Debt: The Good, the Bad, the Ugly
Wisely chosen and managed, debt can actually be good for your balance sheet. For example, a real estate mortgage, a college loan or money borrowed to start a business can be good debt if it fits within your ability to repay and allows you to afford something that will grow in value — like a college degree — or provides a source of income.
On the other hand, some types of debt are not so good. The most common example is high-interest credit card debt when it's used to finance your lifestyle. Maxing out a credit card to buy a big-screen TV or a European vacation is a risky proposition. Even a low-rate card can turn nasty if you miss a payment.
From bad to worse
Sometimes we run away from bad debt but smack into debt that's worse. In the rush to erase debt from their pernicious plastic, many consumers turn to a home equity loan or home equity line of credit (HELOC), believing that they've somehow turned their bad debt good because their interest may now be tax-deductible. That scenario can turn out for the better — but only if you also address the poor saving and spending habits that got you into trouble in the first place. Otherwise you'll end up with still more credit card debt on top of the new home loan.
Plus, as many borrowers in the mid-2000s discovered, banks can raise interest rates quickly and dramatically in times of turbulence in the financial markets. And owners of HELOCs who happen to live in an area with falling housing prices can find that their lender has frozen their line of credit, leaving them with no headroom to tap in case of an emergency.
A HELOC can be a sensible choice for an emergency source of funds. Think of it as a life jacket to tide you over in a temporary setback such as a major car repair. Just be sure to pay down the balance as fast as you can.
The new rules of debt
Today banks and other lenders are increasingly scrutinizing borrowers' ability to repay a loan. Those who are in good standing, debt- and credit-wise, will have access to the most favorable terms. For borrowers with less than stellar credit, the only available loans may turn out to be bad deals in the long run.
The best way to improve your chances of getting a loan you can live with is to play by the rules. That means making your payments on time every time and trying to keep your total debt in line with your income. Any total above 33 percent of your income is worth reducing.
Thinking about applying for a loan? At least six months out, get copies of your credit reports (at annualcreditreport.com) and purchase your FICO scores (at myfico.com). That way you'll have time to correct any inaccuracies in your reports, which is critical because it's the information in those reports that determines your FICO scores. Try to pay down balances and avoid opening new (or closing old) lines of credit.
Take the next step...
Cut your credit card debt now! Consolidate your debts and pay off high interest rate credit cards with a home equity loan at The Principal Bank.
