Good Debt & Bad Debt: 5 Things to Know

No one wants to be in debt. However, there are times when owing money in order to reach a higher goal is a good thing. It can be argued that our economic system requires some level of borrowing and owing. So, knowing whether a debt is good or bad for you or your business is helpful. Here are 5 things to think about when you are considering taking out a loan.

1. Debt will not solve a planning problem.

It’s true that debt that helps you manage your finances, such as a consolidation loan, can be considered good debt. However, if you or your business is in trouble, simply taking on new obligations will rarely solve the issue. You must have a specific plan or reason for taking on the additional debt in order for it to be helpful.

2. Good debt increases your net worth.

Good debt includes student loans which can help you get a new, better paying job. Home improvement loans that will increase the value of your house are also considered good debt. For your business, equipment loans can be good. A loan that helps you purchase more supplies or hire additional staff can also be beneficial. But, you must make sure that you’ve planned appropriately and will make more than the cost of the debt.

3. Don’t take out debt for things that decrease value.

Car loans are probably the most obvious example of bad debt. According to some estimates, cars lose 20% of their value within the first year of ownership. Any loan that doesn’t lead to you making more money is likely to cause a value decline.

4. Other people’s problems can cause you problems.

If you own a business, you might not consider yourself a lender. But if you perform services or provide product for someone before receiving complete payment, you are essentially loaning them money. Unpaid invoices are potentially bad debts. Once an invoice is 90 days past due, industry statistics show there is already a 27% chance it will never get paid. That increases to 75% when the bill is a year past due.

It’s important to stay in contact with your clients and be able to spot the warning signs that trouble is coming. If you have clients who do not pay you, this will affect your cash flow and possibly push you into debt as well.

5. Interest rates matter.

Loans that carry high interest rates are dangerous and considered bad debt. Some alternative finance companies have products with an implied interest rate of 50% to 150% per year. Your credit rating may affect the interest rate you are offered for a loan. This is just one of the reasons it’s important to keep tabs on your credit score and be careful about the amount you owe. Your credit score is determined in part by comparing the amount of your available credit to the amount of debt you have.

The idea of owing money can be intimidating. But, understanding the difference between good bad debt can help make it easier to decide if you should borrow.

If you are worried that unpaid invoices from clients are pushing you into trouble, please contact us.

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