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Nov
26

Good Debt vs Bad Debt How To Know The Difference

Good Debt vs Bad Debt How To Know The Difference

Debt can be a financial blessing or a curse, depending on how it's managed. Understanding the difference between good debt and bad debt is key to having a happy, fulfilled life.

The first step for finding out if your debt is good or bad is understanding what debt actually is. Simply put, it's an agreement between two parties that one will owe money to the other. The person owing the money - the debtor - agrees to give up something of value now in exchange for getting something of equal value later. This something can be either cash up-front (called interest) or future goods and services (this means turning those goods and services into cash).

Good debt is debt that is used for something that is actually needed or wanted by a person or family. Examples of good debt include:

Collecting interest from money you have in your savings account to help you buy a new car;

Buying a house and putting down a 20 percent down payment; or

Paying an amount of money on an installment loan for a purpose other than making extra financial gains, such as paying for school or textbooks.

Bad debt, on the other hand, is taken out without any kind of value exchange going on. Examples of bad debt include:

Buying something with cash (that's why it's called "cash"). This is a gift from you to yourself, not an investment.

Buying something with credit cards to get cash back on purchases.

Using a payday loan, expecting to get the money back and pay off the debt next paycheck.

Using student loans to pay for luxuries or extras that aren't related to your education (like paying for your car instead of walking or taking a bus).

Extravagant loans are considered bad debt because they're likely to cost more than they're worth in the long run. If you find yourself borrowing money often under these circumstances, you need to make a change in your habits now.

So, how do you know if debt is good or bad? It's easy to make a decision about borrowed money. A common misconception is that you should only borrow for things that are needed and wanted at the time, but this is not always the best advice. If a person does not understand their own financial situation, they may be taking out too much debt and end up paying way more than they need to. The only way to know if borrowing money is worth it or not is to actually pay off the debt so that it's gone forever. If you don't have $40 in cash and you borrow $40 then pay back the loan, your credit score will decrease because you left $100 on the table.

In order to make the best decision about what type of debt you need to use, you must first understand the qualities of good debt. A good debt is debt that serves a purpose and that you can use for a period of time. It's not meant to be left on the table forever, but until it's paid off, it helps keep you afloat. Good debts are those that:

Are used for something that is actually needed and wanted by a person or family.

Are considered very safe investments, especially if you have a solid credit score.

Don't require a lot of money up-front. Good debts can even be paid for over time with installments, with the help of monthly income from your job or household income from others.

Are used in order to open a good long-term investment account. However, you must be careful not to use good debt as an excuse to spend too much money on this kind of investment.

Are used to help build good credit. A good debt is not the same as a bad debt - using decent debt to build your credit score is good and beneficial. The problem becomes when you use too much of it at once or go into default or bankruptcy.

Posted on Nov 26, 2013, in Credit, Life Tips and tagged Bad debt, Credit, Credit card, Credit score, Debt, Debt 101, Finance, Generation Y, Good debt, Millennials

Any information contained within the contents of this blog are opinions and suggestions of the writers and do not necessarily reflect any policies or positions of the credit union. Any reference made to products or promotions are not guaranteed at any time. This information is not intended to be considered financial advice. It is provided for your education only. Community 1st Credit Union is Federally Insured by the NCUA.