Good Debt Vs Bad Debt
What is the Difference Between Good Debt and Bad Debt?
When speaking of debt as "good" or "bad," we do so from the perspective of debt management, not from the perspective of credit management. We are speaking of the debt/purchase itself as “good” or “bad,” with less emphasis on its effect on your credit rating.
It can indeed look very good on a credit report to have outstanding debt(s) (whether credit cards or loans) if you are paying on time every month and if your total debt does not exceed 20% of your income (accepted debt income ratio). A solid history of on-time payments looks good to prospective creditors, as long as they also know that you have some wiggle room in your monthly budget.
Your history of payments for a debt although, has nothing to do with whether or not that debt is considered good or bad debt. The terms "Good Debt" and "Bad Debt" refer predominantly to the items for which the debt was incurred.
What is Good Debt?
Good debt is debt that produces income or cash flow over and above the payments and interest on the loan used to secure the purchase. For example, if you decide you want to go into debt in order to purchase a business that makes cogs, and that business will produce income as well as tax deductions — that is good debt. If you buy a home that will almost certainly appreciate in value that is good debt. Mortgage debt is good debt. Any debt that is tax-deductible or will produce income in the long run is good debt.
What is Bad Debt?
Bad debt is debt that occurs usually with the purchase of disposable items or durable goods, or even generally speaking, the purchase of anything with high interest credit cards when the balance is not paid off in full each month.
The problem with these high interest credit cards is that people do not realize that they are really just plastic cash. People buy things thinking that they won't have to pay right away, which of course is true in the short run. Then before they realize what has happened, they've lost track of how much money they've actually spent. Then, when the credit card statement arrives, the credit card user realizes that they have spent more than they should have, so they then decide the prudent choice is to make only the minimum payment. This is how serious debt begins. If you're late on payments your interest rate rises and there are fees. If for some unforeseen circumstance, you miss an entire payment, then you'll really see your rates go through the roof. This is often how debt escalates into unmanageable debt.
Debt to Income Ratio
Debt to income ratio is the amount of what you owe relative to the amount that you earn. Most creditors set 20% as an acceptable debt to income. This means that you should not owe more than 20% of what you make. Even if you pay all your bills on time, if you're over 20% debt to income ratio then that's considered bad debt by the creditors.
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