Understanding Debt

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What is Debt

Debt as defined by dictionary.com is:

something that is owed or that one is bound to pay to or perform for another

Essentially when you are taking on debt someone has agreed to give you something in return for something else to be paid at a later time. The lender agrees to take on a certain amount of risk and you agree to pay them a certain amount extra, interest, for them taking on that risk.  The debts you owe can range from the .25 you owe your cube mate to the $250k you owe your mortgage company, hopefully your cube mate isn’t charging interest.

Types of debt

Personal Loans

Personal loans are those loans you have made or have been made to you by family members or friends. These loans are typically loosley arranged and may or may not have defined interest terms or payback requirements. Seemingly this type of loan would be ideal but experience shows that loans to and from family and friends can put undo stress on relationships with dangerous side effects.

Student Loans

Hopefully you are, or will be, lucky enough to make it through school without taking out any loans, if not than you are going to fall into this boat. Student loans can be subsidized, where the government pays your interest while you are in school, or unsubsidized where it accrues until you start paying. Either way student loans aren’t necessarily a bad thing. You are financing your future, I don’t like paying it but I am glad I went to college.

Mortgages

The mack daddy of all debt.  A mortgage is essentially a loan for a piece of property that is secured by the property. What this means is that if you dont’ pay back your debt, they take back their house.  Typically mortgages have been seen as an investments which is “guaranteed” to increase in value. As we have all witnessed this couldn’t be further from the truth. Don’t buy a house for an investment unless it is really just an investment property.

Credit Cards

Credit card, or plastic money, are little portable debt tallying machines. A credit card is a method for getting a short term loan for something you are going to purchase. You are given a plastic card, an exorbitantly high interest rate, and a spending limit.  The credit card company hopes you do two things, 1.) max out the card and 2.) carry a balance. That way they continue to make money off of you. I like to have my card just because I have always had it, we use it for any large purchase but we never carry a balance on it we just collect the points.

Payday loans

These are the devil, no seriously they are the devil. I won’t even describe them here other than to say they make credit cards look like the saints of the debt world.

Good Debt vs. Bad Debt

Lets start with the fact that debt, no matter what kind, is still debt. You OWE soemone money and THEY have some type of leverage against you for it. In this sense all debt is bad debt, however, there is definitely debt that is OK and debt that is bad. The OK debts are things like your house which will eventually increase in value and your student loans which will eventually help you get a job. In some select cases it may even be OK debt if it is on a credit card, don’t tell Dave Ramsey I said that, it all depends on the WHY and the WHAT, not the WHERE.

Bad debt is debt associated with flipant spending for unnecessary items. Credit card debt is the biggest drain on the American household and yet so many people just can’t wait to swipe that AMEX or VISA for that new Coach bag, or the hottest new trend. These types of debts are typically referred to as consumer debts and should be avoided. If you can’t pay for it, don’t buy it just save your money and get it later.

Photo: (kevinkrejci)

This article is part of the Suburban Dollar Back to the Basics series. I plan to cover remedial personal finance topics which aren’t as sexy, or typically covered, in the personal finance blogosphere. My hope is for people to get a better understanding of basic personal finance without boring you to death, hopefully you will be able to share these posts with family and friends to get them into personal finance and have a good foundation of knowledge.

{ 5 comments… read them below or add one }

1 Christopher J. August 27, 2009 at 10:15 am

That’s it! I’m telling Dave Ramsey on you! Hahaha!
Come on…student loan debt isn’t good debt because it helps you get a job. The act of going to college and getting a degree doesn’t guarantee that you’ll get a job. There’s a lot of college students, especially now in this market, that spend all that money and can’t get a job in their field once they’re out. The only thing that gets you a good job is… YOU. Don’t fall into that trap thinking that if you go deep into debt by financing a big school college education, you’ll come out the other side OK because you’re for sure going to get a huge paying job. I’m proof of that, I have no college degree and I make far more money than my wife does with a Masters degree. Guess who has all of the student loan debt of course? Not me, but I’m helping to snowball it out of existence.

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2 Kyle August 27, 2009 at 11:52 am

I am not saying go out and get a Harvard education on loans, but without my degree I would have never gotten my job I have now, of course I think my interest rate on my student loan is around 2% or less so it doesn’t bother me quite so much.

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3 ctreit August 27, 2009 at 8:35 pm

I agree with you that debt is usually not a good thing, but for most of us it is a fact of life. Who can buy a house for cash, for example? In my view debt is only ok, if you have something to show for it so to speak. That something should be an asset that does not decrease in value. So, I agree with you on that point, too. Using debt to buy a house or to get an education is ok in my book.

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4 Matt Jabs August 28, 2009 at 1:53 am

I respect and understand the opinion and the school of thought that holds the belief of some types of debt being OK. I am not practicing that belief currently.

I am working to rid myself of all debt until that glorious day where I sit at $0 owed. Until then I will fight against all forms.

I’m not an extremist… I do know and believe that some debt is much worse than others (which is what you’re saying in this post.) I just choose to say that it’s all bad, just that some are of course worse than others.

Oh that sweet and wonderful day when I can be a man without usury. I crave that day with a fiery passion!

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5 Roshawn @ Watson Inc August 29, 2009 at 9:15 am

Excluding my mortgage, I became debt free over a year ago, and I have to say that the restrictions on your cash flow due to good/ok or bad debt is absolutely frightening. I don’t believe that all kinds of debt are the same, but regardless of its classification, it does increase your financial risk.

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