Four letters that might keep you up at night: debt. However, it can also serve as a tool. Your ability to manage both forms of debt and distinguish between them is essential to your financial well-being. Here’s everything you need to know.
What is Considered Good Debt?
Debt is frequently justified if it enables you to acquire an item that will increase your wealth. Examples of this include education loans, company loans, and mortgages on homes.
They are viewed favorably because they present the chance to increase an asset’s future value or produce income.
Due to the historical 3-5% annual average gain rate of home values throughout time, mortgages are considered desirable debt.
Given that people with a bachelor’s degree earn about 55% more than those with only a high school diploma over the course of their lives, student loans may be a wise investment. In the same way, company loans facilitate growth and expansion, which may result in a notable boost in profitability.
What is Considered Bad Debt?
If you’re pondering what separates good debt from bad debt, bad debt is classified as such if it originates from credit card expenses for furniture and clothing, for example, or from buying items that depreciate.
In September 2023, the Investopedia card database’s median interest rate for all credit cards was 24.12%. Additionally, bad debt usually has high interest rates, so if you don’t pay the bill in full when it arrives, you’ll end up paying even more than the original amount.
Payday loans have worse rates. They can surpass 400%.
Bad debt can have terrible effects. Your credit score might drop, your future borrowing options might be more constrained, and your ambitious saving and investment plans might be impeded by that high debt load. It’s possible that you’ll declare bankruptcy.
Still, there are more than just monetary costs involved. Severe financial difficulties can have a negative impact on one’s physical and mental well-being, marriages, and are frequently the primary cause of divorce.
The Debt Game’s Rules
The truth is that every debt needs to be closely watched over and managed. If you have more debt than you can afford to pay it off, even “good” debt might turn bad.
You want to pay off any debt as soon as feasible and at the lowest interest rate available.
Know your debts well. You must carefully consider the prices. Is it possible to pay off a 12-month loan at 0% interest followed by an 18% interest rate?
You’re not receiving the fantastic deal you believe you are if you can’t pay it off in full within a year. Will the expense be justified when the interest rate rises to 18%? Before making a purchase, you should have an answer to a question like this.
If you follow this rule, you won’t stray too far. Make sure your existing salary provides a positive cash flow before taking on any debt, good or bad.
Second, accumulate a sizeable sum of money to use as an emergency fund (six to twelve months’ worth of monthly costs); only then, and only for good debt, should you think about borrowing.
Do some introspection before taking on any kind of debt. Analyze your needs versus your wants. Determine where in that rubric the purchase falls.
If it’s a want that is out of your budget, make a commitment to begin saving money for it instead.
Make a Payment Plan
While being debt-free is undoubtedly the goal of many people, it’s not always a reality in the actual world. However, having a plan to pay off debt is crucial.
You don’t want to live with debt, whether it’s healthy or not. Put together a basic budget using an app, spreadsheet, pencil, and paper, and include payments for the plan you’ve selected.
To prevent paying interest, it is best to pay the bill in full as soon as it is received. However, it might not be feasible. Using the snowball method—paying off debt from the smallest amount owed to the largest—is one technique to minimize debt.
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Make minimal payments on all your debts, apart from the lowest, which you should pay off as much as you can. Then do the same with the rest of your bills. Getting a bill paid is an accomplishment that gives you motivation.
It’s not always easy to draw the distinction between good and terrible. It all comes down to how the loan fits into your life, profession, and financial objectives. Analyze the statistics and examine your future earning potential before taking on a substantial financial commitment.
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