Good Debt and Bad Debt – What is the Difference?

It is easy to tell the difference between good debt and bad debt: good debt helps you turn your own limited assets into more assets. It is good debt to buy a new home, expand a business, buy a car or pay for college education. Bad debt is the kind of debt that makes you spend more than you have on things that you don’t really need, like a fancy vacation, or a new plasma TV.

Having a mortgage loan is good debt, because after you have paid the loan you will have a house that is probably worth more than the price you purchased it. Using a loan to buy a car is also considered good debt. In a few years a new car will worth much less than its initial price, but having a means of transportation adds value to your life: you can visit your friends, or commute to your job. Paying for college education is also good debt, because a degree will help you get a higher paying job.

A debt that makes your money work harder is also good. The reason is simple: if you have $10,000 and you want to make improvements to your home, you have two options: spend your money on the improvements, or invest your money, while you pay the improvements from a loan. If the interest rate of your loan is smaller than the interest rate of your invested $10,000, you should choose to take a loan and invest your cash.

Not knowing exactly what you are doing can lead to serious consequences. There are people who take on a home equity interest rate to buy a car, or pay off their credit cards. There is some sense behind this: home equity interest rates are usually lower than interest rates on other kinds of credit, and interest on home-equity loans is tax deductible.

The thing is, if you are not able to pay back your debt for your car, the lender will take away only your car. Most of credit card loans are unsecured, which means the lender will not take from you any goods. But if you had a home equity interest rate and fail to pay, you can loose your home.

Some people use their 401(k) to pay off debts. This may seem a good trade-off at first time, because the interest is lower than on any other kind of loan. But if you look in perspective, you are giving up a secure financial future for a more stable financial present.