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11/5/08

The Difference Between Good and Bad Debt

There are two different ways to understand the concept of "good" debt. Good debt can be described as either (1) debt that makes you money; or (2) debt that does not count against your debt to credit ratio. An example of debt that makes you money is a real estate loan. Although you are paying a loan, the real estate is appreciating, and you could collect rental income from a real estate property. An example of good debt that does not count against your debt to credit ratio is a school loan. One of the components of a credit score is your debt to credit ratio. If you have more than 30% (meaning that of all your available credit, you owe more than 30% in outstanding balances), your credit score is lowered. Student loans are not calculated into this ratio. Thus, if, for example, you owe $50,000 in school loans and have only $10,000 in available credit card credit of which you owe no money, your debt to credit ratio is still going to be zero, regardless of the fact that you owe $50,000 in school loans.

Now that good debt has been defined and you understand it, the question becomes, what is bad debt? There are many variations on the definition of bad debt, however, the consensus is that bad debt is debt that costs you money. In other words, if you borrow money to purchase something that will never increase, or in fact decreases, in value, you have bad debt. The most common example of bad debt is credit card debt. This is debt that costs you money.

The distinction between these two kinds of debt causes much confusion among people who carry the debt. In you are concerned about "getting out of debt," you need only be concerned about your bad debt. Bad debt is the debt that needs to be paid off in order to relieve any financial pressure you may be feeling. This means, car payments, credit card bills, and other high interest loans for depreciating assets need to be paid off as quickly as possible.

I understand the difficulty that people have with comprehending "good debt." Most people think that owing money is bad regardless of its use. However, if you stop and think about it, there are many things that debt can create. Using the real estate example above, if you take out a loan to buy an investment property, and then rent that house out to another, you are enjoying many benefits: (1) your rental property (assuming you did not overpay) is appreciating; (2) you are taking in a rental income that hopefully pays for the mortgage on the rental property and all other expenses on the property; (3) you are making a property available for another person to live; and (4) you are increasing your net worth. All of these things occurred because you incurred some debt.

Know the differences between the kinds of debt and you will be able to prosper. Get rid of all your bad debt and utilize the good debt to your advantage. A college education, an increased net worth, and additional income streams could be the benefits of good debt. On the other hand, high interest rates, fees, and depreciating assets accompany bad debt. Which would you rather have?

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