In order to properly manage debt, it is first important to distinguish between “good debt” and “bad debt.” From a purely financial perspective,good debt is borrowing in order to purchase an asset that is likely to appreciate in value (e.g., purchasing a home or business). Good debt may become “better” debt when the government subsidizes the repayments, as it does with the home mortgage interest deduction.
On the other hand, bad debt is borrowing in order to purchase an asset that is likely to depreciatein value (e.g., an automobile) or borrowing for nonasset consumption (e.g., to take a vacation). And, bad debt has been made “worse” now that the government no longer subsidizes repayments for certain kinds of debts (e.g., interest on personal loans and credit card debt is no longer tax-deductible).
In order to deal with debt effectively, it may help to begin by answering some of the following important questions.
Good vs. Bad–How much debt do you have? If you don’t know, the first step toward controlling your debt is to characterize your debts and then break them down into short-term (e.g., credit card), intermediate-term (e.g., car loans), and long-term (e.g., mortgage and home equity) debt. This will give you the overall picture of your current debt situation.
Right vs. Wrong–To which debt do you belong? Generally, it makes sense to pay off higher interest rate debt first, particularly if the interest from that debt is nontax-deductible (e.g., credit cards). Payment schedules are most appropriate for intermediate- and long-term debt, but ideally you should have enough in savings to pay off short-term debt. Also, since credit cards are typically used for current consumption items (and not for appreciating assets), this form of “bad debt” can tempt us to live beyond our means.
Paying Today vs. Paying Tomorrow–Are you aware of how much you’ll borrow? Are you tempted into making minimum payments on your credit card bills in order to increase your purchasing power? The interest that accumulates by stretching out payments makes any “bargain” purchase costly in the long run. One way to understand the impact of a minimum payment strategy is to ask your credit card company to calculate how long it would take you to pay off your current balance, and how much interest you will be paying along the way. The numbers might shock you into adopting a pay-as-you-go strategy.
To Spend or Not To Spend–Can you answer this question? If you are prone to impulse spending, avoid shopping trips that don’t have a specific purpose. Or, try delaying buying impulses for 24 hours. Quite often, the impulse will pass once you’ve had a chance to sleep on it.
Spending is not always based on purely financial considerations. It can be complicated by emotional factors that may cause confusion between things we think we need and things we really do need. Nevertheless, the reality of living in the modern world leaves most of us with little choice but to amass some “bad debt.” However, common sense strategies (such as the ones outlined above) can help you control your debt, making it manageable within your means. Asking yourself the right questions won’t cost you a dime, and may help save you a lot of dollars!