It might be a four-letter word, but not all debt is bad, and knowing the difference between good and bad debt can prevent you from getting in over your head with creditors.
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“Good debt has to meet two criteria,” says Grant Cardone, author and host of National Geographic Channel’s “Turnaround King”. “It has to be necessary and sustainable.”
According to money experts, most people think all debt is bad and needs to be paid down as soon as possible. That plan makes sense for debts like credit card bills with high interest rates, but it could behoove you to pay down other debts at a more moderate pace.
“Bad debt or consumer debt is the debt you acquired to buy things that will eventually lose value. There is no obvious benefit to your finances in bad debt. Good debt is debt used to buy things that will increase in value over time,” says real estate and investment expert Tanya Marchiol.
One of the best examples of good debt is student loans, granted you come out of college making more money than before you entered. A car loan is another example of good debt, according to Cardone. Not only are the interest rates low on many automobile loans, but the vehicle will presumably get you to and from work to make more money.
Contrary to conventional wisdom, your home mortgage, on the other hand, can be considered bad debt, “People don’t make money in their home. Most people think owning a home is the American dream but it’s not good use of debt,” says Cardone.
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While it’s always smart to reduce your bad debt, Marchiol says there are harmful ways to do it. In fact, she says some debt reduction methods can slow down your ability to create income and wealth. She points to bankruptcy: It may seem like the fastest way to get out from under hefty debt, but the ramifications are long and costly. Not only will the filing stay on your credit history for at least seven years and hurt your borrowing prospects, it can also negatively impact your employment status.
“Many employers today are reviewing the credit history of job candidates,” says Marchiol. “A bankruptcy could be viewed as a signal that you are unreliable, irresponsible and unable to handle your finances, which could cost you a job.”
Debt consolidation companies can also hurt your potential future income, according to Marchiol. She says many of these companies will put you in a program that includes arranged monthly payments. While the creditors will stop calling you, often the monthly payment will only cover the interest and not pay down the principal balance.
Even refinancing a mortgage may not make the most sense if you are doing it to consolidate bad debt. It will undoubtedly give you a lower interest rate than credit cards, but it can be dangerous if you start charging again. “Many people who are unable to control their spending transfer their debt to their home, thus reducing the equity they have in the property and then immediately begin incurring more debt,” says Marchiol. “If you choose to refinance your home to pay off your other debts, make sure you are ready to be responsible about your spending”
At the end of the day, Cardone says people should consider any item that they consume as bad debt and anything that can truly create more income as good debt. A concept that he says, “requires a tremendous amount of discipline.”