Thursday, May 14, 2009

Good Debt. vs. Bad Debt

When it comes to debt, most consumers fall into either of two camps – those who fear debt and those who embrace it. Let’s call the first group the debt-o-phobes. To these folks, debt is to be avoided at all costs. They don’t carry a credit card and refuse to buy anything, except a home perhaps, on credit. We’ll call the other group debt-thusiasts. As long as they can have whatever they want right now and can afford the monthly payments, they don’t care how much debt they are in or interest they will pay.

Neither extreme is healthy. The debt-thusiasts never get ahead and have little chance of building wealth.

The debt-o-phobes, on the other hand, can save a considerable amount of money in interest, but they have less money available to fund revenue-generating investments.

Bad Debt

What exactly is bad debt?
Bad debt is availing of a loan that would be used to purchase something that would depreciate or decrease in value over time. It is money you owe on something that does not increase your earning potential. Generally speaking, if you go on a spending spree with your credit card, you are taking on bad debt.

Good Debt

Good debt is
when you avail of a loan to buy an asset that would appreciate over time or will give you good value or use over the years. It is money you owe on something that increases your earnings potential sufficiently to pay back the debt. Examples of good debt include availing of a loan to buy a house or fund a business that would generate income for you.

Debts have a cost attached to them. You have to pay for the cost of borrowing, which is interest. And when you miss a payment, you would also have to pay other charges including penalties, depending on what's covered in your loan contract. This is why one should think twice about going into debt. If you can, take only good debt.

Consider these things if you are serious about availing of a loan:
  1. When choosing a home, consider its location. It should have the potential to appreciate in value over time. Some indicators of good location and appreciating value include proximity to schools, shopping malls, business districts, and commercial areas. Visit the location first before committing to buy a home.
  2. Think of ways to maximize the use of the asset you’re buying. For instance, you can rent out the property if your family will not use it as a residence, or rent out one room to a boarder. If you are getting a car, consider carpooling so as to lower your gasoline cost.
  3. Shop around for the best terms before signing on the dotted line. Go to several banks and financing companies and compare rates and other terms. Generally, in-house financing offered by real estate companies and car companies are the most expensive. Choose the one that offers the best.
  4. Find ways to lower your cost of borrowing. Check out loans available with the Social Security System, Government Service Insurance System, and PAG-IBIG Fund. If you are buying a car, consider trading in your old one to lower the cost of purchasing a new car. It may even be wiser to buy a one-year-old car than a brand new one. It will be cheaper, yet still give you good mileage.

  5. Always read the fine print before signing documents. Read about penalties, defaults, and the like. Find out if there are penalties for prepayments. If none, pay off the loan faster if you can to save on interest expense.

  6. Safeguard loan documents. Keep them in a safe place but make sure your spouse knows where these can be located.

A debt can be a good tool to secure your financial future. Go into it only after careful thought and manage it well. Financially healthy, wealthy, and wise individuals are not opposed to taking on debt, but they are very proactive in limiting bad debt and maximizing the power of good debt.

source:, (photo)

*Disclaimer: Readers are solely responsible for their own investment decisions and should thus conduct their own research and due diligence and obtain professional advice.

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