The Basics of Debt and How to Identify a Bad from Good Debt

Every person takes debt in his life whenever he acquires an asset or takes the benefit of a service without immediately paying for it in return. When viewed in this perspective, it becomes apparent that debts cannot be avoided completely. However, understanding debt can go a long way in ensuring that you take up more of good debts than bad.

Every debt comes with its own attendant conditions and terms of agreement detailing how, when and in what manner it will need to be paid off. The concept of debt, in common parlance, is always restricted to payments which are not made outright.

That is, we associate debt only to those situations when we get possession of an asset or get benefits of a service for which we haven’t paid in full. For instance, even buying groceries raises a debt on us for the bill amount. However, as we pay the bill over the counter we never consider this as such.

Debts are viewed with uncertainty and doubt because of the unpredictability of our future finances. No matter how solid our current financials are, we can never be 100% sure that we will be able to fulfill all our repayments in future. This uncertainty makes people feel more secure if they avoid long term debts and make payment upfront for any product or service they need. However there may still be some debts which cannot be avoided. Purchasing a car or house may be one such unavoidable debt.

An important factor to remember before undertaking a debt is that things appreciate or depreciate in value over time. Usage will steadily erode the value of a car until it is worth only a fraction of the original price when you sell it. If you still have some of your auto loan to pay off at that point, your sale proceeds may not be sufficient to meet this debt. Such a debt is what we call a bad debt. On the other hand, your house may actually appreciate in value over time until your sale proceeds can comfortably pay off your debt and still leave behind a significant sum for you to enjoy.

These debts, which give you a return even after paying them off are good debts. Other example of a good debt is your education loan. In contrast, credit card debts are almost always bad debts and should be avoided unless absolutely necessary.

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