Good Debt, Bad Debt: Know the Difference

Because of tight credit and financial worries, consumers aren’t borrowing as much as they did a few years ago. That means they’re not spending big sums that could help boost the economy, which is a problem. But on an individual basis, tighter budgeting and stepped-up saving is good.

So what’s a savvy consumer to do?

It would be silly to pile on debt just to do your little part in ending the recession. But debt isn’t always to be shunned. The key is to know the difference between good debt and bad.

The Federal Reserve has reported seven straight months of shrinking consumer debt. Balances on credit cards and other revolving loans fell at an annualized rate of 13% in August, while nonrevolving debt, which includes things like auto loans, fell at a 1.6% annual rate.

Of course, part of the reason is that lenders have made it harder for consumers to borrow. But there’s not much doubt consumers have become more cautious as well, setting aside money for a rainy day and investing more for long-term needs like retirement and college.

The big drop in revolving loans suggests consumers do understand that most credit card debt is the bad kind.

Whether credit is good or bad generally depends on whether the benefits outweigh the costs. It’s harder to make that case when interest rates are high, as with credit cards.

Also, taking on debt is more likely to be worthwhile, or good, if it has a long-term payoff rather than a short-term one.

That means a $100 credit card charge for this week’s groceries is bad debt, since it’s a short-term benefit and a potentially long-term obligation at high interest rates. There’s nothing wrong with using the card as a convenient alternative to carrying cash, but that requires paying the balance off during the grace period, so there’s no interest charge. The worst approach is to keep a balance for years on end.