Living debt free is possible but probably not the smartest thing to do. Most people might not earn enough to put down full cash payment for a house or a car or fund their children’s education or their business growth. That’s when debt comes in handy. What is important to know is that when you take a loan are you incurring a good debt or a bad debt?
Simply put, it is important to ensure that the debt you are taking is serving a real purpose –it is raising your net worth and future value.
A bad debt is anything that does the opposite – does not add any value to your portfolio and serves no significant purpose. Bad debt typically includes payday loan, title loan or debt taken for indulging in luxuries.
Now, let us check more on bad debt and why should you avoid it completely.
What is Bad Debt?
Bad debts are those loan types which do not add value to your net worth and often results in the reduction of income. In simple words, loans that are taken to purchase depreciating assets, which do not add to your income generation ability, create bad debts. These loans are mostly taken to buy things that quickly lose their value and do not generate long-term value.
Such loan types carry a high-interest rate along with strict terms and conditions.
Here are some types of bad debts that should be avoided to keep your finances stable.
Credit Card Loans
Plastic money can cause havoc on your financial health. It’s a kind of bad debt where the high interest rates become the killer. What most consumers do not know is that by the time they pay off their credit cards, they have paid back much more than what was the actual cost of the asset. The rule here is – what you cannot afford, and do not need, do not buy.
This falls under the category of short-term and unsecured loans. These loans have a repayment schedule linked to borrower's next payday. Often taken to meet the cash crunch or emergency situations, these loans carry a higher interest rate.
If you fail to pay, the interest accrued gets added the total loan amount and keeps compounding. In this situation, you don't even have a full right over your paycheck, until the loan is fully repaid.
Car Title Loan
In this loan type, the lender keeps the title of the car until the loan is fully paid back. Since the value of the car depreciates with time and does not add any value to your income and net worth, the interest paid is a total waste of money. What is even bad news is that over time, until the loan is repaid, the value of the car depreciates to half.
Why should you Avoid Bad Debts?
A bad debt significantly damages your financial credibility and negatively impacts your credit score. Here is how that happens.
Increases your credit utilization ratio beyond 30%, which adversely affects the score
In case of non-payment or balance carry-forward, it is red-flagged and a negative comment is added to the credit report
The negative comments as well as the credit history stays on your credit report for seven years
All these factors may impact your future credit applications and also have a cascading effect on all your long-term financial goals.
How Should You Deal with Such Debts?
We all know how debts can be useful but not managing them properly can create a lot of problems. Thankfully, there are also ways through which you can manage and repay your debts smoothly so that they don’t come back to haunt you.
Consolidate your Debt
One of the most effective measures in managing debt is through debt consolidation. The process involves taking a new debt with favourable terms to pay off all your high-interest debt first. Combining all your loan accounts into one loan account at a lower interest rate helps to repay your debt easily and quickly.
Reduce Credit Spending
Spending your credit card is fun, but only till the time that you don’t indulge in overspending. This results in difficulty paying off the debt within the timeline and gets carried to the next billing cycle. The interest on the balance just keeps on piling, resulting in a higher payoff.
A better idea would be to restrict yourself to spending only through cash or debit card that ensures reduced credit spending and also overspending. Also, maintaining your credit utilization rate within 30% helps to improve your credit score quickly.
Make a Budget
Preparing a budget is very important and helps in improving your money management skills. Poor money management skills always result in financial instability and inability to take care of your financial obligations.
If you have a loan, first allocate a part of your income towards its repayments and then allocate accordingly to your expenses.
An ideal way to ensure this is by following the 50/30/20 approach.
Fifty per cent of your income should go towards meeting essential expenses, 30% should be allocated towards financial goals like savings and debt while the remaining 20% should be used for discretionary spending.
You should not be afraid of debt. Debt can often be a good thing, but only if we know how to recognize and invest in good debts. The best rule to live by is not to incur debts, good or bad, which you cannot pay off comfortably.