Borrowing money can be smart, but it can also be a trap. Debt comes in the basic varieties: Good, bad and ugly. Here’s how to recognize each one.
The idea might make some shudder: Debt can be good? Believe it or not, it is actually good to have certain types of debt in your financial portfolio, assuming you are comfortable with owing money. Why? Because it is through debt that you can acquire assets such as housing, automobiles and other types of property. In short, the strategic use of good debt can improve your finances and help you achieve your dreams and goals.
However, beware, as debt falls into three categories — the good, the bad and the ugly. Ugly debt and bad debt, of course, will do the opposite of what good debt can do for you.
Ugly debt is easy to define. More often than not, you acquire this kind of debt when your expenses exceed your income because you are in a situation beyond your control — for example, you lost your job or you had to take a pay cut — and so you use credit cards to pay your expenses. If your situation does not turn around, even making the minimum monthly payment on those accounts could become impossible, and filing for bankruptcy may be your only way out.
Given the state of the economy and the rising rate of bankruptcy in past years, it’s clear that many, many Americans have become all too familiar with ugly debt.
Bad debt is unsecured debt that increases because you use credit cards to live beyond your means — maxing out your credit cards by charging luxury items, vacations and the like. This can lead to your being able to afford only the minimum monthly payments, which costs you more in the long run. This is also how bad debt can spiral into ugly debt.
Good debt is debt that helps you achieve a positive result within a specific period of time, helping you increase your assets and, slowly, your net worth. This is the kind of debt that financial advisers are comfortable with and will even encourage their clients to take on. A mortgage is a common example of good debt, assuming it has a favorable interest rate (usually defined as 5% or lower); is not an interest-only, variable-rate or adjustable-rate loan; and has monthly payments you can comfortably afford. A good mortgage allows you to own a home within your ability to make the loan payments.
A loan to finance the purchase of a sensible automobile is another example of good debt, assuming the loan has an interest rate of less than 9%. And by “sensible,” I’m talking about a car that is high performance, gets great gas mileage, meets your transportation needs, has a good safety record, fits your budget and, yes, looks good. Let’s face it — no one wants to drive an ugly car. Although your car will begin to depreciate in value as soon as you drive it off the lot, for most people owning a vehicle is a necessity.
An education loan can be good debt, assuming that the education you finance will help you better yourself — by increasing your income, expanding your job opportunities or by moving you onto a new, more promising career path. Never borrow more than you honestly believe you can repay, and use the money to attend only an accredited institution. The adage that “no one can ever take away your education” is true. Education is an investment in yourself, and, following these guidelines, the price you pay can be well worth the effort.
A final word of advice: Before you take on any kind of good debt, consult with a professional financial adviser. The adviser will help you make sure that you can afford the debt, that you can truly benefit from it and that you’re not throwing good money at an unwinnable payoff. Used carefully, good debt can reap rewards down the road and provide the ability to better your life and finances.