You need to know the types of debt you have sooner than later. This is a rather simple exercise once you understand what these two types of debt mean, however most people don’t think about it, haven’t heard about it or just plain don’t understand the difference.
1. Preserves or grows your current earning potential (College education).
2. It helps to make money, adds value, or produces wealth in the long run.
3. If the debt is financing something that’s going up in value or at least holding at the level of inflation it’s usually “good debt.” (reasonable sized home or a business loan).
4. If it is something that you truly need versus a want or desire but cannot pay for in full without wiping out your cash reserves.
1. Credit card balance is almost always bad debt because rarely is it used to finance something that goes up in value greater than the (very high) interest rates of a credit card.
2. If it’s financing something that’s losing value, it’s usually “bad debt.”
3. It doesn’t have an obvious way of helping your financial position or success.
4. Is used to build up ones image.
5. Is primarily used for entertainment or pleasure.
6. When used to finance things that are consumed. You should never accumulate debt to purchase everyday items like clothes or food.
7. It is used to buy something because I feel “I deserve it?”
May be good, may be bad
Most often a car loan is not good debt. For it to qualify as good debt, it has to be treated as transportation to achieve daily living needs. Purchasing more car than you need or if it is purchased as a status symbol is bad debt.
What to do
Gather up all of your various debts. Categorize each debt as either bad or good using the above definitions. This whole effort usually takes about 5 to 10 minutes.
Since bad debt provides no increase in value or improves ones financial position, most of
the time it is a better idea to focus on paying off bad debts first (For example credit cards and auto loans should be paid before tackling a home mortgage payoff). Paying off debt by incurring another debt usually is not a good idea and deserves detailed benefit investigation first.
Adopt the policy that if you’re going to buy something that doesn’t go up in value, and you can’t afford to pay cash, then you just can’t afford it.
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