What Qualifies as Debt

A debt is any obligation of an individual to pay another individual or entity for loaned money, or for the purchase of goods or services.  The most common types of debt are mortgages, car loans, credit card or other revolving debt (e.g., personal loans), medical bills, and student loans.  The wise consumer looks carefully at all of the details of a debt contract before entering into the agreement.  The difference between good debt and bad debt involves several factors.

Amount of Debt

Before entering into any debt, be certain that the amount being borrowed or the credit limit on a credit card is a total with which you can live.  If you make $45,000.00 a year, incurring $30,000.00 in non-mortgage debt is not responsible.  Payments will be far greater than you can afford, even if they are stretched out over a prolonged period of time.  Be certain that the amount of non-mortgage annual debt is no more than 20% of your total income.  Too much debt is bad debt.

Interest Rate

Interest rates vary greatly and are usually dependent upon the borrower’s credit score and income.  The greater the risk, the higher the interest rate is likely to be.  Further, an individual with poor credit usually cannot obtain credit from reputable, established traditional sources.  Often, loans will have to be obtained from finance/loan companies which work only with poor credit risks.  Interest rates are likely to be exorbitant.  If your credit is poor and you must seek non-traditional sources for loans, that is, other than established credit card companies or banking institutions, then your debt is bad debt.  You will be paying terribly high interest rates.

Penalties

A thorough understanding of any penalties involved in the repayment process is critical.  A traditional, reputable creditor will usually have penalties involved for late payments and, in the case of mortgages, a pre-payment penalty.  There may also be provisions that if payments are late, a higher interest rate will be charged from that point forward.  With less traditional loan sources, late payments may be treated in a predatory manner, that is, there may be severe penalties and an extremely large increase in interest rate.  Any debt that has severe late payment penalties and exorbitant interest rate increases is a bad debt.

Nature of the Debt

Bad debt can also be defined as debt incurred for luxury items which places the debtor into an untenable credit position.  This type of bad debt is not the fault of the creditors per se, but, rather, the lack of self-discipline on the part of the debtor.  Luxury items should never be purchased on credit but only as cash is available to pay for them.  In this way, credit will be available for emergencies and necessities when a cash crunch occurs.

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