What is Bad Debt?
Bad debt can cover a wide variety of definitions. The most common meaning is money owed which is unlikely to be recovered. This form of bad debt may be written off by a company or may ultimately lead to the person with bad debt finding himself unable to gain anymore credit. Many companies have a bad debt allowance, as it is unlikely that all bad debt will be recovered. Companies make an estimate of the bad debt that may be incurred within a current time period. This estimate is based on past records and used in the process to estimate overall earnings. Major banks have a strange way of looking at bad debt. A bank can make a profit of 10 billion US dollars (USD) while stating that they have 4 billion USD in bad debt. Most of a bank’s profit is made from the interest on loans, credit cards and bank charges from their customers. If a customer falls into debt with a bank, the interest payments and late charges make the bank money. It seems to be in the bank’s interest to have customers who
Bad debt is incurred when you purchase something that depreciates over time with an interest-accruing account, such as a credit card. For example, let’s say you pay 11% interest on your credit card, and you purchase $500 worth of clothes. As soon as you pay for your purchases at the register and walk out the door, the value of those products depreciates considerably, but you’ve still incurred debt that you must pay off. In addition to the price of the clothes, you’ll pay interest on your purchases until you satisfy the debt in full. While the clothes depreciate in value, the amount you pay for them increases. This is a classic case of bad debt. Another example would be your car loan, which might be necessary but still falls under the category of bad debt. When you purchase a car, the vehicle depreciates considerably as soon as you drive it off the lot, but you’re still saddled with the principle of the loan plus any accrued interest. In fact, many people discover that they owe more on
Bad debt, on the other hand, does nothing to improve your financial position and is most often used to purchase items that depreciate in value. Credit card debt is almost always bad debt not only because of the nature of the items that are purchased with credit cards but also because of the high interest rates that credit cards have. Even though you might consider a car something that could help you earn more money, an auto loan is most often considered bad debt because cars (typically) depreciate in value.
