Economists, parents, business people and newscasters throw out the word "debt" like it’s the boogey man of our generation, But what exactly is debt? Technically, debt is something–usually money–owed by one party to another. Whether it is by charging a credit card, taking out a loan, or asking your buddy to spot you five bucks for a burger, it’s all debt. What you might not know is there are actually good forms of debt too. Here’s how to tell the difference between good and bad debt (and the debt in-between) to avoid getting in over your head.
Your automatic reaction to the word "debt" may be negative, but some kinds of debt really can be good, or at least better than others. "Good" debt applies to smart investing, things like a house or education that at least have a reasonably high potential to pay for themselves in the long run. Hopefully, the value of what you purchased increases, effectively making you money.
Think of good debt as a tool you can use to get ahead, improve your credit score, and increase your net worth. Consider student loans. Outside of scholarships and financial aid, they are the only way many students could afford to pay for college. The benefits of a college education should help you land better paying jobs later–the U.S. Census Bureau found that in 2005 those with a bachelor’s degree made over $25,000 more than those with only a high school diploma. The education you receive can have tangible, long-lasting benefits, which is why debt accumulated to pay for it isn’t so bad.
Bad debt is essentially when you purchase things on credit or with a loan that don’t hold their value and you can’t afford to pay off soon afterwards. And thanks to interest, the amount you ultimately pay for those things continues to increase over time.
This kind of debt is not evil by nature. In many cases, it makes sense to charge purchases to a credit card and it’s often necessary to take out a loan to buy a car. It’s more important, however, that you make sure you’re able to keep this debt under control. One in 136 households filed for bankruptcy in the second quarter of 2007. It’s easy, and unfortunately common, to get sucked into debt.
How do you control debt? The first step is to not have too much of it. Some experts say that long-term debt payments (for education, home, and automobile loans) should take up no more than 36 percent of your gross monthly income. Second, pay off bad debt as quickly as possible. The longer it takes you to pay off bad debt, the more money you pay total. Take into consideration how much you can afford in monthly payments, and think in the long-term.
Remember, all debt is still money you have to pay back, usually with interest. If you practice good debt-repayment techniques, you can look forward to a sparkling credit score. Too much debt, even good debt, can be a bad thing.