Good, Bad And Ugly Types Of Debt
Over the past few decades the debt of U.S. consumers has increased to more than $2.5 trillion, according to the March 2012 Federal Reserve Statistical Release. This is just consumer debt. If you include mortgages, home equity lines of credit and other real estate debt, that number increases to $13.5 trillion! Debt in general should be limited, but there are different categories of debt that, if used properly, can help you reach your financial goals: The (kind of) good, the bad and the ugly.
The (Kind of) Good
Although I wouldn’t call any debt good, the following types of debt may be necessary at times and even potentially helpful.
- Student Loans: Studies show that the benefits of a post-high school education range from financial to cultural. It can be expensive, so student loans are often a necessary evil to earn a degree. But it is important to only borrow what you need. Minimize your student loan debt to get the degree and get a better standard of living without having to pay off student loans years later.
- Mortgage Loans: Paying cash for a house is extremely rare, and most people will need to take out a loan.
But as we learned in the 2008 housing bubble, buy only what you can afford and need, not necessarily what you want and desire. The mortgage deduction is just icing on the cake and should not be the primary reason for purchasing a home unless you can afford the payments. Also keep in mind interest rate changes, especially if you have a variable mortgage loan.
The loans below although common should be limited, if possible.
- Auto Loans: Unlike a house, a car depreciates in value. Most of us require a car for transportation, but your transportation costs (car payments, maintenance, gas, etc.) should not exceed 10 percent of your income. Buying what you need, not necessarily what you want, is important to keep your payment at a reasonable level. Being practical is more important than name brand.
- Credit Cards: Some credit cards offer good perks, and using them for convenience is OK, but if you are unable to pay off the balance each month the interest payments could be quite high. For example, if you put $1,000 on your credit card with an 18 percent interest rate and only make the minimum payment, it would take 153 months, or 13 years, to pay off the original $1,000 with an additional $1,115.41 in interest!
These loans are the worst kind and should be avoided at all costs.
- Payday or Advance Loans: These types of loans are under scrutiny from Congress because interest rates can actually hit more than 1,000 percent! If you need these type of loans, first look at your spending habits and possibly adjust your lifestyle. Paying these types of rates is obscene.
- High-Interest Auto Loans: Reconsider any car loan that has a double-digit interest rate. A $30,000 car financed for 60 months at 12 percent will end up costing you more than $40,000 in total payments. Essentially, you are paying an extra 33 percent for a car that depreciates 30 percent the moment you drive it off the lot. This certainly doesn’t make sense!
In a perfect world, there would be no need for debt. Unfortunately that’s not the case. But if debt is used properly it could be useful, but the key is using it wisely.