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Bills that are good and bad debts
A brand new home, a new car and a college education... These are examples of things most people cannot pay for upfront in cash without a secured or unsecured loan. Hence, most of us cannot even afford to live debt free. Even still, not being able to live debt free is not an excuse to get into bad debt.
As for mortgage lenders, they prefer to loan money to people whose total monthly long term debt payments; including mortgage and credit cards, are less than 36% of their gross monthly income. Unfortunately, with credit cards in hand it's much easier to buy now and worry later about repayment. It's becoming an American thing, since the average U.S. household with at least one credit card has nearly a $9,200 balance. Meanwhile, personal bankruptcies have hit record levels.
On the flip side, it's not too bright to spend all your available hard cash just to avoid accruing debt. What will you do in an emergency? The key is to balance debt with income while maintaining an emergency safety margin, and the best way to do that is to decide which is good debt and which is bad debt. Then you can more effectively manage borrowed money.
What is good debt? Good debt is for things you need but don't have the money to pay for unless you blow all your cash, savings, emergency funds and liquiding investments. But, don't borrow money that exceeds your ability to afford the monthly repayment plan while keeping your safety margin.
What is bad debt? Bad debt is money you owe for things you didn't really need, but you borrowed money for it since you didn't have available cash. What's worse, is to buy something you really don't need, and then to use a credit card to make the purchase. Credit card debt usually has the highest interest rates.
But debt is not always a bad thing, especially if the borrowed money will give you financial leverage like that of a home loan.
If; like most of us, you cannot payoff a home without a loan, consider how much you can afford as a down payment and how much you can afford in monthly payments. The bigger the down payment, the lower your monthly payment and the less you'll pay in interest. But don't scrape up every available penny for your down payment, and don't invest all your cash into a home if you have other debt. Mortgage loans typically have lower interest rates than other types of debt, and the interest may be deductible. Even if your mortgage has a high interest rate, you can refinance later if and when rates lower.
An auto loan is another example of a good debt. There are different ways to finance an auto. Think of how long you plan to keep it and the down payment you have.
If you plan to keep the car well beyond the term of a loan, you may do better by paying in full in cash. Once again; however, most of us don't have the money to pay in cash. In such case, we need to put down as much as possible without risking financial hardship. An auto loan makes most sense if you plan to keep driving the car long after you've paid it off.
Instead of a standard auto loan, you could choose a home equity loan. This may offer you a much lower interest rate, and the interest paid on the equity loan is tax deductible whereas interest on an auto loan is not.
But, if you want a new car every three or four years; or if you want to avoid a down payment of 10-20%; or if you don't drive more than the 15,000 miles a year; and you keep your vehicle in good condition, you may do better with a lease.
As we've seen, there are a few instances of good bills... Yet there are numerous types of bad debt.
Borrowing money for furniture and appliances; even though these items go into a home, are often bad debts. Why? Because they don't add value to your home and they are depreciating assets. If you do borrow money for them, read the fine print. Retail stores often charge high interest rates. Even if they offer a low interest or no repayment period for several months, you may be required to pay for the item in full at the end of that period or risk being charged a high interest rate dating all the way back to the day of sale.
Borrowing with a home equity loan or home equity line of credit makes sense if you're making home improvements that increase its value, such as adding an additional room. The interest you pay in many cases is deductible, and you increase your equity.
If, however, the project doesn't improve your home's value, consider paying in cash or taking out a short term, low interest loan like a personal loan.
If you've got a lot of high interest, bad credit card debt, you might be tempted to pay it off by borrowing against your 401(k) or by taking out a home equity loan.
Home equity loans typically charge interest rates that are less than half what most credit cards charge, and the interest paid is often deductible. But if you default on your home equity loan payment, you could lose your home. Borrowing against your 401(k) is even less advisable, because you lose out on two of the biggest advantages to workplace retirement plans: tax-deferred compounding of your money and tax-deductible contributions. Sure, you pay yourself back with interest, but that interest is paid with after-tax dollars, and it will be harder for you to make new contributions while you're repaying your old loan. Also, if you quit or lose your job, you'll probably have to repay the entire borrowed amount within three months. If you aren't able to do that, you'll owe income taxes on the money, plus a 10 percent penalty if you're under 59-1/2.
Another warning about getting a loan to pay off your credit cards... Once your credit card debt is paid off, you have to control the urge of charging back to the same debt level.
If you find yourself making month-to-month credit card payments and never having frequent periods of paying off the balance in full, consider a debt counseling service for financial management help.
To get debt under control, start by figuring your spending habits and by identifying unnecessary expenses. For one month, write down every cent spent. This will identify how much of your spending is fixed and how much is variable, as well as frivilous.
Tally the expenses and compare the sum to your monthly, after tax income. You may be surprised by how much of your hard earned money you waste unnecessarily.
For an even bigger eye opener, make a list of all your loan and credit card debts and the interest you've paid on each, and the average monthly interest. Looking at the interest fees paid on unnecessary purchases really strikes home and can motivate you to knuckle down.
The basics of debt reduction are simple... Reduce your variable spending and put the extra money toward your debt payments. Once you determine the maximum amount you can pay off each month, pay down the debt with the highest interest rate first; that usually means credit cards, while paying at least the minimum monthly amount due on all other revolving bills.
After the debt with the highest interest rate is paid off, put your money toward paying the debt with the next highest rate. Also consider credit cards that have a low introductory rate which is about to expire and hit you with a high interest rate.
Another strategy is to balance transfer some of your high interest credit card debt to a card with a lower interest rate. But read the fine print carefully to avoid balance transfer fees, over limit fees, etc. Also be aware that credit card balance consolidating may lower your credit score if your debt-to-available-credit ratio worsens.
If reducing variable debt isn't enough, next try to reduce your fixed expenses. Maybe refinance your mortgage to get a lower interest rate; or, if you have a good payment history, ask your credit card company to lower the interest rate you're being charged.
Order copies of your credit reports, which are free annually. You'll have to pay if want the actual credit scores. Your credit report score determines the interest rates you're offered on credit cards, mortgages and other loans.
When lenders review your credit reports and your FICO scores, they consider how much you owe as well as how much credit you have available to you. Too much of either and they may not loan you any more money. Review your reports to check for inaccuracies which can cost you.
Get personal finances under control and pay bills timely. Use our free personal budget software to track expenses so you can stop wasteful spending, and use our free bill reminder calendar so you send in your payments on time.
Free desktop software to balance checkbook entries, or use the software as a computer checkbook register.
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