Before I start talking about the different kinds of debt, there are two things in terms of debt (some people call it credit) that I want you to know.
The first thing is the importance of knowing your credit rating. There are a number of organizations that will provide this information for a small fee and even your bank may do this for you as part of their services. Why is this important? Well first of all, it should give you a very clear indication about how lenders will see you should you ask for a loan and secondly, it will also allow you to make sure there are no errors or identity theft issues associated with your name.
The second thing I want you to know is that if you are currently unable to pay your bills or meet your minimum debt servicing obligations, you are not going to find anything of real use to you on this web site. If you are in this situation, please make an appointment with a not for profit credit advisory or consultancy firm. I suggest not for profit because many for profit credit management firms really just want to consolidate all your bills under another loan to them with a profitable interest rate. This may be one possible solution for your issues but I strongly suggest getting objective third party advice before you do any "debt consolidation".
The other thing to consider here is that racking up debt you cannot pay, may not just be a debt or cash flow issue. It could well be a result of some bigger issue going on in your life which deserves due care and attention. Financial counselling may be of great value to you but you won't know until you ask.
Okay, so just to make sure we are on the same page in terms of language and terms, let's define a few of the words we will be using in this section.
Credit - Is the amount of money available to you for borrowing. Sometimes this is referred to as a credit limit.
Debt - Is the money you owe and on a credit card statement is sometimes called the "balance owing".
Interest - Is the fee you pay to borrow the money usually as a percentage of the balance.
Payment - Is a combination of interest (the fee) and a return of the principal (that which you borrowed) you pay to the lender.
Default - You default on your obligations when you fail to make the payment that you agreed to make in the time-frame that you agreed to make it. If you are in default, the lender can "call the loan" which means you have to pay it all back at once. If you can't, the lender may seize assets or garnishee your wages to get his money back."
Bankruptcy - is when your liabilities or that which you owe, exceeds the value of your assets or that which you own and there is no reasonable belief that you will be able to pay the money back. Bankruptcy is a legal proceeding that provides your creditors (those that lent you the money) access to your assets as partial payment while protecting you from having absolutely nothing left.
Leverage - When someone uses a down payment or some initial cash as the foundation to borrow additional cash, it is called leveraging because you are making 10% of the value of the asset in support of borrowing 90% of the value of the asset so that you can buy it. Thus you are highly leveraged.
Collateral - Is something of value that is used to guarantee a loan. For example a car loan has the value of the vehicle as collateral. If you default on your car loan, your creditor can seize the car as a means of recovering his money.
One of the big questions any of us face is whether or not we should borrow money to buy something we want. Of course there is no one answer that fits every situation but here are my thoughts to help provide some guidance.
So what is good debt? Well to me it requires a few different criteria before it can be considered good debt.It should be relatively inexpensive. This means the interest rate you are going to be charged for your debt should not be incredibly high. What is high? Almost any credit card will have an interest rate that I would consider to be unacceptably high. Some are in excess of 20%! No matter what you purchase, there is no way you should consider credit card interest to be a "good deal" or represent "good debt".
Why is credit card debt so expensive? One, it is convenient and so you pay for that convenience. After all, once you have a credit card and as long as you don't go over your credit limit, no one judges if you should be using it or not. It is very easy to use and you pay for the convenience.
The other reason credit card debt is so expensive is that quite often there is no collateral that the lender can seize to get their money back. Say you go to a restaurant and buy a nice meal on your credit card and then can't pay it back. What is VISA or MasterCard going to do, pump your stomach? Nope.
So credit card debt does not meet our number one criteria for good debt and nor should any credit offered with an interest rate over say 12-15%. It is just too expensive.
Key Tip: Often your credit card company will lower your interest rate if you phone them and ask them to do so. this doesn't work all the time but it does sometimes and it costs nothing. It is worth asking!
The Second thing is that good debt should hold the promise of future value. To me good debt is almost like an investment. For example, a mortgage could be considered good debt because in many cases, the value of your house and property will go up over time. This isn't always the case of course but as a rule of thumb, borrowing money on a mortgage can be considered good debt.
Another example might be a school loan. With a school loan you are borrowing money to invest in yourself and your future earnings potential. Without the loan, you may never get that diploma or degree and without the diploma or degree, you may never get that high paying job you want.
Some people borrow money to invest in stocks. I think this is very risky and do not recommend it. Stocks vary very widely in value and are often unpredictable - even the so called "blue chip" stocks can suffer huge losses in value. You may think you are making a smart investment by borrowing money to invest in stocks, but I would suggest you don't do this.
Borrow money as an enabler. By this I mean that it may be good debt if you borrow money to enable you to do something in support of your financial future. An example of this might be a car that you need for work, or tools that you need to perform a trade or even a small business loan to get your business up and running. In these cases, you are borrowing money to enable you to work and earn an income. This is probably good debt.
As I already mentioned, bad debt is any debt that is expensive. Bad debt also has some other characteristics worth noting.
The first of these occurs when whatever you are buying something with credit that has a "value" less than what you owe on it.
An example of this might be a new car loan where you pay zero down and make zero payments for the first three months of ownership. Say the car costs you $10,000. The minute you drive it off the lot, it becomes a "used" car and is automatically worth less than it was when it was "new". Now this off the lot depreciation varies widely but certainly, at best it is only worth 90% of its "new" value and sometimes it can be has low as 70% of its new value.
Three months down the road, it will have depreciated a further 5% or more. Now you have an asset that is worth at most $8,500. How much do you owe on it? That's right $10,000 because you didn't put any money down and you have yet to make a payment! This is bad debt because even if you default on your loan, they lender will not only reposes your car - they will seize other assets as well to get their $2,500 back! This is a bad situation and thus this is bad debt!
Please note that I am not saying car loans are a bad idea. Just make sure that you are paying off the loan at the same rate as the car is depreciating so that you are never owing more than the car is worth!
Bad debt is associated with almost any consumer good you might purchase, be it stereo equipment, Televisions, computers, iPods, clothes, you name it. If you own money on anything like this, make sure it is very little indeed because even selling it to a pawn shop will not come close to paying off your debts.
You have already seen the commercials where you are not required to "pay a cent" for a year or more! These situations take a bad debt and make it worse. How? Because they suck you in to buying and using something without paying for it for a year or more and then they want their money in full or they will "help you" pay for it with a loan at outrageous interest rates.
Not only do you have an asset that is worth next to nothing, you also owe full price on it and if you can't get a loan anywhere else, you will be forced to accept their loan on their terms which will be very favorable to them. In short, they have you over a barrel. In fact, some of the time the furniture they sell you (as an example) is sold at a loss (what a great deal!) because they know they will make a huge profit on the loan you will be forced to take out. This is terrible debt! Think about it. If you can't afford it now, will you be able to afford it in a year?
Obviously by now, you have a good idea that debt can be a good thing or a terrible thing depending on how you use it.
If you find yourself over your head and struggling to make your payments, here are some suggestions: