Different types of debt
Almost everyone has debt. You have a mortgage? That’s debt. Car loan? Also debt. But debts aren’t all bad. In fact, there are “good” debts and “bad” debts. There’s also a situation called “overindebtedness” that can happen whether you have “good” or “bad” debt.
What is “good debt”?
If you own a house, you probably have a mortgage. After all, you can’t expect to pay for a house in cash. This is an example of what we call “good” debt.
Why is it “good” debt? A few different reasons. First of all, when you take out a mortgage, your quality of life is immediately improved by having a family home. You don’t have to save up the full cost of a house, which takes about 25 years.
Secondly, having a mortgage helps improve your standing with financial institutions. Lastly, because mortgage loans have low interest rates (around 3.5%) and terms that are shorter than the lifespan of the asset you’re financing (often 20 to 30 years). In other words, you’ll still be using your home long after the mortgage is paid off.
What about “bad debt”?
“Bad” debts are purchases and loans that are subject to very high interest rates and that you have trouble paying on time. For example, financing a vacation with your credit card at a rate of 19% is bad debt. You might still be paying it off months (or years) after you get back! Leasing or buying a car that’s beyond your means and ending up with payments you can’t make is another form of bad debt.
What is overindebtedness?
So you can have “good” debt and “bad” debt. But bad or good, there’s always a risk of having too much. In other words, being “overindebted.”
Overindebtedness happens when a person is no longer able to make their payments on time. Late fees pile up. And the amounts you owe only grow as they accumulate interest.
When this happens, most people will say, “No big deal! I’m just going through a rough patch.” But money doesn’t just appear out of nowhere! And debts are never going to disappear on their own.
Once a person becomes overindebted, they fall into a pattern that looks like a spiral: a debt spiral.
How do people end up in a debt spiral? There are many different reasons. It could be a personal emergency or poor spending habits. No matter the cause, however, the stages in a debt spiral are largely the same.
The debt spiral explained