What's the Difference Between Good and Bad Debt?
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Car Loans

You’ve probably heard that new cars lose up to 20 percent of their value as soon as you drive them off the lot—which means all car loans are bad, right? Generally, yes.

But while car loans can turn upside-down quickly, you may not want to completely write off this debt because of the very cheap rates available. (For example, a $15,000 loan with 3-percent interest over 48 months costs $937 in interest or about $20 per month.) And cheap money can be advantageous.

I learned this the hard way. After graduating law school, I funneled all my savings into a car purchase to avoid a loan. Two months later, I got the job opportunity of a lifetime—across the country. I had to move, set up an apartment and buy new clothes, and ultimately ended up with thousands of dollars of high-cost credit card debt to cover it. I wiped it out in six months, thanks to my new income, but I also paid quadruple the interest than if I’d kept my cash and took out a car loan.

Of course, the best option is to have enough money saved to cover expenses like this without having to incur any debt. But if you need a car and buying a used one outright will wipe out most of your savings, and you can borrow the money cheaply, it’s worth considering it—especially if you’re earning money on the savings you have left (though you’re not likely to be making as much in a savings account as you’d pay in interest for a loan these days).

Now when I buy a car, I pay half in cash, half with a low-rate loan. That offers manageable payments and liquidity. (And you can always pay the car loan off early.)

Credit Card Debt

Most of the time credit card debt is bad for you, even when it’s cheap. While 0-percent-interest promotions sound great (until they expire and spike to expensive rates), they rarely solve someone’s financial problems because they don’t fix cash flow. Until you change the spending habits or other circumstances that drove up your balance, you’ll always shoulder bad debt.

That’s why I hesitate to call any credit card debt good. So I’m inventing a new term called “not-so-bad debt.”

The foundation of financial security is the emergency fund, which should contain about six months’ worth of living expenses for when unexpected expenses come up—but nearly half of Americans don’t have anything close to that. So realistically, a credit card in good standing with a “not-so-bad” interest rate—like, say, 8 to 10 percent—is the next best thing, as long as you don’t miss a payment and pay it off quickly.

The problem is when you fall into the habit of carrying a balance and become a “revolver.” That means all new charges are subject to immediate interest fees, and it’s easy to lose track of June’s spending versus May’s borrowing and so on. Revolving is deadly to budgeting.

I recommend having two low-interest cards—one is for everyday purchases that you pay off in full (ideally, this one rewards you with points or cash back and has no or low annual fees); the second is a line of credit to only be used if a surprise life event comes up that you can’t cover with cash, like a hot water heater replacement. Then stop using it until you pay it off. This way, you have a tight grasp on how much your “not-so-bad” debt is and when you can free yourself from it.

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