Just How Costly Is A Little "Bad" Debt?

While being "in debt" often has negative implications, not all debt is construed as being harmful to your financial situation. Different types of debt are often referred to as, "good" debt, or "bad" debt. Having a mortgage (that you can really afford) is considered to be "good" debt because it can be beneficial in the long run. A mortgage pays for an asset that is expected to gain in value, you are paying a relatively low interest rate, it can provide certain tax deductions, and it is an expense that you would have anyway (at least in part) even if you were renting. For reference, your total home debt (which applies to rent as well as a mortgage), should never be more than 28% of your gross income. Less than that is even better.

Credit card debt (that is not paid in full each month) is considered to be "bad" debt. You are paying high interest rates for an item that has already been purchased, and that is now decreasing in value. To make matters worse, each month that you carry a balance on those purchases you are adding to their actual cost. At the same time, your monthly payment amount is money that can not be used to add to savings, or to invest.

Consider this example:  A $200 monthly payment on a $5,000 credit card balance (with 18% interest), would take more than 2 1/2 years to pay off, and cost $1,313 in interest charges. If you were able to invest that same $200 per month over 2 1/2 years (with a 7% return), it would result in almost $10,000. At the end of 2 1/2 years, would you rather lose $1,313 and have $0 cash in hand, or make $4,600 on your $6,400 savings, and have $10,000 in hand? It sounds like an easy choice, yet a majority of households continue to carry large credit card balances from month to month. The next time you reach for your credit card (and don't intend to pay the balance within 30 days), think of the real cost of whatever it is that you're purchasing. By carrying a balance, you could easily end up paying 25%, or more, for the item you're purchasing. Does it still seem like a good value? Would you be happier overspending for that item, or actually making a profit off of the money that is not spent?

One more thought to drive this point home - if you invested $200/month from age 30 until retirement at age 65, you could end up with close to $400,000 (assuming a 7% return). That's a tidy sum for a relatively small savings goal. With all the reports about how little people have saved for retirement, it doesn't seem all that hard to save quite a bit if you get your priorities straight early on (or even later!). Always make sure that you understand the impact, current and future, of your decisions.

Do your best to save, make more money, and then pay cash for life's pleasures. This will help you to pay off any debt as soon as possible, relieve the stress of always having a balance due, and give yourself the best opportunity to control your destiny and achieve financial security.

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