Mary Hunt: Debt: Good, bad and really ugly
All debt falls into one of three categories: reasonable, toxic and neutral.
Reasonable, or good, debt is the result of borrowing money to buy something that has a high likelihood of increasing in value, and in so doing will increase your net worth.
Buying a home with a low-risk mortgage would be an example of reasonable debt because as the debt is repaid and the home appreciates in value, your net worth will increase proportionately. That is financially reasonable, without imposing an unreasonable financial risk for you, the borrower. A reasonably small amount of student loan debt can also come under the umbrella of good or reasonable debt, provided it meets certain criteria (as described below), because you have a reasonable likelihood of getting a better-paying job after you graduate than the job you would've had without the education.
Toxic debt is exactly as the name implies: dangerous and financially life-threatening. Toxic debt includes credit-card debt, payday loans and other high- or variable-rate borrowing. Toxic debt is deadly and should be avoided. Toxic debt is not secured by collateral, and the interest rates are typically so huge they could choke a horse. If you have toxic debt, it needs to be paid off quickly, and then avoided by every means possible. I cannot state this too strongly: Toxic debt is hazardous to your wealth.
Neutral debt includes all other borrowing that is neither good because it's not going to increase wealth nor bad because it's not exactly toxic.
With these definitions in mind, let's look at Rule 7: Borrow Only What You Know You Can Repay from "7 Money Rules for Life" (excerpted with permission from Revell Publishing).
The following safe borrowing guidelines apply to all forms of borrowing — all forms of debt.
1. Borrow the least you can get by with to achieve your intended result, not the most that the lender will approve. Never let a lender determine how much you should borrow. Mortgage lenders will try to nudge you into the "most house you can qualify for," not the house you can afford.
2. Repay debt quickly. Opt for the largest payment you can handle, not the smallest the lender will approve. Auto lenders, as one example, will try to steer you into a long-term loan of 60 to 72 months, pointing out that your payment will be smaller. This is great for them because dragging it out over a longer period of time with smaller monthly payments means you'll be paying a lot more interest over the term of the loan. That adds up to a big payout for the lender, but that's a lousy deal for you.
3. Have an escape plan. You need to have a plan in mind to pay off the debt early in the event life takes an unexpected turn, either by selling the collateral or paying the debt with other resources or assets.