Good Debt, Bad Debt: Know the Difference
Because of tight credit and financial worries, consumers aren’t borrowing as much as they did a few years ago. That means they’re not spending big sums that could help boost the economy, which is a problem. But on an individual basis, tighter budgeting and stepped-up saving is good.
So what’s a savvy consumer to do?
It would be silly to pile on debt just to do your little part in ending the recession. But debt isn’t always to be shunned. The key is to know the difference between good debt and bad.
The Federal Reserve has reported seven straight months of shrinking consumer debt. Balances on credit cards and other revolving loans fell at an annualized rate of 13% in August, while nonrevolving debt, which includes things like auto loans, fell at a 1.6% annual rate.
Of course, part of the reason is that lenders have made it harder for consumers to borrow. But there’s not much doubt consumers have become more cautious as well, setting aside money for a rainy day and investing more for long-term needs like retirement and college.
The big drop in revolving loans suggests consumers do understand that most credit card debt is the bad kind.
Whether credit is good or bad generally depends on whether the benefits outweigh the costs. It’s harder to make that case when interest rates are high, as with credit cards.
Also, taking on debt is more likely to be worthwhile, or good, if it has a long-term payoff rather than a short-term one.
That means a $100 credit card charge for this week’s groceries is bad debt, since it’s a short-term benefit and a potentially long-term obligation at high interest rates. There’s nothing wrong with using the card as a convenient alternative to carrying cash, but that requires paying the balance off during the grace period, so there’s no interest charge. The worst approach is to keep a balance for years on end.
Good debt pays for things that have long-term value. A mortgage is far more likely to be good debt than a credit card charge. Not only is the interest rate lower, but home ownership has financial benefits if you keep the property long enough. A loan for college tuition is likely to be good debt, since it will fund a more interesting and lucrative career, a long-term benefit. Many student loans carry relatively low interest rates.
Debt on a car loan falls somewhere between good and bad. It obviously pays to borrow if the alternative is not getting to work. But cars don’t last as long as houses, and they lose value over time, while homes appreciate.
Since it may be impossible to free yourself of all debt all at once, the best strategy is to avoid bad debt when you can, and to pay it off first. That means paying down those card balances charging 18%. Use the Accelerated Debt Payoff Calculator to devise a strategy.
And since some bad debt may be unavoidable, it pays to minimize the damage. Consider shifting your credit card balance to a new card offering no interest charges on transfers. Just be sure to pay the balance by the deadline and to watch out for cards that may not charge interest but do have one-time balance-transfer fees. Use the shopping tool to find a good card. Discover Card (Stock Quote: DFS) and Citybank (Stock Qutoe: C) have cards charging no interest on transfers for six months.
Also think about using a home-equity loan to pay off a big card balance. The average 36-month installment loan charges just 8%, according to the BankingMyWay.com survey, and many home equity lines of credit start in the low- to mid- single digits.
As for good debt, the standard 30-year fixed-rate mortgage is a terrific deal, charging just more than 5%, according to the survey. With the shopping tool you can find rates even lower.
—For more ways to save, spend, invest and borrow, visit MainStreet.com.