There is good debt and bad debt, but mostly bad debt.
Good debt is for things that appreciate in value, like the mortgage on a house (other than immediately following a massive real-estate bubble!) or education, and for necessary medical expenses (including those of our companion animals).
Bad debt is for things that depreciate in value. Yes, even a car loan—as essential as a vehicle may be—is considered bad debt because a vehicle depreciates in value. The worst form of debt is a consumer loan, with interest rates often over 20 percent.
Care needs to be taken with home-equity loans. “Home-equity loan” is just another name for a second mortgage. It’s not wise to use a good debt, like a mortgage, to pay bad debt if it’s just a way to consolidate bad debt, especially if it leads to incurring new bad debt.
Credit cards are like fire. Used wisely, they are a terrific tool. Used recklessly, they are extremely destructive. Credit cards can’t be beat for convenience, for keeping track of budget expenses, and for providing free credit for up to nearly two months (payment for purchases made at the start of the billing cycle are only due a few weeks after the end of the billing cycle). The trick is to always pay the credit card balance in full.
One of the benefits of most credit cards is the rewards program, where credit (typically 1 percent) is given for the amount charged. Using the cash option for the rewards provides a credit directly to the account. Another effective way to use a credit card is with one of the many affinity programs, like the PETA credit card, which automatically generates a contribution to PETA of 1 percent of all purchases.
There is nothing more sinister than credit card debt. The lure of paying only the low minimum monthly payment is tempting, but it carries a very hefty long-term price. With interest rates often in double digits, making minimum payments makes the lender very happy—and rich. For example, that $1,000 shopping spree charged to a credit card with a 15 percent interest rate and a $20 minimum monthly payment will take seven years to be paid in full—and with a total interest expense of $580!
As for making loans to family and friends, follow the advice of Polonius: “Neither a borrower nor a lender be, for loan oft loses itself and friend ….” Beyond the strain often created by the indebtedness, there are tax consequences (even if interest isn’t being charged, the IRS assumes it is—and it’s taxable income). A better alternative is to give a tax-free (to both the giver and recipient) gift. The IRS allows each taxpayer to give an unlimited number of gifts of up to $13,000 per year per recipient.
Have questions about your own debt? Let me know in the comment section below!