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Good Debt, Bad Debt: Keys for Knowing the Difference

Today debt and instant credit are part of our everyday lives. The convenience of instant credit, however, has taken its toll. Many individuals use credit cards to spend more than they earn. Some, who never use credit, can be denied a loan or credit when they have a justifiable use for it. Using credit establishes a history of financial responsibility: Until you establish a credit history, your chances of qualifying for an important loan, such as a mortgage, are greatly reduced.

Where is the balance between using credit wisely and staying out of overwhelming debt? Let’s look at the facts and some pros and cons.

Installment Debt

Debt comes in many forms, and most types help us in our daily lives -- when used responsibly. For instance, the money borrowed to purchase large-ticket items, such as a home or a new car, is called installment debt: The debtor pays a portion of the total at regular intervals over a specified period of time. At the end of that period, the loan with interest is paid off.
Installment debt allows you to purchase items at a competitive interest rate: for example, 3% to 7% for a 30-year home mortgage and 6% to 9% for a car loan. The loan is paid back in monthly installments of a fixed amount that remains constant over the life of the loan. At first, most of the monthly payment consists of interest. In later years, principal begins to be paid down.

Installment debt is easily budgeted, and the debt is eliminated on a predetermined date. Even for those who may actually have the cash to purchase the desired item, installment debt can make financial sense if you can earn a higher return (after taxes) on your investment of cash than you must pay on your installment debt.

Revolving Credit

A revolving line of credit is made available to you for use at any time. Examples of revolving credit are credit cards such as Visa, MasterCard and department store cards. When you apply for one of these cards, you receive a credit limit based on your credit payment history and income. When you use the credit line, you must make monthly minimum payments based on the total balance outstanding that month. Some lines of credit will also have an annual account fee.

While revolving credit is a convenient way to borrow, it can also become an endless pit of minimum payments that barely cover the interest due. Many cards charge annual rates of interest of 18% or higher. As you pay off your debt, the minimum payment is also reduced, thus extending your payoff period and, consequently, the interest you pay. Paying just the minimum due on a $2,000 credit card loan could mean making monthly interest payments for 10 or more years!

Revolving credit, in addition to being convenient, eliminates the need to carry a lot of cash and can help establish you as a creditworthy risk for future loans. But some people yield to the temptation that the convenience of credit cards offers. Impulse buying, failing to compare costs and purchasing large items you can’t afford are all downfalls brought on by always-available purchasing power. Spending more than you earn in any given period is a dangerous practice at best, but doing it over an extended period of time can be financial suicide.

Installment Debt vs. Revolving Debt

(Lower interest rates and an amortizing repayment schedule can make installment debt a much cheaper alternative to revolving credit.)
  Installment Revolving
Beginning Balance
 
$2,500 $2,500
Interest Rate
 
8.0% 18.0%
Years to Repay
 
4 19.3*
Interest Cost
 
$430 $4,829
*Paying the higher of 2% minimum monthly payment or $25.

Using Credit Wisely

To use credit intelligently, start by examining the terms of the card(s) you are currently using. Keeping track of your cards, their rates and your current balances will help you to be aware of how you use credit cards. Increased competition in recent years has led some credit card companies to offer enticing features to attract new cardholders, including no annual fees and low interest rates for an introductory period. (And credit card companies sometimes will give their introductory rates to existing cardholders so that they won’t transfer their balances to another credit card company.)

Eliminating Credit Card Debt

If you think you may have too much credit card debt, begin to address it by honestly evaluating your spending habits. Examine your existing expenses to analyze how your money is spent. You will most likely be able to identify the problem areas where you are more likely to spend too much with credit cards. Then, based on your current spending practices, create a realistic budget to pay off your credit card debt in the shortest time possible while not adding any more debt to it. For assistance, you may want to turn to your financial advisor, who can help you to allocate your resources wisely to address your credit card debt.

As the aging baby boomers get closer to their peak earning years, many are realizing the need to reduce debt and increase savings. Even though analyzing your spending habits and creating a budget to address your debt may seem a little overwhelming, the simplicity of the philosophy of the Depression era still stands: Never spend more than you earn. Once you have come to grips with this basic fact, managing your debt will become far easier and more rewarding.



This article was prepared by S&P Capital IQ Financial Communications and is not intended to provide specific investment advice or recommendations for any individual. Consult your financial advisor, or me, if you have any questions.

Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscribers’ or others’ use of the content.

 

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