A debt is nothing more than money you owe to someone else. Generally this is in the form of a loan from a bank or other lending institution. Because you are using the bank’s money the loan comes with an interest charge associated with borrowing that money. Let’s say you buy a $15,000 car. Your down payment is $3,000. The lending institution loans you the additional $12,000 and charges you 8% for the privilege of using their money. The institution computes a monthly payment and you drive away in your new car. This becomes one of your fixed expenses – a monthly bill.
Good debt is characterized as debt that improves your life and something required for you to live. The two primary good debts would be a house loan and a student loan. Both of these debts provide significant benefits. A house is something you can live in, usually it appreciates in value over time, and there is some tax advantage associated with home ownership. A student loan allows you to get a significant education which can lead to reasonable paid employment. It is in essence, an investment in you. I will also include car loans here as most of us need a car to live life.
One thing to remember about vehicles: from a financial point of view, they are almost always worth less the day you drive them off the lot. In general, they are not a good investment but they are necessary.
A primary source of bad debt is credit cards. Bad debt can devastate the foundation of You, Inc. if you’re not careful. One of the reasons we are such great spenders is the willingness of institutions to extend credit to us. They do not give credit from the goodness of their hearts. Consumer credit is an extremely profitable business. Too many people buy items on their credit card to achieve that ‘good feeling.’ However, when the statement comes, they are surprised at the amount they have spent. It is very easy to over spend when using a credit card. On the flip side, it’s totally okay to use a credit card as long as you pay the entire balance each month.
Here’s how credit debt works. You buy an item using your credit card. When you receive your bill you’ll notice there is a ‘minimum payment’ required. This number is generally significantly less than the totalamount you owe. Many unsuspecting people think paying the minimum payment is all they have to do. This is certainly true but it becomes highway robbery after that. Most credit card companies will charge 12 to 24% on outstanding balances. They require a minimum payment to stay current but then charge exorbitant interest rates on your overall balance.
If you’re paying the minimum payment you are NOT getting ahead of the game. Some red flags to pay attention to that indicate you may have a problem with credit card debt:
- You cannot make the minimum payments
- You realize you’ve been borrowing money from family and friends to cover payments
- You’ve gone to a lender you wouldn’t normally go to (payday loans, etc.)
- Monitor very closely what you charge on a credit card
- Do your best to pay the full balance each month
- Call the credit card company to determine what interest they charge on unpaid balances
- Do your best to pay off your credit cards rapidly
- If you find yourself in trouble take the scissors to the cards