Do you know what distinguishes good debt from bad debt?
Today I’m going to be talking about good debt versus bad debt.
Many people think that all debt is bad and is something to be avoided and paid down as quickly as possible. But, there are really two types of debt: good debt and bad debt.
Now, one quick and dirty rule of thumb for identifying whether a particular debt is good or bad is to ask yourself whether the debt is financing something that’s appreciating or depreciating in a value. If the debt is financing something that’s going up in value, it’s usually “good debt.” On the other hand, if it’s financing something that’s losing value, it’s usually “bad debt.”
What is Good Debt?
Examples of good debt would be the mortgage on your home and a loan for a college education. A mortgage finances a house, an asset that, over the long term, goes up in value, and a student loan finances an education, which is likely to result in a higher paying job and better employability down the road—at least that’s the idea any way.
What is Bad Debt?
An example of bad debt would be a car loan—most new cars lose more than half of their value within the first five years after being bought. A second example of “bad debt” would be money you borrow to buy something that’s losing value that you could actually afford to buy without a loan, like a dinner out, for example.
How to Pay Off Debt
Ok, so that’s the difference between good debt and bad debt, but what’s the smartest way to pay off debt? When tackling debt, it’s a good idea to start paying down your highest interest loans first, especially if they’re financing items that are losing value. For almost everyone, this means paying down your highest rate credit cards first. After that, work on paying off your lower rate consumer loans, like a car loan. [[AdMiddle]
After you’ve paid off these types of debts, the next step would be working toward paying off your “good debts” if—and this is a big if—if you don’t have a better use for the money. If you can invest your money at a higher rate of return than the interest rate on the debt, you’re usually better off investing the money instead and paying down the debt more slowly.
If you do have a mortgage, you don’t necessarily want to rush to pay it off more quickly. Mortgages typically have low rates compared with other types of loans and, in the U.S. and several other countries, the interest you pay on your mortgage is tax deductible.
Cha-ching! That's all for now, courtesy of Money Girl, your guide to a richer life.
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