The Concept of Debt

Figure your debt-to-income ratio to stay in control.

Figure your debt-to-income ratio to stay in control.

Negativity is typically associated with debt, as reflected in the idea that people "drown" in debt. At the very least, debt means you owe someone something. But debt is not always bad. There is good debt, too. Once you understand the difference between good and bad debt, you can make debt work for you instead of being enslaved by it.

Mortgage Debt

Without the ability to borrow money and take on debt, you probably couldn’t own a home. Not many folks can plop down cash to buy one without borrowing. Being in debt from a mortgage allows you to own property while building an asset you can later borrow against, if needed. A mortgage debt you to build wealth at a low rate of interest on the debt as long as your home appreciates. Many people who bought homes during the housing bubble between 1997 and 2006 now owe more on the house than it's worth; this is the exception to the rule of mortgage debt being good debt.

Other Good Debt

Another example of good debt is a student loan. Getting a college education can boost your income, and if you need to go into debt to get a degree, your increased revenue eventually pays the loan and could yield higher lifetime earnings for you. Be careful with student loans, though. In 2012, student loan debt surpassed credit card and auto loan debt. There is not enough evidence to show that an expensive degree is worth more than a cheap one, according to Jeff Selingo of "The Chronicle of Higher Education" in an October 2011 article, "How Much Student Loan Debt Is Too Much."

Bad Debt

Going into debt for something that depreciates after you buy it, such as an automobile or credit card purchase, is bad debt. Debt with a high interest rate, such as a payday loan or title loan, is also bad. When you buy clothes with a credit card, for example, the clothes depreciate and you are paying interest on them until you pay off the credit card. Cars depreciate the minute you drive them off the lot. If you can’t pay cash for a car, buy one that you can pay off as quickly as possible — no longer than three or four years. Payday and title loans are usurious loans. People often end up paying more in interest than the original loan amount. If you can’t pay these loans off in the first month or two, you should not get them.

Debt Pitfalls

Being in too much debt can make your debt-to-income ratio too high, and that can hurt your credit score. Both factors can cause you to be denied credit. Your debt-to-income ratio is the amount of debt you have compared to income. If your personal debt is higher than 36 percent of your income, you will have a difficult time getting credit. If your debt is so overwhelming that you miss payments or if you are maxed out on credit cards, your credit score will go down, also preventing you from getting credit.

 

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