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People who know the advantages of good debts and disadvantages of bad debts know how to avoid falling into the bad debt trap. But many people are unknowingly incurring one bad debt after another. While it is best to hire a professional to advise you on how to handle your finances, there are ways that you can do on your own to become debt-savvy.
According to experts, the first step is to assess what the debt or credit is for before incurring it. Ask yourself three key debt questions: Am I going to pay interest on this purchase?; Would this purchase add to my current earning potential?; and Am I buying this for a good reason, and not impulsively?.
Another good way to identify if a debt is good or bad is to check whether the debt is financing something which value is appreciating or depreciating. For instance, if you borrowed money to pay your home's mortgage, it is good debt, because the property's value would eventually appreciate.
But if you took a car loan, it is usually considered bad credit loan because a car loses more than half of its value after five years or so. Of course, most credit card purchases which are not paid within the billing period are bad debts.
It is not really a bad idea to borrow money or incur debts. It is how you manage these debts that would determine whether the debt would turn out to be good or bad. There is a smart of handling debts.
The most common advice that financial consultants would tell you is pay off those loans with the highest interests, topmost is of course credit card debts. Then pay those with lower rates next such as personal or car loans.
If you still have more money in your hand, it is also smart to start paying down even the good debts. But experts would likely advise you that if you can invest your money at a higher rate of return than the interest rate on the debt, it is better to invest the money instead and pay down the debt more slowly.
Falling into this category is mortgage, which relatively has lower rates than the other types of loans. As cited earlier also, the interest on mortgage is tax-deductible.
The rule of thumb, according to most experts, is to keep bad debts as much as possible under 25 per cent of one's income. The best way to do this is to slow down on credit card purchases. Many fall into the bad debt trap because of irresponsible usage of credit cards. They often think that they are getting a good deal by swiping away most of their purchases but in the end, credit card purchases become expensive due to high interests.
Living within one's means is the path towards financial freedom. Everyone should have a sound but simple strategy in managing one's finances. Avoid falling into a bad debt trap; juggle your finances and debts good and bad well.