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Credit - Heart Matters


4. Good Debt, Bad Debt

a.    Define Good debt and bad debt

Is there really such a thing as good debt? Isn’t all debt financially risky and therefore bad?

Certainly, you run a financial risk when you borrow money, but with good debt, your financial risk is low and your chances of making money are high. For example, most Americans create much of their wealth by buying a home. Traditionally, homes increase in value so a home mortgage is good debt because it’s debt that makes you money. A home mortgage also makes you money by providing tax breaks, such as writing off your loan interest. When your home appreciates, you’re getting an increase in value based on the purchase price of your home. So, if you “paid” $200,000 for your home and your home appreciates 25 percent over five years, you could sell it for $250,000. You’ve made $50,000 in five years. If you put $20,000 down for the loan, you get your $20,000 back at the time of the sale and you get your $50,000. Had you invested your down payment of $20,000 at 3 percent interest, you would have only earned approximately $3,200 over the same five-year period.

That’s good debt. So, what’s bad debt? Bad Debt is when you borrow for things that immediately go down in value or will likely go down in value. You can probably find good examples of bad debt on your credit card statement–eating out, entertainment, travel, clothing, and most household items. If you’d like to see how quickly many of your purchases decline in value, visit local flea markets or garage sales. You’ll find that many of your purchases are nearly valueless within moments of purchase.

If you charged these items, and you’re maintaining a monthly credit card balance that you roll forward, you’re actually paying considerably more for stuff that’s losing value by the day. These things are often called depreciating assets because their value goes down, or depreciates, as soon as or soon after they are purchased. One very common depreciating asset is a brand new car, which usually loses value immediately after you purchase it because it becomes a “used” or “pre-owned” car. Many people buy new cars on credit and end up owning $20,000 to $25,000 or more on something that might now be worth less.

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