What Is Bad Debt?

Too much debt can cause stress and it can sap the monthly budget. Some debt is necessary, but there Is such a thing as good debt and bad debt. You can tell the difference by looking at the different types of debt.

Types

There are many different types of debt. Most people need to secure a loan to purchase something that is difficult to pay for in cash, such as a home or business. Debt can also be used to finance a college education. Credit cards are sometimes used to pay for items, such as clothing, furniture or food. There are also loans to finance a car purchase.

Identification

With the many different types of debt, how can you identify bad debt? Bad debt is generally described as debt that is used to purchase something that does not appreciate in value. If a credit card was used to go out to eat, buy clothing or to go on vacation, that would be considered bad debt. When deciding whether a purchase on a credit card or loan would be a bad debt, it's helpful to ask whether the item will go up in value, and if using debt is the best way to purchase the item. In the case of buying a home, a loan is generally used because it is difficult to pay cash for the purchase price of a home. Homes also generally go up in value, so using debt to purchase a home is sometimes considered a good debt. Sometimes good debt and bad debt aren't so easy to identify, such as using it to buy a car. Since a car generally depreciates in value, a car loan is usually considered a bad debt. However, if the car is necessary to get to work in order to earn money, then the car might be considered an asset. Use your best judgment in such cases.

Effects

Having bad debt can have negative effects. For one thing, a person usually pays significantly more for an item when it is purchased with debt. A credit card can have an interest rate of 21 percent APR or more, and when a person makes only the minimum payments, it can take a long, long time to pay off that purchase. Often, the item purchased is used up, broken or worn out before it has been paid for. Having too much bad debt can sap the monthly budget and can create additional stress.

Prevention/Solution

The best solution is to not use debt for anything consumable or that will depreciate. Use debt sparingly, only if necessary, for assets, such as for a home, education or for business investments. If you find yourself in debt, it is important to pay it off quickly. Using the "Snowball" or "Pyramid" method will make it possible to pay off debt much sooner than if you were to only pay the minimum payments. In a nutshell, the idea is to pay off the debt with the highest interest first. When that debt is paid off, take the minimum payment that you had been putting toward the first debt and add it to the minimum payment to the next debt with the highest interest. Continue this pattern until all debts have been paid. Some people choose to pay off the debt with the smallest balance first instead of the debt with the largest interest rate. Choose what will work best for you.

Expert Insight

Experts agree that it is best to avoid all bad debt. It is important to have a liquid emergency savings for when things come up. Try to have at least $1,000 for emergency purposes. Use cash for items, such as food, clothing and entertainment. Most people tend to spend less money when they use cash instead of a credit card.