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Lesson 3b: Debt

Objective: Differentiate between good debt and bad debt.
In 2001, 17.6 percent of all households had negative or no net worth while 30.3 percent had net worth less than $10,000.
- Economic Policy Institute

Part of the reason that Americans are in so much debt is that they do not have a savings or emergency fund plan.  Many Americans live paycheck to paycheck, which means that if any emergencies arise, they fall into debt.  In addition, falling into debt is becoming easier with the use of credit cards.  In the 1950's and 1960's, Americans had to pay everything in cash, and going into debt was difficult.  Now with credit cards and access to instant payday loans, the stigma of going into debt has lessened.  Americans can quickly get in over their heads in debt without even thinking.  With such easy access to credit and instant cash, it is important to think cautiously about spending, to avoid going into debt.

So is all debt bad?  Some debt in certain situations can be good (e.g., home mortgage or student loans), which are beneficial as a long term investment.  What distinguishes between good debt and bad debt?

    Good Debt
    Bad Debt
    Building up your assets (e.g., mortgage) Credit card debt
    Educational loans Going into debt in order to meet current wants (e.g., vacation)
    Well-planned investments (with a clear plan for paying off the debt) Debt for unexpected expenses
    Unplanned emergency early in one's life (before an emergency fund can be built) Debt used as a general emergency fund rather than saving for an emergency fund
    Bank loans Loans from quick loan sources (e.g., payday loans)
    Fixed payment loans (variable interest loans would be okay if you can handle the variability) Variable payment loans, balloon payment or 401(k) loans
    Manageable (low) debt burden that does not cause you to live in fear of defaulting

    Debt payments that are greater than 40% of income

    Non-mortgage debt payment that are more than 15% to 20% of your income

Basically bad debt falls into three parts:

  1. Unplanned debt due to poor budget planning
  2. Debt that does not build future assets, such as a house or an education. Bad debt includes loans for vacations, clothes, and electronic toys, (even home equity loans).
  3. Debt with high interest rates (e.g., credit cards) or whose payments become a large portion of one's income

Some of the other improper loans (bad debt) listed above are:

  • 401(k) loans, because if you lose your job, the loan needs to be instantaneously repaid.
  • Payday loans and instant tax refunds, due to high interest rates.   Even loans for just 2-4 weeks can be dangerous because the fees add up if you need more than one of these loans in a year.
  • Deferred payment loans.  If you do not have the money now for a piece of furniture, you will probably not have it a year from now.  If you are even one day late paying off the loan, the back interest will be retroactively applied.  If you have the money, look for a store that gives a discount on the price versus a store that increases prices in order to offer "no-payment" sales gimmicks.
  • Variable interest rate loans should only be taken if you can afford the payments should interest rates go up significantly.   However, it can be difficult to predict how high payments will go.
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