Many consumers will finance at least one purchase in their lifetime. This means debt will be a part of that process. Knowing when to carry “good debt” and when to avoid “bad debt” is an important step to building wealth and securing fiscal stability.
So, here are six questions to ask yourself when managing debt.
What is financing?
It’s the act of obtaining funds to buy an item which is then repaid, along with a fee or interest charge, over a set period of time. Consumers often obtain financing for larger purchases, which cost more than the consumer may have on hand. Examples include a home or vehicle.
How does it work?
Consumers can finance directly from the seller of the item or through a third party when your financial institution finances a vehicle, house or even a credit card. The amount of the unpaid balance is considered debt. Depending on whether the item will improve your assets or lose its value will determine if it is “good” or “bad” debt.
What is “good debt”?
Good debt is considered an investment which creates value or will increase in value over time. Common examples of this include a home mortgage, land purchase, most college degrees and used vehicle purchases.
What is “bad” debt?
Renowned financial author, David Bach, sums up bad debt as such, “When you buy something that goes down in value immediately, that’s bad debt. If it has no potential to increase in value, that’s bad debt”.
Using your college student loan to buy pizza or go on spring break is a classic example of bad debt.
Are there any benefits to financing or carrying debt?
Financing allows consumers to make purchases which can build their assets and improve their financial situation. A great example is buying a home with a fixed interest rate; the property is purchased at today’s value and the owner pays a set amount for the term of the loan (30 years).
At the end of the loan, the owner can sell it. The same person who rents that property would face rental increases over that same 30 year time period while gaining no ownership or value in the property. Pay upfront for purchases which lose value quickly, like meals out, so that the items you finance will work to improve your net worth and financial stability.
For more great financial literacy information like this, check out our next workshop, Croissants and Credit.