You may have heard the terms good debt and bad debt before, but it is not as simple as labeling credit card as bad, and a home loan as good because a home loan can in fact be considered bad debt too. It is important to understand the differences between and the definitions of good debt and bad debt so you know how to manage each when they come into your life - and they will. However, if you know what to look for and what to do, you can be in control of both good and bad debt in your life, and you can win the debt battle.
What Makes Debt Good or Bad?
There are endless opportunities for you to get into debt every day whether it be a purchase at the mall, a dream house or a hot investment tip you want to follow, but before you follow anything, know what you are getting yourself into.
- Is traditionally thought of as debt on an asset which will increase in value. This is actually a simplistic view of good debt because even a mortgage on your home , a house which is increasing in value, can be bad debt because you are paying it with your after tax dollars.
- Good debt is paid with pre-tax dollars. Good debt will be tax deductible which means that the money you have borrowed to buy an investment property or shares is a good debt. This is because the interest you pay on that money can generally be deducted from your overall taxable income, possibly putting you into a lower tax bracket where you can pay less tax at the end of the year.
- Gains from good debt can be taxed. The capital gains you make from your investment property or the shares you have borrowed to invest in can be taxed, but as you just learnt in the point above, the money you borrowed to make those investments is tax deductible so your good debt evens itself out and keeps you ahead.
- Will not increase in value. This means anything you buy on your credit card which is a consumable such as clothes, shoes or electronics is simply adding to your bad credit card debt as none of it will increase in value.
- Your car loan. Getting into debt to buy a car , especially a new car, is accumulating bad debt as cars are notorious for losing almost half their value as soon as they are driven out of the dealer's lot. Plus, there is a very small chance that you will be able to sell your car for more than you bought it, making it a depreciating asset.
- Is paid from your after tax income. This includes interest payments not only on your credit cards and store cards, but your home loan too and because the payments are made from your after tax income, they are more expensive and therefore bad for your finances.
See this article for more on How to Effectively Manage Your Debts
About the Author: As a leading personal finance blogger, Andy shares his thoughts on working life, money management and related topics. You can see more articles like this at his top 50 personal finance and investing blog : www.savingtoinvest.com