us deal with at one point or another: debt. Is there such a thing as "good debt"? We hear the term thrown around all the time but it seems counter-intuitive to most sound financial advice. Debt, in and of itself, is not a bad financial tool to use. In fact, it can be a very powerful tool when used properly. It can also be devastating when abused or used improperly.
In very basic terms, debt is something that is owed, generally money, to another party.
So the question is, what is the difference between good debt and bad debt and how do you prioritize paying it off? Let's start with good debt. When debt is used to acquire or grow an asset which has potential to appreciate, then it is viewed as good debt. For example, in the case of the mortgage, you would anticipate the value of your home to grow over time. Since you don't have enough cash available at the time of purchase, the mortgage allows you to finance an appreciating asset. If the real estate value goes up, then you get the benefit of that appreciation and are only required to make the payments initially agreed upon. Other types of good debt that should be serviced but not necessarily paid off in a hurry are business loans and student loans.
On the flip side, bad debt is the type of debt that is used to acquire depreciating assets. The most common example is credit card debt. Running up a credit card balance that you are unable to pay off can be devastating to your finances. Typically credit cards are used to purchase consumer goods like clothes, TVs, toys, electronics, etc. These goods do not appreciate in value and are often times rendered useless or obsolete after a certain amount of time. Financing the purchase of these goods, as in the case of running up credit card debt, is considered bad debt and should be avoided to the greatest extent possible.
But, undoubtedly we find ourselves in a scenario when we have accrued various forms of debt and have to figure out how to prioritize paying them off. First and foremost, we must get rid of the bad debt as quickly as possible. Here are a couple of ideas to help navigate these treacherous waters:
- Look into "zero interest" balance transfers. Often times you can consolidate your outstanding balances on a new credit card that has an introductory rate of zero percent. If you do this, be sure to pay off the balance within that introductory period to avoid the accrued charges from piling up on you!
- Pay off the highest interest rates first. If you have two credit card balances and one is 21% and the other is 12%, knock out the 21% ASAP!
- Call your credit card companies and ask for a rate reduction or a payment plan. Most of these companies will work with you if you have a mutually beneficial plan to get the balances paid back.
- Start small! Tackle the smaller balances first and then work your way up to the larger balances. This is what we call the "Snowball Effect". You'll find satisfaction in small wins and this will help you gain momentum to pay it all off.
- Focus on putting your available cash flow towards these debts to get it paid off. For ideas on how to find that cash flow to put towards your debt, be sure to read our ebook on holding an Economic Shutdown.
Suggested New Years Resolution:
I will decide in what order to tackle my debt by _____(date)_____ . I put _____($ Amount)_____ more toward my debt each month. I will work with my _____(number)_____financial institutions to update negotiate my interest rates by _____(date)_____.
Financial New Years Resolution Series: Part 1: Planning Your Resolutions - Where to Start Part 2: Organizing Your Finances Part 3: Creating A Budget