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What is “Good Debt” vs. “Bad Debt” and what makes them different? Millions of Americans each day use debt, which can be defined as money borrowed from one party to another, to pay for a wide range of products and services. Whether you have a car loan, a home mortgage, or a credit card – you have participated in taking on debt in exchange for immediate cash flow. We’ll take you through the various types of debt, and together explore a platform for decision making when it comes to debt.
Good Debt or Bad Debt?
If you are like millions of Americans, the list of different types of debt is reminiscent of a personal experience – or an ongoing issue that you are currently battling. Don’t worry – you are not alone. While most debt feels like a burden or obligation, some types of debt provide a chance to either build credit or provide purchasing power that you wouldn’t have otherwise. So, let’s take a look at what might be considered “Good Debt” or “Bad Debt” so you can prioritize your financial decisions and possible payment plans for your current debt.
To keep it simple, let’s define “Good Debt” as any type of debt that helps build your income or overall net worth. You’re probably thinking, wait – are you telling me there is debt that can allow me to improve my income and my net worth? The answer is, YES – but it has both its pros and cons. Let’s take a quick look at what many would consider to be “Good Debt” and why this would be the case.
Home Mortgage – Many would consider a mortgage to be at the top of the list for “Good Debt.” Not only does this debt provide you the purchasing power to get into a home, it is often an asset that appreciates over time. Said another way, by securing debt for a home you have the opportunity to see the value of your home rise over time and become a positive growth asset.
Student Loan – While this type of debt is debatable among Americans, it continues to be considered an opportunity to experience higher-education and grow your earning power. Have you ever heard of the term “The more you learn, the more you earn?” This is typically the case for those who secure a degree. There are many options for higher education, whether you choose a trade school, community college, or a state university. If you keep an eye on where you go to school, the overall cost, and where you plan to secure post-graduation work – a student loan can be a great decision.
Small Business Loan – This type of loan can have significant upside, but an equal amount of risk. As noted prior, many businesses have trouble surviving in their first couple of years – so the risk and reward need to be weighed appropriately. If a small business owner has the ability to secure a loan, which is hard to come by, and successfully run a profitable business – the original debt secured to run the business can mostly be considered good debt.
The bottom line is this – if you secure debt that can potentially lower your income and net worth, it can be considered “Bad Debt.” Many items we purchase in our life immediately depreciate after purchase, like clothes and other consumables, and the vehicles we drive each and every day. While many of these types of debts are necessary to acquire, the best bet is to limit your exposure to these expenses and maximize your potential with appreciating assets. Easier said than done, right?
Car Loan – While a vehicle is essential, it is even more important to secure a reliable manufacturer and a healthy vehicle report. The smart play is to be vigilant in your approach to purchasing a vehicle so you don’t overextend yourself with your preferred mode of transportation.
Credit Cards – Credit Card companies have made it unbelievably easy for Americans to charge an expense with ease and speed. Since most consumers know exactly what their limit is, the spending control as a behavior is tough to manage. Carrying a balance month-to-month accumulates with high-interest rates and compounds with late fees if a minimum payment is not made. It is very easy to over-utilize the all-important credit utilization rate, and in turn damage your credit score – which is one of the main health indicators for lenders.
Late Utility and Cell Phone Bills – This expense should be an obvious “Bad Debt” flag, but many people still put off payments on these bills month after month. At the end of the day, a timely payment to a utility bill or cell phone company can improve your credit score and your borrowing ability. If you sacrifice your timely payments to these companies, you can find yourself quickly in a bind with collection agencies and lower credit worthiness in the eyes of many lenders. Stick to an on-time payment and find other areas in your financial life to negotiate when the rubber meets the road.
If managed correctly, both “Good Debt” and “Bad Debt” can be utilized to provide you the lifestyle that suits YOU. According to the Consumer Financial Bureau, if you keep your debt-to-income ratio under 43%, you put yourself in a good position to show lenders that you have the ability to pay off a loan. As a good practice, keep paying your bills and debt obligations in a timely manner, and allow yourself the ability to improve your credit score over time. When considering future financial decisions, take a moment to evaluate if your new debt will provide you with greater income and net worth. Even the best “Good Debt” choices can work against your financial situation, so take care in your decision-making process, and keep these borrowing basics in mind.
Good Debt vs. Bad Debt
zap August 31st, 2018
Posted In: 1FFC Blog, Education Articles
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Through the course of life, there are times you may need additional money beyond your expected monthly take-home pay. The reality is – life costs money. Even the best planners can find themselves in a position where they need extra funds. Whether you’re trying to cover an unexpected expense, planning to consolidate debt, or preparing for a major purchase – a personal loan might be a good solution for you. Before you apply for a personal loan, here are eight questions to consider:
1. What is a Personal Loan?
A personal loan is money borrowed for personal reasons. Personal loans are often used to consolidate debt, fund home improvement projects, cover medical expenses, or simply pay for a major purchase or vacation. Personal loans are often borrowed from a consumer finance organization, and provided in a lump sum payment. This personal loan is typically repaid at a fixed interest rate over a set period of time.
2. Are there different types of Personal Loans?
Yes. Personal loans can be either “secured or unsecured” and vary depending on your ability to meet specific credit criteria. Secured debt is a loan that is guaranteed by collateral, and collateral is an asset that the lender an take if the borrower defaults. Collateral can include personal vehicles, jewelry, or other personal property. Unsecured debt is a loan guaranteed without an asset serving as collateral. To break it down even further, it depends on your annual income, credit score, existing debt, and the availability of credit (among other factors).
3. How are my Finances?
Before making a financial decision, many people check in with their current financial health. If you know your full financial story, it allows you and a potential lender to put together the right plan for your finances – and figure out the amount of money you may need for a loan. Take a close look at your overall annual income and expenses. You’ll also want to know your overall debt, because this will also be considered when applying for a loan.
4. What is my Credit Score?
A credit score is used by lenders (and other financial institutions) to determine whether or not to offer you a loan. A higher number is a better number and is calculated on a range of 300 – 850. Before securing a loan, there are many resources available that provide a free annual credit report. There are three major reporting groups that often offer free credit reporting: Experian, Equifax, and Transunion. Not only can you receive your score, but you will then have a better understanding of what factors are impacting your score.
5. What is an Interest Rate?
An interest rate is the amount charged, as a percentage of the loan principal, by the lender to the borrower for use of the asset. This is basically a rental charge (interest rate) to the borrower for the use the of the money (personal loan). If you take out a personal loan, you will most likely pay both the principal and interest back to the lender, in addition to any other fees that might be associated with the loan. A lender will often charge a lower interest rate for lower-risk borrowers, and a higher interest rate for higher-risk borrowers – which can be determined by your annual income, credit score, existing debt, and the availability of credit (among other factors).
6. Will a Personal Loan Help My Credit Score?
It depends on the lender, and whether or not they are reporting to a major credit reporting bureau. (Please note, customers who choose 1st Franklin Financial Corporation will have their information reported to a major credit reporting bureau.) If the lender is reporting to a credit bureau, and you pay off your loan according to the provided terms, you will definitely have a chance to boost your score with on-time payments throughout the life of the loan. It’s important to note that this can have the reverse effect to your score if you don’t pay on-time, which is usually within 30 days of your monthly due date. If you happen to be swapping credit card debt for a personal loan, this can reduce your credit utilization, (which measures the amount of your credit limit that’s being used) which in turn could boost your overall credit score as well.
7. How much should I borrow?
The minimum and maximum borrowing limits are set by each lender and the amount of your personal loan limit depends on your creditworthiness. (This goes back to our questions above for “How are my Finances” and “What is My Credit Score?”) When you work with a lender it’s important to secure an amount you feel absolutely confident you can repay – so you limit the risk of overextending yourself.
8. How long will it take to pay off my loan?
Before taking out a personal loan, you’ll want to know the term of your loan. The term is defined as the amount of time or how long your loan will last with successful, regular payments. Loans are either “short-term or long-term,” from as little as one year, or as long as 30 years. The repayment of the principal and interest are due at the end of this time-frame. The “loan term” is important because it plays a part in determining your monthly payment and interest costs associated with your loan.
These are the 8 questions that should assist you in beginning your personal loan journey. As a reminder, be sure to get a full look at your current financial situation so you can make the best possible decision for your financial future. In the end, a personal loan has the incredible potential to build your overall credit worthiness and most importantly – secure the funds you need when you need them most.
zap August 27th, 2018