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This is part 2 in a series about bad debt. The parent is at What to do about Bad Debt and part one can be found at The Motivation Behind Bad Debt.

Unfortunately, not everything is simply a matter of cash or credit. With the wrong financial advisers or a bad financial background it is possible to get bad terms on your credit.

This can be a difficult position to get out of. If the problems that led to getting bad terms still exist, it will be difficult to find a way out that only includes good credit terms. Do the right things with your debt and it will eventually be possible to get good credit loans and terms even if all you can get approved for are bad credit loans and terms.

Bad credit terms can exist in a lot of ways. Here is a partial list with information on what you can do about them.

Prepayment penalty

This often caps off bad credit loans. Lenders who put this clause in their loans do so because they know how much of a good deal it is for them. They want you to be stuck in that loan for as long as possible so that they can make the most money off you. There are three ways out:

• Wait it out. If the term of the credit is short enough, you can make the payments until the prepayment penalty expires. Then refinance into a loan with more favorable terms.
• Refinance now. You will have to pay the prepayment penalty, but if you can get a more favorable loan by refinancing, the improvements in the terms may exceed the cost of the penalty. Try Bankrate’s Refinance Calculator (or any of the other 500,000+ such calculators out there). That calculator can be used for non-mortgage loans if you leave the correct valuesat zero.
• Negotiate. It will probably not work, but it cannot hurt to ask the lender if they will remove or reduce the prepayment penalty on the loan.

High interest rates

In general, a high interest rate is anything above 10%. Credit cards are almost always in this category. Even home mortgage rates have been above this threshold - even for prime borrowers. Most of the time however, any asset-backed loan (home mortgage, home equity line of credit or auto loan for example) should be below this rate.

• For any loan with an asset as collateral, try to refinance the loan to get a more favorable interest rate.
• For non-collateral loans, such as credit cards, it is often cheaper to get a better interest rate. You will probably not get a long term rate below 10%, but just by threatening to move the debt to a different credit card or to open a line of credit elsewhere, many companies are willing to offer you a reduced rate to stay. No Credit Needed Blog covers doing this in Call for Discounts.

Balloon

A payment balloon is simply one or several large payments to be made at the end of the loan. This is done to allow for a lower payment up front. This is favorable to the lender for two reasons.

First, the principal amount of the loan shrinks slower. This causes more interest to accrue over the life of the loan.

Second, if the economy is in a recession or the borrower has difficulties, the loan is unlikely to be paid off at the end, and the lender will either get to make another bad terms loan or will get possession of the house or car that was financed.

Negative Amortization

Negative amortization happens when the monthly payment is lower than the amount of interest that in generated each month. In other words, the loan gets bigger with every payment made. Eventually something will break. The loan must be refinanced or the monthly payment will have to suddenly grow much larger - large enough to pay off the loan in a compressed time frame plus the extra interest accrued.

Since negative amortization loans are generally used when somebody will not otherwise be able to get a loan, the refinance or larger payments usually becomes a financial disaster. These types of loans are a part of the sub-prime loans that are creating a crises in the American housing markets right now.

Extended Repayment Period

A loan that is financed over a longer than normal period of time is a great thing - for the lender. It secures payments for more years than normal, often at a higher interest rate, for only a small savings in monthly payments. No matter who tells you to do it, paying for a house over 40 or 50 years is not a good idea.

Conclusion

There are other terms that can be harmful to your financial health. The key is to carefully consider the downsides of any credit that you are offered before accepting and to not give in to a hard sell tactic, especially if it is designed to get you to ignore or treat the condition as minor. If it was that minor, it would not be in the contract.

If there are any in particular that you would like more information on, feel free to add a comment and ask. If you want more detail on any particular term listed above, I can get it for you as well.

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This is part 1 of 3 articles discussing what makes a debt a Bad Debt to have. The parent article is What to do about Bad Debt.

Here is a short post from Debt Consolidation Lowdown called Live Within Your Means that touches on a similar topic.

Motive is the greatest and most difficult source of bad debt to solve. We all have reasons, usually completely defensible to ourselves, on why we have taken on each and every bit of debt that we have. The problem with this is it allows our creditors to control our lives because we have to work to pay them off.

I am not going to go extreme and say that all debt is evil. It is not, but most debt for the average consumer is not good for them. With the exception of homes, most credit is received to purchase items that lose value over time. For credit cards, personal loans, and even some car loans the benefit does not last as long as the payments do.

Here are some of the motives that we use to justify taking on more debt:

• Habit
• Supersizing
• False Economy
• Sales
• Matching Friends
• Convenience

(more…)

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Now that we have discussed what makes up Good Debt in How to decide if something is Good Debt, lets turn our attention to Bad Debt.

Bad Debt can have a lot of elements that make it bad. Sometimes it is just one reason that makes us consider something Bad Debt. Other times, there are multiples reasons. The reason why something is bad has a lot to do with what it will take to fix it and even more to do with how to avoid the problem in the future.

It is especially important to note that whether something is Bad Debt or not is strongly dependent upon a person’s situation. The exact same debt for two different people can be Good for one and Bad for the other. As we go through the categories below, the reasons this is true should become clearer.

I’ve loosely organized these reasons into 3 categories:

• The Motivation Behind Bad Debt
• The Terms of Bad Debt
• Too Much is Bad Debt

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As I am not the first person to discuss good debt, lets treat the topic a little bit differently. In this post, you will find a list to a number of other posts and online articles that discuss Good Debt. After each link, you will find a single sentence with the most important point about Good Debt at that link.

• Good debt vs. bad debt at Money.com. This link covers the platitudes, saying that good debt is for what you ened but cannot pay cash for while bad debt is for anything that you do not need; despite not telling you how to figure out if something is a need or a want.
• Good debt and bad debt at Bankrate is a much better article. This article points out that good debt helps to make you wealthy but still sticks with generalities like “Mortgage debt is good debt” (it is not always). Same article is also at MSN as Good debt versus bad debt.
• Garden and Hearth also talks about Good debt vs. bad debt. Their article lists out the key points (good terms, purchasing an asset, etc.) that differentiate good reasons for taking out a loan from bad.
• My Financial Awareness revisits the topic with A New Look at Good Debt vs. Bad Debt. This new look emphasizes that once you have the debt, it does not matter why you got it: debt is debt and needs to be dealt with regardless of how you incurred it.
• On the Rule #1 Blog, Phil Town elaborates on a reader’s question in GOOD DEBT, BAD DEBT. This post is a good one that shows how to tell if a mortgage is a good debt using a positive example.
• There is Freedom in the Hills of New Hampshire to discuss Good Debt vs. Bad Debt. This is different from the rest because it discusses how any debt can be considered bad, but mentions how credit cards - for all that is bad about them - can still help “smooth” out one’s financial life.
• Queercents get personal in Almost Debt Free: Good Debt vs Bad Debt. The key point here is in his discussion about student loans where he points out that some of it is good, and some of it is not so good.

Reading through these articles, and all of the others you can find with a simple Google search (or Yahoo! or MSN), you start to get a sense that there is a wide gamut of opinions on the value of debt. This is true because there is a wide range of tolerance for risk. No Credit Needed Blog has done well for his family by attacking debt and eliminating it from his life. Others, like Donald Trump (see wikipedia) have used massive amounts of debt to reach their goals.

In the end, regardless of where on the spectrum that you are, the decision on if a particular debt is a good one is one that you will have to make. Use the general guidelines about using loans for assets and leverage, but do not take on any debt - even if it is otherwise ‘Good’ debt - unless you are comfortable doing so and do not take on more than you need to reach your goals.

Good luck, and may all of your financial goals be reached while you enjoy the rest of your life.

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Debt has frequently been compared to a mountain. It can be massive, just being present it can cast a shadow over anything else, and it is difficult to remove. The best way to get rid of a mountain of debt is to chip away at it a little bit at a time. It won’t disappear quickly, but eventually it will no longer shadow your life.

A mountain is a fair metaphor. There is little question what somebody means when they talk about working on a mountain of debt. Yet,to me, it is not the best possible comparison. Better may be: Debt is a canyon. I’ve talked a little bit about this before in my post Debt Analogy that was inspired by Blunt Money’s Debt & the Grand Canyon post. I want to go into more detail this time.

Our lives can be viewed as living by a river. The river represents the money that flows out of our hands for anything: the groceries, rent and mortgage payments, speeding tickets, new clothes, etc. When we are debt free, it is like living in a small valley. Sometimes the river may flood, but it is not too much work to fix everything up and keep on living. If you have a lot of money saved up, it gets even better, because it is like living on a hill or mountain by the river - even when it flood, your home is never threatened.

Living in debt though, begins to look like a canyon. The river keeps on eating away at your resources and digging deeper and deeper. It also gets more powerful the deeper it cuts. The financial equivalent are the interest payments and fees that you experience because of being in debt.

The deeper that canyon gets, the harder it is to climb out and the longer it is going to take. To get back to the nice river valley - much less the mountain - is going to take a massive amount of rock and soil. Even as you fill in the canyon, the river is still going to be there trying to cut through everything you are dumping in there. If you don’t keep shoveling, eventually the river will win through again.

The worst part is that, just like a canyon, it is much easier to get in than out. The downhill is simple, and if you slip going downhill, it just takes you further in. Climbing out, you have to put in all the effort - gravity hinders getting out. Any slip sill stop your forward progress and may even move you backwards.

If you are struggling out of your own canyon, may good luck and hard work see you out as soon as possible. I’ll be working right along side you for a while more. For those in the river valley, may fortune favor you building your own hill or mountain for added safety. And for those on the mountains looking down, your advice and assistance are always welcome.

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I must admit that I’ve just read a great analogy for debt. Having backpacked the Grand Canyon three times in my life- once in the summer - I know just what Blunt Money is describing.

I can even recall my experience on the Bright Angel trail. I was doing a week long trip, so I just went down the Bright Angel Trail. I was amazed (still am!) at how many people venture below the rim when they are unprepared for it. Nobody else that I saw exceeded that of one nicely dressed lady that I passed near the first rock shelter on the trail.

She had no water with her - like many of the inexperienced hikers. What set her apart was the fact that she was doing the trail in 2″ heels. No sissy hiking boots on her. No utilitarian backpack or floppy brimmed hat. No suncreen or functional jeans. She was hiking in a dress and heels. I do not know how far she made it or if she walked out barefoot, but I hope she came out fine.

Enjoy the analogy. You could probably add in the different amounts of preparation people have, but it is not necessary.

Debt & the Grand Canyon @ Blunt Money

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