Some financial literature differentiate between good debt and bad debt, like a student loan is considered a good debt while a credit card is considered a bad debt. These quick generalizations may be simplistic, if not unfairly analyzed, since the “bad” and “good” tags are applied based on general terms like high or low interest, high or low yields, with elements of investment or without element of investments, and other similar “benchmarks.”
Tagging debts as bad debts or good debts is a general view that may hinder someone from taking advantage of good opportunities that some debts, associated with being bad, can actually give; or being restricted into loans that are (mis) classified as good debts but may actually entail bigger payments and lesser actual proceeds in the end.
Truth is, the core debt itself is not good or bad.
A debt or a loan only becomes bad when the borrower does not know how to get the best out of the money loaned or credited with, and is unable to comply with the terms of payment. These two reasons are often the cause of any good debt transforming into bad debt.
Rather than making a sweeping generalization between good debts and bad debts, the better way to support our collective financial education is to recognize that a loan or debt takeout is a necessary financial tool with benefits to the economy, industries, businesses and of course, to individuals.
A debt or loan extends solution to a money problem, which makes it a necessary and positive transaction. Business loans, education loans, and other multi-purpose loans are made available with the aim of brokering opportunities and generate income from their specific purposes.
Even credit card, much maligned because of the horror stories associated with it, is a good debt when the owner sticks to their agreed payment obligations. There are actually premium benefits one can enjoy with responsible credit card ownership, foremost is a good credit history. Others include flexibility and safety of payment, payment time allowance, and emergency cash source (with terms that are even better than some lending companies require.) It can also incur some form of “income” for the owner through rewards.
Debt and loan takeouts have accompanying Terms of Reference (TOR) that the borrower agrees to comply with. Not only is this a legal requirement, it sets out in full transparency the minimum condition of profit for the lender (example a bank) in granting the loan and the minimum condition for obligation (payments and interest) on the part of the borrower. From these terms, the borrower has the factual, real values of proceeds.
We emphasize here “minimum” because once the borrower is unable to comply with his terms of obligation as expressed in the TOR, then that borrower has to deal with the effects of the non-compliance, which may be in the form of compounded interests, late fees, legal fees, and other penalties that will transform the debt into a bad debt.
(It should also be pointed out the debts and loans we refer to are the standard, legal and general credit instruments from banks, lending companies, credit agencies and the like, and not debts or loans transacted under “personal arrangements” that transgresses US Federal laws, specifically the Truth in Lending Act, and to which a borrower freely agrees.)
Student loans have been hailed for a long time as a representative of the good debt list. Why? It has low interest rate, it has an investment element in the form of future earnings opportunity (better employment and therefore higher salary).
The same good tag is associated with a home mortgage loan – lower interest rate, longer payment terms hence lower monthly fees, tax deductible interest payments, and a belief that home prices increase over time.
On the other hand, credit cards are notorious for being bad debts, with its high interest rates, compounded interest, late payment fees and because of its “nature” to induce unnecessary spending. Cash advance loans (more in the form of payday loans) are also in the bad debt category.
While we do not debunk the “good” commonly associated with standard loans and credit mentioned, it is also clear that some of these good factors do not rest on the loan itself. The attainment of these perks and benefits linked to so-called good debts hinged foremost on the borrower – his or her ability to make good and proper use of the loan proceeds, the borrower’s own skills and abilities in making the object of the loan grow, and most importantly, in the discipline of complying with the payment terms, especially payment amounts and schedules.
It is also clear to note that there are traditional elements in “good debts” that have come into question, given the recent economic developments in the United States. The instability of traditional “upward” home market value, the practicality of longer loan payment terms in relation to higher total value of the loan payment, as well as the wisdom of blaming credit card debts and unnecessary purchases to the plastic tool, and not to the credit card owner.
To put it simply, regardless of interest rate size, length of payment allowance, or any other “good debt” elements, if a borrower defaults on the payment, all debts whether it’s a low-interest bearing student loan or a high-interest premium mortgage loan end up being bad debts.
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