What’s the dirtiest word in personal finance?
Debt is a no good, rotten thing to be avoided at all costs, right?
Well, sort of. In fact, debt is a lot like fire. It can be a powerful tool that helps you achieve your dreams, or a dangerous, destructive thing that can burn down your financial world. Thus it’s vitally important to know the difference between good debt and bad debt.
Good Debt is borrowing that’s done to acquire an asset that will pay dividends of some sort. A home mortgage is good debt because you can reasonably expect the value of your home to increase over the years. A business loan is good because it allows you to start or buy an enterprise that will generate profits and provide a living. A college tuition loan can also be good debt – assuming it helps you build a career.
Of course, it’s possible to have too much of a good thing. Buying too much house can hobble your ability to achieve other financial goals. (Try to keep your total house payment to about 20% of your gross income.) Excessive debt has sunk more than one company. And borrowing $175,000 to earn an anthropology degree might not be the best investment.
Bad Debt is the borrowing you do to fund short-term spending. This type of credit is dangerous because it allows us to ignore our financial realities and plans to achieve instant gratification that isn’t lasting or profitable. Credit cards are the main culprit here. Think about it: Would you have dropped $126 on dinner this past Saturday if you had to pay cash for that outing?
Car loans are problematic, too. They allow you to bust the budget to buy something that is losing value from Day One, while saddling you with a fixed $300-$400 per month obligations for three of four years. Ugh.
Credit cards can have a place in your financial life. They make it easier to travel, and sometimes offer nice rebates or rewards. But it takes discipline to reap those benefits without finding yourself with a considerable rolling balance. Be intentional about your use. Maybe don’t carry it in your purse all the time. Consider having just one general credit card – and no store brand cards. Arrange to have the card’s monthly balance auto-pay form your bank account.
As for car loans, well, ideally you will pay cash for that new vehicle, even if it isn’t the whip of your dreams. But if you decide to finance, do your homework. In some instances leasing might make sense. If you are going to take a loan, shop it – hard – and get pre-qualified. Don’t just accept whatever financing the dealership offers.
During the debate over Prohibition, a Southern senator was asked if he was for or against whiskey. His response: “If by whiskey you mean that golden elixir that feeds companionship and lubricate conversation, I’m for it. If by whiskey you mean that vile drink that destroys souls and families, I’m against it.”
When it comes to debt, choose your drink carefully.