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Good debt and bad debt

Debt is a concept as intricately intertwined with America these days as baseball, mom and apple pie.

The amount of personal debt in this country is ever increasing, and a large part of the reason is that credit has never been easier to get. Whereas credit card issuers previously looked for customers who could repay, today card issuers relish the chance to reel in those who'll continuously charge beyond their means at 18 or 20 percent.

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But debt is a complex concept. Not all of it is good -- which surprising number of Americans fail to realize until they're in the hole -- and yet not all of it is bad. When used intelligently, debt can be of tremendous assistance in building wealth.

One of the secrets, therefore, to being smart with your money is to differentiate between good debt and bad debt. While the differences often seem logical, it is a logic that apparently is missed by many Americans.

"When you buy something that goes down in value immediately, that's bad debt," says David Bach, CEO of Finish Rich Inc. and author of The Finish Rich Workbook. "If it has no potential to increase in value, that's bad debt."

Good debt
"Good debt produces cash flow, and bad debt doesn't," says John Waskin, CEO of national nonprofit debt counseling service Bill Free - American Credit Counselors. "If you go into debt buying an apartment building that will produce revenue and deductions, that's good debt.

"Mortgage debt is good debt. You're borrowing money, but you're getting a tax advantage and can write off interest on an asset that's appreciating over time. Plus, you get to live there."

Robert D. Manning, a professor of finance at the Rochester Institute of Technology, also recommends taking on debts that are tax-deductible, and debts that produce more wealth in the long run.

"If you are talking about reducing current debt, that's where it starts to get nuanced," says Manning. "If you take a home equity loan because you have 17 percent credit card, and you go with a 6 percent loan that's tax-deductible, that's good debt."

These general rules of thumb set some clear delineations -- buying a home or refinancing to get rid of excessively high rates is usually good debt, as is generating debt to buy high return stocks, bonds and other investments.

Bad debt
The concept of bad debt comes in when discussing the purchase of disposable items or durable goods using high interest credit cards and not paying the balance in full.

"Some people have a difficult time living within their budget when they charge items rather than paying cash," says Ann Ray, senior spokespwoman for the National Foundation for Credit Counseling. "They lose track of how much they have charged and are unable to pay the total amount by the due date.

"Paying less than the total balance results in additional interest charges making the real cost of the item higher."

Every month you make a partial payment on your credit account you are charged interest. The disposable or durable item you purchased continues to lose value and the amount you paid for it continues to increase.

"When you buy clothes, they're probably worth less than 50 percent what you pay for them when you walk out the door," says Bach. "So if you borrowed to pay for them, that's bad debt."

Not to mention what that debt could potentially do to your credit rating.

"Your unsecured debt, including credit card bills, should not be above 20 percent of your annual income," says Michael Hirsch, debt product manager at "If it is, it looks bad on your credit report, even if you're making payments on time.

"The recommended debt-to-income ratio is under 15 percent to help qualify you for the lowest interest rates possible when extending your credit to buy a home or car."

When it comes to buying durable goods that won't contribute to wealth generation, Bach offers a basic rule of thumb.

"My grandma used to say that if you're going to buy something that doesn't go up in value, and you can't afford to pay cash, then you can't afford it."

Exacerbating the bad debt factor is that people will apply for store credit for the savings, offers that say if you open a credit card account today, you can take 10 percent to 20 percent off the cost of your purchase. What people often don't realize is how much of that savings will be destroyed by the high interest rate on the card if they fail to pay for the items immediately.

"You can open a store credit card account," says Bach, "and what they're not telling you is that after the first few months, the rate jumps to 20 percent or greater."

Driving into debt
Another bad debt area is auto debt. While most people need an automobile, and the ultimate cost of an auto is higher than many people can pay in one lump sum, the way people go about it -- namely, purchasing more car than they need -- turns it into bad debt.

"People can afford to pay cash for a car," says Waskin, "but not the car they see themselves in from an ego extension standpoint. So you buy a car at a much higher rate than a house, and that asset is worth less the day you drive it off the lot."

Bach considers auto debt a Catch-22.

"People borrow to buy cars before homes," says Bach, "and that's unfortunate. For most people, their first major loan is a car loan. That's guaranteed to go down in value. So you really want to borrow less. For example, instead of rushing out to borrow to buy a $50,000 BMW, you'd be better off buying a $25,000 car."

Harol reminds us that just a few years ago it might have made more sense to buy a car at 6 percent or 7 percent, and then invest in other avenues and earn 10 percent or higher on your money, than to pay off the car. Now, of course, with traditional market investments substantially riskier, that is no longer the case.

The best type of debt is debt that builds wealth over the long run, and the No. 1 example of that is mortgage debt.

"Home values have increased an average of 6.5 percent a year over the past 30 years," says Bach. "So when you borrow to buy a home, chances are that's good debt. You'll build value."

Bach heavily promotes the idea of homeownership, saying that everyone needs to own where they live.

"About 40 percent of Americans are renters," says Bach, "and the fastest way to wealth in America is buying where you live."

Bach cites some shocking numbers to back this up.

"The average renter has a median net worth of $4,000, and the average homeowner has a median net worth of about $150,000."

Manning also emphasizes what a good time this is to build wealth through debt.

"This is the most advantageous time ever to be in debt," says Manning, "in terms of opportunities to get low income loans, or to renegotiate or refinance."

Duh, debt?
One of the reasons so many Americans seem mired in bad debt (both Bach and Waskin report that the average American carries approximately $8,400 in credit card debt) is that financial education is virtually non-existent.

"This type of common sense stuff isn't taught in school," says Bach, "and most Americans don't realize how bad high-rate credit cards are hurting them."

"We are stupid people when it comes to financial education," says Waskin. "Only 40 percent of high school students receive any economic training. We don't teach kids how to balance a checkbook, what a credit card is, paying rent. We just say, 'Figure it out.'"

"People are getting in debt before they have a job," says Manning. "Education is important. We used to encourage kids to save, and that has been missed. Students now refer to their credit cards as yuppie food stamps. They see cards as entitlement, and see they will be in debt all their lives."

Waskin says that the way to fix this is to educate kids on the difference between good and bad debt, and to return to some basic fiscal common sense.

"We need to go back to the fundamental values our parents and grandparents had, saving for a rainy day," says Waskin. "The best thing you can do is hope for the best, but plan for the worst."



-- Posted: Aug. 6, 2004




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