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Managing Debt: What is Good Debt
A few fortunate people are able to go through life without acquiring any debt. However, this scenario is not the case for a majority of people.
While financial experts constantly maintain the importance of staying out of debt, they do recognize that not all debt is a bad thing. In fact, as long as your total monthly long-term debt payments, including your mortgage and credit cards, do not exceed 36 percent of your gross monthly income, you should be OK.
In addition, avoiding debt too vehemently can actually be detrimental if you do so by depleting your cash reserves, leaving yourself with nothing in case of emergency.
However, not all debt is equal. Some debt is considered to be good debt. This debt typically includes items that you need but are unable to pay for up front without using all of your cash reserves or liquidating your investments.
On the other hand, bad debt includes any debt you have acquired for items that you do not need and are unable to pay for up front. The worst form of debt you can have is credit card debt because it typically comes with the highest interest rates.
Recognizing Good Debt
So, what exactly is considered to be good debt? There are three primary forms of debt that are not considered to be negative: a mortgage, college loans and a car loan.
Good Debt: Your Mortgage
Purchasing a home is a significant expenditure, and very few people can afford to pay for a home with just their cash on hand. In addition, utilizing every dollar you have to purchase a home is not always prudent – it is more important to have a cash reserve available in case of emergency.
While your mortgage is not necessarily bad debt, there are smart and not so smart ways to buy a home. The first rule is to make sure you are purchasing a home you can afford. Additionally, you should aim to pay at least 20 percent toward the down payment. This step will help you secure the best mortgage deals and you can avoid paying Private Mortgage Insurance, known as PMI, which then can lower your monthly mortgage payments.
Good Debt: Attending College
Typically, it is much wiser to tap into the many financial options out there to pay for college tuition rather than dipping into your cash reserves or borrowing against your retirement fund.
There are numerous financial opportunities for college-bound students, from scholarships to federal aid. In addition, federal loans for college offer guaranteed low interest rates, no interest payments until after graduation and, in most case, the interest paid is tax deductible.
Good Debt: Your Car
If you are fortunate enough to have enough savings on hand and you plan on keeping that car for an extended period of time, then paying for a new car outright makes the most sense. However, if you find that you do need to finance the purchase of a new car, this debt will not necessarily count against you, provided you purchase a car that you can truly afford.
When purchasing a car, experts recommend that you pay at least 10 percent toward the down payment, primarily because of how much the car depreciates in value the moment you drive it off the dealership’s lot. You also should shop around for the best deal possible. Additionally, you should avoid financing a car based on what the monthly payment is. Instead, you should focus on the total deal: how much you are paying for the car in total and what the interest rate is.
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