Good debt, bad debt

You've heard that money is the root of all evil. But lately, it seems like credit might as well be the culprit. It's said that the average American has almost $10,000 in credit card debt. While experts might argue about the exact cause of our current economic crisis, most seem to agree that a country of people spending more than they earned sure didn't help.

But I'm going to go out on a limb here and suggest that credit isn't all to blame. Maybe it's not the debt that's the problem; rather, it's the fact that most of us can't tell the difference between good debt and bad debt.

If you ask my grandma, she'll tell you that the best kind of debt is no debt at all, even if you're talking about a mortgage (my grandparents paid for their house in cash--of course, it was the 1960s and the house was under $20,000). But that isn't entirely true.

When you make an investment likely to (eventually) go up in value, it can be good debt. The best example is a house (assuming you're getting a good loan with a realistic mortgage payment). If you hold onto the home long enough, it will be worth more than when you bought it. Everyone needs a place to live, so it's not as if you're splurging--in fact, unlike with rent, you're actually gaining equity. And unlike in grandma's day, most people have to take out a mortgage for a home--we just don't have $150K or more sitting around in the bank. So in this particular situation, having debt is beneficial. (And because homes have the potential to increase in value, it's all the more reason to avoid foreclosure, if possible). Other possible good debts are student loans (you're investing in your education/career/future) and business loans.

However, the sad truth is that most of our debts are for material things, which tend to lose value. When you take out a $20,000 loan for a shiny new car, you can lose a couple thousand dollars just by driving the car off the lot. In minutes, it goes from new to (still shiny) pre-owned. Not only do you lose money in terms of value, but you also end up spending more than the original amount of the loan if it takes you a few years to pay it off because of interest but also inflation (which makes your money less valuable in the future). It's not just large purchases like cars that are the problem. Think of the pair of jeans you just bought. Would you pay full price--or even half price--if you knew that someone had been wearing them a few months first? How about your groceries--they're eaten within a week of bringing them home, but if they're on your credit card, you're paying for them long after they've been consumed.

Most everything we put on credit cards ends up costing much more than it would have in cash. To make matters worse, credit card companies charge 15%, 20%, even 30% or more in interest every time you fail to pay off the balance. If you regularly make just your minimum payment, you are only covering the interest, meaning it could be decades before you pay for stuff you don't even have anymore.

Unlike popular myths, racking up credit card debt doesn't help you build a relationship with creditors or improve your FICO score. It just puts you in the hole. When more and more of your money goes towards making credit payments, you have less in your accounts--and are therefore even more likely to use credit. It's a vicious cycle.

If you're like most Americans, you probably already have too much credit card debt. But it's not too late to change. Start paying for small purchases like groceries and gas with cash. Make some minor spending cuts here or there. It will add up. For more tips on changing your finances for the better, check out our free Financial Toolkit. Even if your bad debt is threatening to rob you of your only good debt--your home--there's still time to get help. Sign up for our free debt analysis for some one-on-one expert advice. Think of it as an investment in yourself--one of the few investments that won't cost a thing.

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