Debt is a tricky thing. Handled wisely, it can help you reach your dreams. Handled poorly, it will do the opposite. After all, debt can pay for a graduate degree that doubles your salary within five years … or it can lead to unmanageable interest payments.
The word debt can sound scary. And it’s true–many of us haven’t been using this tool responsibly.
Despite these harrowing statistics, using debt wisely can be the very definition of living richly. It’s an integral part of buying your own home and for many people, buying a car or becoming qualified for their dream job. Read on to find out what using debt wisely really means.
Debt in a Nutshell
In short, debt is money borrowed from someone with the promise of paying it back at some point, often with interest. That someone could be the bank, credit union, credit card issuer, the government, a furniture store or even your mom, among many other places.
When you take on debt, you get a lump sum of money up front and you pay it back in installments. You also pay the lender interest every month for letting you borrow the money.
In most cases, the lender will send you a monthly bill stating how much you are required to pay that month. You have to pay the minimum, but you can choose to pay more in order to pay off the loan faster and save yourself money on interest.
How Debt Works for or Against You
Whether debt is beneficial or not is determined by two factors:
This is the money you pay the lender for the privilege of having the money upfront. This interest will compound, which is another way of saying it snowballs. And the higher the interest, the more quickly it will snowball. Interest is the main reason why debt sometimes gets out of control.
- Whether the debt is taken on as an investment in your future:
If you take on the debt in order to leverage, say, greater earnings in the future, then the debt has furthered your financial goals. If the debt won’t yield any future reward, it isn’t an investment but a burden.
But when deciding which debts to pay off first and whether it’s even a good idea to take that type of debt on in the first place, these designations are good rules of thumb:
Good debt usually has a low interest rate–6% or less–and is often seen as an investment in your future happiness and financial stability. These are three common types of good debt:
- Student loans, which can increase your salary and lifetime earnings, plus improve your quality of life
- Mortgages, which can help you buy your own home, instead of spending money on rent
- Business loans, which help you start your own business–which will hopefully lead to higher earnings and a fulfilling career
Not only do these kinds of debt normally offer low interest rates, but the interest may even be tax-deductible! Real estate has the added bonus of sometimes increasing in value.
However, good debt can easily become bad debt if it is taken on without a solid plan for repaying the loan. For instance, if you took out a college loan of Rs.150,000 that lands you a job paying Rs.30,000 out of college, then the debt-payoff ratio is probably dismal enough to make it more like bad debt than good. Also, any debt is bad debt if you aren’t taking responsibility for paying it off.
Bad debt has higher interest rates, and is the kind of debt you can probably stay out of if you manage your money wisely.
- Credit card debt, if not paid off every month, can quickly accumulate. If you aren’t paying your balance every month, it’s time to redo your budget and start living within your means.
- Car loans are important if you need a car to get to work, but unfortunately cars are depreciating assets. That means they start losing value as soon as they are driven off the lot. Plus, the interest rate on car loans is usually higher.
- Consumer loans charge high, even predatory, interest rates. If you have some or a lot of consumer loan debt, again, you likely need to revisit your budget and begin living within your means.