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Good vs. Bad Debt - What You Need To Know


on 12/21/2016

Young woman frustrated with her financesFor many young adults, their first experience with debt comes when they need to consider loans to finance their education.

  • It is more expensive than ever to pay tuition. 
  • Textbook costs are eye-popping. 
  • Minimum-wage jobs that many students hold don’t provide enough income to meet expenses like they once did.

Young adults face the realities of debt much earlier than people did in the past.  Understand the difference between good debt and bad debt before taking on too much debt.


What is “bad debt?”

You may have heard that debt is bad.  This statement often comes with horror stories from those who have had to overcome mountains of debt or maybe never fully recovered.  Those lessons are valuable and may help you learn the benefits of controlling your spending and use of credit.  However, the stories may also have instilled unnecessary fears in you.


Bad debt is credit that you take with no real plan to pay it back. 

In some cases, you may even know that it is unlikely you will be able to pay the debt anytime soon.  When you borrow without knowing how you will repay, you are taking on bad debt.

Credit card debt can stay with you for a long time and may be “bad debt.” Without a plan to pay the debt, rather than just keeping up with minimum payments, your shopping spree will end up costing you far more than the value of your purchases.
 

Borrowing for reasons other than good cash flow management can also lead to “bad debt.”  Stores frequently offer discounts if you open one of their credit cards.  If this causes you to buy more than you otherwise would, you may be heading for trouble.  Store cards often come with high interest rates that make repayment difficult.  The discount you just got may be less than the extra you pay in interest.
 

Bad debt can also occur when you make a budget to meet your current needs with no contingency for the unexpected.  Your budget may tell you that you can afford more car or house than you currently have.  Unless you can also contribute regularly to saving, those payments will become a problem when an emergency financial need occurs.

 

Is there such a thing as “good debt?”

Yes, good debt exists.  Good debt meets these criteria:

  • Debt is used to make a large expenditure that you need and could not afford to pay for immediately.  You need to travel to and from work, and your savings are not sufficient to buy a reliable automobile.  Purchasing a car with a monthly payment that fits well into your budget is a good use of debt.
     
  • You have a solid plan to pay the debt as agreed.  If you think you’ll be able to “squeak by” to make your payments, you’re heading for trouble.  Know that you have sufficient savings and cushion in your budget so you can make your payments even if you have surprise expenses.
     
  • Debt can be used to yield a likely future financial reward.  Starting or expanding a business usually involves taking on a loan.  If you have a solid business plan, your debt risk can be expected to pay off in the future.  

 

Student loans can be an example of good debt. 
You may greatly enhance your lifetime earning potential with the degree you are pursuing.  Be sure to have a realistic idea of earnings and job opportunities in the field of study you pursue.  Also, be sure to understand what your expected payments will be when you start repayment. 

How does that amount relate to your expected income following graduation and other expenses you will have?

At some point, you’re going to want that good debt to buy your own home, start a business, or finance a car.  If fortunate, you may even be comfortable enough to borrow for less essential items.  


Prepare for that future by turning bad debt into good debt. 

Get a credit card with a low interest rate.  Use that card for your monthly expenses, such as groceries and gas and pay it in full every month.  

If you have outstanding credit card debt you can’t pay off, roll it into a lower interest rate loan. Start with the highest interest rate card and work your way down.

The younger you are when you start learning about good debt, the easier it will be to responsibly use credit in your future.  As long as you have a plan to meet your payments and build savings and wealth at the same time, you will be taking on good debt.

 

© Genisys Credit Union and www.genisyscu.org, 2016.  Unauthorized use and/or duplication of this material without express and written permission from this site’s author and/or owner is strictly prohibited.  Excerpts and links may be used, provided that full and clear credit is given to Genisys Credit Union and www.genisyscu.org with appropriate and specific direction to the original content.

 

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