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Good debt versus bad debt: understand the differences

2020-08-05T22:04:25.634Z


Believe it or not, there are debts that benefit you. You just have to know how to identify them. Janet Alvarez, CNBC contributor, explains what path you should take to avoid ruining your financial future.


You may have heard that debts are classified into two types: good debt versus bad debt.

"Good" debt is money you owe for things that can help create wealth or increase income over time (like student loans, mortgages, or business loans), while "bad" debt refers to things like credit cards or other consumer debt that does little to improve your bottom line. However, these are mere simplifications, and the distinction between "bad" and "good" debt is much more complex. It is worth reviewing this topic and understanding the new rules of the debt game.

What is really "good" debt?

While student loans, mortgages, car promissory notes, etc. they can be used successfully to generate wealth or increase their income, that is not always, or necessarily, the case. Using this debt successfully depends on several factors.

The student loans are a necessity for many low - income Americans means they wish to fund a college education, but as we have all understood, not all college programs are the same. The general rule is that you should not borrow more (in total) than you expect to earn in your first year on the job.

For example, if you're studying for a master's degree in education, and the average starting salary for someone at your school with that credential is $ 65,000, then you shouldn't take out more than that amount on loans to finance that degree.

Carrie Schwab-Pomerantz, Financial Advisor, Chairman of the Board and President of the Charles Schwab Foundation echoes this guideline and says, "You should never have a higher student loan debt than you think your first-time salary will be. year".

This general rule is based on the notion that with annual salary increases, you should be able to keep up with the interest on your debt and pay it within the standard 10-year payout window. That being said, if you are graduating in an unstable economy or a weak job market, you may want to have even less debt.

Of course, it is not possible to anticipate a recession years in advance, so freshmen may not know the working conditions that await them at graduation. Still, if you are in school now, it is suggested to minimize your debt even more than usual, or if you are considering going back to school right now, avoid as much debt as possible. Chances are, some lingering effects of the COVID-19 recession may still be present when you graduate.

Mortgages : Mortgage debt has historically been considered one of the safest forms of "good debt," since your monthly payments eventually generate capital.

However, as the Great Recession and the subprime mortgage crisis taught us, prices don't always go up indefinitely, and borrow more than you can afford, or use mortgage terms you don't fully understand, like rate mortgages. adjustable (ARM) pose a significant risk.

During the 2007-2008 mortgage crisis, millions of borrowers lost their homes to risky mortgages, as home prices fell and ARM loan payments adjusted upward.

Mortgages are still one of the most affordable ways for millions of Americans to build a relatively safe investment in the form of equity, but it requires an understanding of how much you can borrow, as well as a solid understanding of the real estate market over time. what do you buy.

Generally speaking, your monthly mortgage payment (including PMI) must be less than 28% of your monthly gross income.

You should also consider other factors, such as the terms of your loan. While ARMs offer lower interest rates (and therefore lower monthly payments) up front, they can be adjusted upward over time, resulting in higher payments that you may not fully anticipate otherwise. you read your contract in detail.

Find a mortgage payment level that works for your long-term home, considering the possibility of layoffs, a larger family, or any number of other events that may affect your disposable income in the future.

The last question

Whether you are borrowing for a title, a house, a car, or a new business, the final determinant of whether the debt you are accumulating is "good" is this question:

"Will this debt ever pay me more than I put in?" It is a question that seems simple, but that may require a little thought. After considering repayment of principal, interest payments, and alternative uses of that money, does the debt make sense? Are you getting all your money back, and more? Could you have done better with the time and money you are investing?

This thought process will help you determine if any debt is more onerous than beneficial, and when you consider it this way, in some cases, even credit cards can be more "good" than "bad." (For example, if you pay all your monthly balances on time and accumulate significant savings or cash rewards, or if you use a 0% APY balance transfer card to pay off debt faster.) The key is what debt does for you, and it should always be more than what you do for debt.

Janet Alvarez is a contributor to CNBC and Acorns

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Source: telemundo

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