The word debt is made up of four letters, and for many people, it has the same connotation as many other four letter words. However, not all debt is bad. For example, most people could not afford to pay cash for a home, but instead must acquire a mortgage loan. Because a home will most likely increase in value during the time it takes to pay off the mortgage, mortgage debt is considered a good investment. In general terms, good debt is defined as debt that allows someone to invest in the future, such as business loans, student loans, mortgages and real estate loans.
Bad debt is generally defined as debt acquired for something that immediately loses value or has no potential to increase in value. Using that definition, a car loan would be considered bad debt. Many people purchase vehicles and are upside down (owe more than the car is worth) in their loans mere months after purchasing. It is also a common practice to purchase a meal with a credit card that has a balance that may not get paid off for three months or more. The meal that was enjoyed at the time and forgotten later ends up costing more because it is not paid for when consumed. Paying interest for dinner, even a nice dinner, charged to a credit card is bad debt.
Money Management International (MMI) offers the following tips to avoid and reduce bad debt:
- Don’t carry balances on your credit cards. If you do purchase something that cannot be paid off at the end of the month, make certain you can pay it off in 90 days or less.
- Purchase a used or less expensive new vehicle and make sure you make a substantial down payment. A smaller loan will help assure you do not become upside down in your auto loan.
- Don’t use credit cards to purchase clothing or consumables unless you will be paying the balance off each month.
- Be wary of spending more than you can pay off each month on rewards credit cards. Paying interest charges will negate the promised benefit of the rewards.