The Difference Bad Debt Vs. Good DebtWhy the rest of us borrow money? Usually, we borrow money because we don’t have enough to buy something we need or want — like a new car. A trip to your friendly local car dealer shows you that a new set of wheels will set you back $25,000+. Although more people may have the money to pay for that than, say, the new car, what if you don’t? The auto dealers and bankers who are eager to make you an auto loan say that you deserve and can afford to drive a nice, new car, and they tell you to borrow away (or lease, which I don’t love). I just say, “No!Why do I disagree with the auto dealers?

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Incase if you’re new here, yes personal finance topic is new in this site [Although I been blogging for couple of years and spent more than decade in the financial field]. I would like you to know that I am not trying to sell you a car or loan from which I derive a profit! More importantly, there’s a big difference between borrowing for something that represents a long-term investment and borrowing for short-term consumption. Read on…

If you spend, say, $1,500 on a vacation, the money is gone. Poof! You may have fond memories and photos, but you have no financial value to show for it. “But”, you say…

Vacations replenish my soul and make me more productive when I return. In fact, the vacation more than pays for itself!

I’m not saying that you shouldn’t take a vacation. By all means, take one, two, three, or as many as you can afford yearly. But that’s the point:

Take what you can afford. If you have to borrow money in the form of an outstanding balance on your credit card for many months in order to take the vacation, you can’t afford it.

 

Realizing the Source of Your Bad Debt

I coined the term bad debt to refer to debt incurred for consumption, because such debt is harmful to everyone’s long-term financial health. You’ll be able to take many more vacations during your lifetime if you save the cash in advance. If you get into the habit of borrowing and paying all that interest for vacations, cars, clothing, and other consumer items, you’ll spend more of your future income paying back the debt and interest, leaving you with less money for your other goals.

The relatively high interest rates that banks and other lenders charge for bad (consumer) debt is one of the reasons you’re less able to save money when using such debt. Not only does money borrowed through credit cards, auto loans, and other types of consumer loans carry a relatively high interest rate, but it also isn’t tax-deductible.

I’m not saying that you should never borrow money and that all debt is bad. Good debt, such as that used to buy real estate and small businesses, is generally available at lower interest rates than bad debt and is usually tax-deductible. If well managed, these investments may also increase in value. Borrowing to pay for educational expenses can also make sense. Education is generally a good long-term investment, because it can increase your earning potential. And student loan interest is tax-deductible subject to certain limitations.

 

How Much “Bad Debt” is Bad?

Calculating how much debt you have relative to your annual income is a useful way to size up your debt load. Ignore, for now, good debt — the loans you may owe on real estate, a business, an education, and so on. I’m focusing on bad debt, the higher-interest debt used to buy items that depreciate in value.

To calculate your bad debt danger ratio, divide your bad debt by your annual income.

For example:

Suppose you earn $40,000 per year. Between your credit cards and an auto loan, you have $20,000 of debt. In this case, your bad debt represents 50 percent of your annual income.

Bad debt / Annual Income = Bad Debt Danger Ratio

The financially healthy amount of bad debt is zero. Maybe not everyone agrees with me. If you don’t, I have the argument for that.

When your bad debt danger ratio starts to push beyond 25 percent, it can spell real trouble. Such high levels of high-interest consumer debt on credit cards and auto loans grow like cancer. The growth of the debt can snowball and get out of control unless something significant intervenes. Let’s see if I can manage to post about how to battle bad debt sometimes next week.

How much good debt is acceptable? The answer varies. The key question is: Are you able to save sufficiently to accomplish your goals?

Borrow money only for investments (good debt) — for purchasing things that retain and hopefully increase in value over the long term, such as an education, real estate, or your own business. Don’t borrow money for consumption (bad debt) — for spending on things that decrease in value and eventually become financially worthless, such as cars, clothing, vacations, and so on.

 

How Much Good Debt is Still Good?

As with good food, of course, you can get too much of a good thing, including good debt! When you incur debt for investment purposes — to buy real estate, for small business, even your education — you hope to see a positive return on your invested dollars. But some real estate investments don’t work out. Some small businesses crash and burn, and some educational degrees and programs don’t help in the way that some hope that they will.

There’s no magic formula for determining when you have too muchgood debt“. In extreme cases, I’ve seen entrepreneurs, for example, borrow up to their eyeballs to get a business off the ground. Sometimes this works, and they end up financially rewarded, but in most cases, it doesn’t.

 

Here are two important questions to ponder and discuss with your loved ones about the seeminglygood debtyou’re taking on:

  • Are you and your loved ones able to sleep well at night and function well during the day, free from great worry about how you’re going to meet next month’s expenses?
  • Are you and your loved ones financially able to save what you’d like to work toward your goals?

 

Understanding Your Credit Card Float

Given what I have to say about the vagaries of consumer debt, you may think that I’m always against using credit cards. Actually, I have credit cards, and I use them — but I pay my balance in full each month. Besides the convenience credit cards offer me — in not having to carry around extra cash and checks — I receive another benefit: I have free use of the bank’s money until the time the bill is due. (Some cards offer other benefits, such as frequent flyer miles, and I have one of those types of cards too. Also, purchases made on credit cards may be contested if the sellers of products or services don’t stand behind what they sell).

When you charge on a credit card that does not have an outstanding balance carried over from the prior month, you typically have several weeks (known as the “grace period“) from the date of the charge to the time when you must pay your bill. This is called playing the float. Had you paid for this purchase by cash or check, you would have had to shell out the money sooner.

If you have difficulty saving money, and plastic tends to burn holes through your budget, forget the float game. You’re better off not using credit cards. The same applies to those who pay their bills in full but spend more because it’s so easy to do so with a piece of plastic.