When you borrow money, you end up with either good debts or bad debts. So whats the difference between these two? For example, you need to borrow money because you want to get something you currently cannot afford, such as a student loan for a four year college education which can be as much as $100,000 and still rising. Since it will take many years of working and saving before you can have $100,000, the faster approach is to take out a student loan first in hope that you can graduate and find a better paying job that can pay off the loan fast. Ideally, this will work out better compared to being trapped for years in a dead end job due to the lack of academic qualifications.
On the other hand, many people prefer to borrow $50,000 to buy a new car, since it is easy to take out a car loan to finance a new car purchase and pay back the money in the future with 60 monthly installments. If given an option, should you take a student loan or a car loan instead? Which is the bad debt and which is the good debt?
The first step to borrowing money and using leverage is to understand the difference between borrowing for investment versus borrowing for consumption. Getting a $5,000 vacation loan to UK to reward yourself may give you an enjoyable experience and memories, but are you sure it is worth borrowing money at consumer rates? This is an example of living beyond your means. If you do not have that much cash, find a cheaper vacation idea that you can afford without having to step into debts just for short term consumption and enjoyment.
Compare Consumer Credit And Bad Debts
Many consumers are bearing a lot of bad debts because of the ease of spending through personal credit. Bad debt is thus named because they can harm your long term financial health. If you have the habit of borrowing money for consumer items such as cars, clothing, vacation, computers etc, you are sacrificing your financial future for instant gratification with these purchases. You will be losing out a lot on long term investment returns since your current income must be used for paying off the unsecured cash loans, credit card balances and interest fees, leaving nothing for investments. and when you have a major expense to take care of, you try to borrow more money and used up whatever credit is available to you.
The high interest rates charged by credit cards and banks will actually quietly eat away at your savings if you are not carefully with your money management. As long as you do not appear to be in financial trouble, they are in no hurry to ask you to pay up the loans and credit card balances in full. In fact, they encourage you to use more credit and take you time with payments through the minimum monthly amount. This way, they can continue to earn high interest rates on credit card balances and outstanding personal bank loans.
when you are wasting money on interest payments, you have less left for savings and other long term investments. This also means that you are more likely to require a personal loan in future should there happen an unexpected loss of job or income. Note that consumer loans such as car loans, credit lines etc are not tax deductible so you gain zero tax savings.
On the other hand, good debts can actually improve the qualify of life you enjoy. For example, when you take a low interest rate mortgage to buy a house or start a small business, it is usually much cheaper compared to unsecured personal loan rates for bad credit and it is also tax-deductible. With proper management, these investments are likely to increase in value above the interest rates you are paying for the loan money. A student loan can be considered a long term investment in yourself, since it increases your earning potential and student loan interests are usually tax-deductible.
How To Calculate Bad Debt Danger Ratio
The best way to detect dangerous levels of personal bad debt is to divide your bad debt by your annual income. For example, you earn $50,000 in the past year and have outstanding credit card loans and car loan amounting to $20,000. Thus, your bad debt ratio is 40%.
Note that you can leave out your good debts in this calculation, because bad debts with high interest rates are used to buy things that depreciate in value while good debts are used to invest in products that appreciate in value.
The best level of bad debt ratio is simply zero, because you are not reducing your earnings for paying high interest fees. However, not many people can achieve this since car ownership through financing is very popular and is often justified as a necessary transportation tool. If you have consumer debt ratio of under 20 percent versus your annual income, it is still alright but do try to pay off your bad debts as soon as possible and not increase your debts.
When your bad debt danger ratio exceeds 30 percent, you are in immediate risk of falling into bad credit due to problems in meeting your debt obligations and bill payments. With uncontrolled spending and abuse of personal credit, your debt starts to grow, aided by the high consumer debt interest rates. You need to seriously cut all spending and find ways to increase your monthly income otherwise there is no way you can pay down your consumer debts.
How Much Good Debt Is Risky?
So is it advisable to add as much good debt as possible? No! Borrowing a reasonable amount money for low risk investments and good debt will help you financially — such as buying a house, starting a small business, going for further education etc. However, with any investments for returns, you have to deal with risks and the probability of making a loss. Your business may fail to make any profits, your stocks and shares may get hit by a market downturn, the real estate market may collapse etc. That is why extremely high levels of good debts will not be recommended either.
Even good debt at lower interest rates still means you owe your lenders money. The maximum amount of good debts that can be handled depends on your risk appetite – can you still sleep well at night and not feel pressurized by your small business loans? Are you still able to save regularly and have sufficient savings or highly liquid assets to cover debt payments for at least 6 months? To play safe, minimize your bad debt to good debt ratio and save at least 30% of your monthly income for your own financial sake.