Defining Good Debt
“Good debt” finances something likely to grow in value. A mortgage is a classic example of “good” debt.
Homes generally appreciate over time, and by the time you pay off a 15- or 30-year mortgage, your home should be worth more than the cost of the loan, including interest.
There have been painful exceptions to this rule. The housing bubble of 2008 revealed thousands of people who had taken loans they couldn’t afford to buy houses that didn’t hold their value.
Many of these borrowers found themselves “underwater,” owing more on their homes than their houses were worth. Some just walked away, damaging their credit rating for years to come.
Borrowing to fund higher education can be a type of “good” debt. Higher education is a worthwhile investment if it provides a path to a rewarding, high-paying career.
A good rule of thumb is not to take on more student loan debt than you anticipate your annual salary will be the first year after you graduate.
Beware of student loan deferrals that “capitalize” interest onto the original principal. The lender may add the deferred interest onto the loan’s principal, meaning you end up paying interest on the interest.
Bad Debt Defined
Bad debt is debt you take on to pay for something that will decline in value. Nearly everything you would put on a credit card (which often carries a high interest rate), such as clothing, furniture, electronics, and vacations, loses value the minute you pay for it.
Car loans can also be a form of “bad” debt if the interest rate is high, and you buy a car that doesn’t hold its resale value. Auto loans may be necessary to fund a vehicle you use to get to work. In that sense, a car loan could be “good” debt.
Be sure you understand the interest rate and the term of the loan to determine its total cost.
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Paying Off Debt
There are several methods for paying off multiple debts. The snowball method of debt repayment tackles your smallest debt first. Once you’ve paid it off, you add the amount you were paying on it to the payment for your next largest loan, and so forth, until you pay all your debts.
A debt consolidation loan rolls all your debts into one loan. This can be a good option if the interest rate on the consolidation loan is lower than the rate on the debts you’re paying off.
You may feel overwhelmed by monthly payments on loans or may be unable to tell the difference between good debt and bad debt in your monthly budget. If so, seek the advice of a non-profit, free debt counseling service to come up with a plan to get you back on your financial feet.
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