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Personal Debt Indicator

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Debt is funny.  Debt is also becoming more and more popular.  Because we live in a society where we need debt to function, Debt is becoming easier and easier to access.  There is one main thing to know about debt, debt can hurt people or debt can help people.  There are two main forms of debt; good debt and bad debt.

First, there is a difference between good debt and bad debt.  Good debt is the debt that you owe on an asset that usually increases in value or an asset that provides or will provide income.  For example good debt includes your home, rental property, a truck that has a snow plow on it, and education.  Usually, the cost of obtaining good debt is fairly cheap.  On the other hand, bad debt is the debt that you should try to keep away from.  With bad debt, you should pay off right away.  Bad debt includes most items that you put on your personal credit card, items that depreciate in value and usually short term loans.  The cost of obtaining bad debt is usually relatively high.

 

I also have to note, not all debt is classified as only good debt or bad debt.  It is more on a sliding scale.  For example, on the political scale, its not like everyone is on one side or the other but instead most people are somewhat in the middle.  Debt is very similar to that type of scale.  One items of debt that would be classified as somewhere in the middle would be a car loan.  The cost of obtaining a car loan is relatively cheap, but on the other hand, a car depreciates in value.  You may also need your car so you can get from one place to another to better you life, like going to work.

 

As a rule, we want more good debt compared to bad debt.  I believe, if one can maximize the ratio of good debt to bad debt (GD/BD Ratio) then one uses debt to better their life as a whole.  If one person has a very low GD/BD Ratio then I believe that person should work on turning this debt around.  The main reason is because if a person keeps on a low GD/BD Ratio for a long time then they will only use debt to hurt themselves in the long run.

 

There are many benefits for having a low GD/BD Ratio.  We first need to know that we don't want to keep on obtaining more and more debt without trying to pay off the bad debt at the same time.  We also have to realize that all debt has risk to it because of unforeseen events.  Now, someone with less Bad Debt and has a lower GD/BD Ratio is less likely to claim bankruptcy.  The reason is, like said before, good debt is debt that produces income or increases in value.  For the most part, these assets could be liquidated into something that they can pay off their debt with.

 

Another benefit of a low GD/BD ratio is this debt either helps you obtain more debt or is looked over as good debt.  Let me give you an example of each.  First, it will help you obtain more debt.  The more good debt you have the wider you can expand your wings.  If you use debt to buy a company or an asset that provides residual cash flows then this shows that you will be able to handle more debt due to your income increasing.  If you can show that your obtaining debt for an asset that will provide cash flows then the bank is more likely to give you the debt.  Also, usually these assets are items that the bank could make your use as collateral if you can't make your payments.  This is a way for a bank to see it as less risky hence why the cost of good debt is usually cheaper.  Second, good debt is sometimes looked over.  I would like to give a personal example, my debt to income level was a little higher then my bank would have liked to see to give me a car loan.  They then told me that they would like to see my debt to income ratio lower, but proceeded with telling me that they will give me the loan due to the only debt I have is my mortgages.  Because I only had that as my debt, I was looked at as a more secure borrower.  They found that I only had good debt and figured I would make the regular payments on the car loan.  As I have shown, there are many benefits to having a low GD/BD ratio.

 

Now one may be asking the question, how can I calculate my GD/BD ratio?  To start off with, there is no one way to calculate it because everyone values their debt differently due to the situations that we may be in.  The best way would be to take the present value of all predicted amounts of good debt interest over the present value of all predicted amounts of bad debt interest.  Because we don't know all of our predicted future debt that we will have, we will look at a Current GD/BD ratio.  Now often, I will call our Current GD/BD ratio as just our GD/BD Ratio.  For a description of how it works, we find the average yearly amount paid in interest.  We decide whether the debt should be labeled good debt or bad debt or somewhere in between.  With the stuff in between we have to figure out how much of this debt benefits us and label that portion of the yearly debt interest amount as good debt and the remaining as bad debt.

 

Now, the best way to calculate this for yourself is on a piece of paper or an excel file write down all of your debt.  Make sure you include the name, interest rate, how much you owe, and how much it’s worth today.  If you don't know what it is then give your best estimate.  Most of the time, if the debt is more then what the market value is today then it's usually considered bad debt.  On the other hand, we can't automatically assume that any debt that is lower then the market value is good debt because we may be good at paying this debt down.  On this piece of paper, include any normal debt habits.  What I mean by normal debt habits is something that you do on a regular basis that increases your debt or reduces your income.  For example, if you go on vacations every year and you put it on your credit card for six months then include this is a normal expense and include the total value that it cost you in interest per year.  An example of something that reduces your income, that someone might not look at as debt, is payday loans.  These are extremely expensive loans, and the cost must be calculated in this process.  Remember we want the yearly amount paid in interest.  So, if you do these payday loans every two weeks, we need to calculate the total cost of these payday loans on a yearly basis.

 

Moving forward, we need to convert all of our debt into how much it costs us on a yearly basis.  For an estimate, if you don't now how much you pay yearly in interest, what you will do is take the interest rate and multiply that by the total amount you owe.  This will give you a close enough answer, the real amount depends on other factors.  from here, place each item into a Good Debt or Bed Debt and put them in order by highest interest rate you pay for each debt on top.  If the item is somewhere in the middle, like a car loan, then classify how much that car is Good Debt and write what percent goes in each side along with the amount of interest paid.  For example, let’s say I pay $1000 in interest per year on my car.  I may think that this car provides me with 50% of benefits that I wouldn't have if I didn't have this car.  These benefits include driving me to work, buying food, and other essential things for life.  There are other alternatives and a car always decreases in value, so I think it provides me with 50% bad debt.  I would then place $500 of interest paid on my car loan in each good debt and bad debt.  Another example, Vacation that you have to put on your credit card might be looked at as more bad debt, like 80%, then good debt, if good debt at all.  From here, get a total amount of Good Debt and Bad Debt.  Now figure out your GD/BD ratio by taking your Good Debt divided by your Bad Debt.  If you don't have any bad debt then you will not get an answer due to you cannot divide by zero.  If you get a number above one then that means you have more good debt than bad debt.  So remember, the higher the number the better.

 

From here, it is important for us to look at this number and figure out how we can make it higher by increasing our good debt or lowering our bad debt.  If we try to increase our good debt, it may increase our bad debt also.  When lowering our Bad Debt we need to look at what we pay the most amount of interest and what will maximize our ratio.  This is why I told you to order the debt in each column by what interest rate you pay with the highest on top.  We also have to sort the "middle" items, below the regular debt items, based on highest percentage of where it belongs.  So in my example above, I would first order all my Good Debt and Bad Debt.  I would then take my Car Loan on put it next on the list for the Good Debt side with the Vacation being last on the Good Debt side.  Now on the Bad Debt side, I would all of my normal Bad Debt and put the Vacation below that and the Car loan last on the list.  In general, the top item on the Bad Debt side would be the item you want to start paying off first and work your way down.  If you have no Bad Debt then you would start from the bottom of the Good Debt list and work your way up the list.

 

Finally, it is important to look at your GD/BD Ratio at least once a year.  There is a lot of information that you can get from assessing your GD/BD ratio.  From this assessment we need to look at how we can in the future keep our Bad Debt low.  We need to realize what our Bad Debt is and change our habits.  There are many benefits to having a high GD/BD ratio!

 

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