Wednesday, June 12, 2013

Good Debt vs. Bad Debt - It's Not What You Expect

by Frances Rahaim, Ph.D.
aka "The Money Doctor"

You may think that debt incurred for certain positive expenses like buying a home, starting or growing a business, or funding education is considered to be “good debt,” while credit card debt in general is dubbed “bad debt,” but it isn’t quite that simple, and knowing the difference between the two can be powerful knowledge. It could help you make your financing decisions more prudently and save you from some gut-wrenching regrets in the future.

A simple test can reveal whether debt is good or bad instantly. In this test, there are three components that must be present in order for a debt to qualify as a good debt. Think of it like needing fuel, air and ignition to make a fire. Omit any of the three components, and the debt slides into the bad debt column. Interestingly enough, this test works for all kinds of debt.

Take a sheet of paper or open a spreadsheet and create two columns. At the top of one write “Good Debt.” Over the other, “Bad Debt.” Then ask yourself each of the three questions below pertaining to this particular debt. For each question that gets a “yes,” put a mark in the “Good Debt” column. For questions that receive a “no,” mark the “Bad Debt” column.

1. Is this debt necessary?
  • Do you need this debt? 
  • Is the item or service that it will fund an absolute necessity or could you live without it? 
  • Is debt the only way to fund it or do you have other alternative funding options? 
2. Will the debt include a finite period by which it will be paid back?
  •  Mortgages, car, business and other loans come with a definite payback life. Mortgages are usually 30 or 15 years, car loans are typically five or six years. Credit cards, on the other hand, are difficult to determine full payoff dates for (especially if you keep using them!). If you don’t know the exact date a debt will be paid off, provided you make the required monthly payments, then mark it in the “Bad Debt” column. 
3. Is this debt easily affordable for you?
  • Can you easily make the payments on this debt or is it a stretch? If it’s not comfortable for you to make the monthly payments for the long term, mark it in the “Bad Debt” column. 

If you answered “no” to any of these three questions (if you put any marks in the “Bad Debt” column), then it’s a bad debt. A good debt will satisfy all three of those criteria.

Sometimes taking this test may allow you to see when a debt is leaning toward the bad debt column, but could actually be a good debt if you could, for instance, pay it off in a finite period of time, etc.

When it comes to borrowing money, be flexible and creative. If you must finance an item, try not to get locked in to one idea and one way of paying for it.

While my preference would be for you to fund all your purchases in cash, when debt is necessary, I hope you’ll apply this test before making the decision to borrow. If you determine that a debt is necessary, at least make the adjustments to satisfy all three conditions and move it into the “Good Debt” column. 

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