All debt is created equal, right? Well, not exactly. While debt is debt – no matter how you look at it – some types of debt are better than others. Understanding the difference between good debt and bad debt can help you make more informed and confident decisions regarding how you borrow money and how you repay your debt. In the slides to come, we’ll outline the differences between good debt and bad debt, while also touching on multiple examples of each.
What is Good Debt?
Think about good debt like this: it takes money to make money. With good debt, you’re borrowing money with the idea of improving your financial situation now and in the future. Before you take on debt with the idea that it’s good, ask yourself this question: will it help you boost your net worth or generate more income in the future?
If the answer is yes, you’re dealing with good debt and it may make sense to proceed.
Good Debt: Student Loans
In the United States, approximately 45 million borrowers owe a total of $1.5 trillion in student loan debt. While it’s become a problem on many fronts, it doesn’t change the fact that student loans are categorized as good debt.
A college education improves your likelihood of earning more money, which is a factor to consider when taking on any type of debt. It’s best to look at your education as an investment, not a debt.
Good Debt: Small Business Loans
There are approximately 30 million small businesses in the United States, employing nearly 60 million people. The benefits of small business ownership run deep, including more flexibility and freedom, along with the potential to help boost the local economy.
There are many ways to secure funding to start a business, with a loan being one of the best (and most common). Since a loan can help you build a company of great value, while also increasing your earning potential, it fits into the category of good debt.
Good Debt: Mortgage
Buying a home is one of the biggest financial decisions you’ll ever make. And if you make a good purchase, it also has the potential to be one of the most profitable. A mortgage is likely to be one of your largest – if not the largest – debts.
Since real estate generally appreciates, you’re in a position to make money over the long run. And when your mortgage is finally paid off, you own your home free and clear.
Good Debt: Paying for Medical Care
If you don’t have your health, you don’t have anything. It’s your hope that your health insurance policy covers all your medical bills, but this is not always the case in today’s day and age. Some bills aren’t covered if you receive out of network care.
Others aren’t paid for in full until you reach your out-of-pocket limit. Taking on debt related to medical care isn’t ideal, but if it makes you feel better it’s something you shouldn’t hesitate to do.
What is Bad Debt?
Good debt has the potential to boost your net worth, increase your income, and put you in a better overall financial situation in the future. Conversely, bad debt is typically associated with borrowing money to purchase depreciating assets.
If an asset won’t improve your finances, such as through appreciation or more income earning potential in the future, think long and hard about making a purchase. Too much bad debt can bog you down, thus resulting in serious financial complications.
Bad Debt: Motor Vehicles
This is a tricky one, as you may require a motor vehicle to get to and from work and/or school. However, motor vehicles quickly depreciate in value, which puts it squarely in the bad debt category. With the average cost of a new car hovering around $37,000, this is no small purchase.
If you need to take on debt to purchase a motor vehicle, consider buying one that’s preowned. This allows you to avoid a big depreciation hit in the early years of ownership.
Bad Debt: Credit Cards
55 percent of Americans are carrying credit card debt. There are times when it’s okay to follow the crowd, but this isn’t one of them. Credit card debt is a leading cause of financial difficulties among American consumers, often leading to a low credit score and a bankruptcy filing.
It’s easy to spend money on a credit card, but much more difficult to pay it off. This is particularly true when you consider the high rate of interest and fees associated with most cards.
Bad Debt: Store Credit Cards
It seems that almost every store – both online and brick and mortar – in today’s world has its own credit card. The availability of a credit card offer, combined with a variety of perks, such as a predetermined discount on your first purchase, may have you considering it.
Store credit cards are bad debt for all the same reasons as a traditional credit card, including the high-interest rate, potential fees, and terms and conditions slanted in favor of the issuer.
Bad Debt: Vacation
There’s nothing more enjoyable than taking a vacation. It’s a great way to unwind, see the world, and give your mind and body time to rest. But if you need to take out a loan or use a credit card to book your trip, it’s best to put it off.
Also, avoid hotels, airlines, and other travel providers that entice you with their own credit card offers. A vacation only lasts so long, but the debt can hang on for many months or years.
Bad Debt: Payday Loans
A payday loan is one of the worst types of debts you can take on, as interest rates can reach as high as 700 percent. Additionally, the payday loan cycle can be difficult to break once you start, as you find that taking one loan after the next is the only way to keep up with your obligations.
When you add this to the fact that regulations and restrictions aren’t nearly as strict as they could be, it puts the borrower at risk of making a poor financial decision.
Bad Debt: Family Loans
A family member or friend may be willing to lend you money, but that doesn’t mean you should jump at the opportunity. It’s enticing, especially if the individual is willing to lend you the money with no interest (or a rate that’s more competitive than a local bank).
The primary risk is that you won’t take the repayment of the loan seriously, which can cause a major divide between you and your loved one.
Bad Debt: Borrowing from a Retirement Account
People borrow from their retirement account(s) for many reasons, such as to purchase a home or fund a renovation project. While it’s possible to borrow from a retirement account, such as with a 401(k) loan, at a competitive interest rate, there are potential pitfalls.
Not only do you risk not repaying the money, thus hindering your ability to retire, but neglecting to do so can result in serious tax implications and an early withdrawal penalty.
Bad Debt: Loan Shark
Much the same as a payday lender, a loan shark has the ability to lend you the money you need. But there’s a catch: it comes with an extremely high-interest rate. Add in the fact that there is no regulation – and many of these lenders dabble in illegal activities – and it’s best to keep your distance from loan sharks.
This type of bad debt should be eliminated as quickly as possible.
Good for You, Bad for Others (and Vice Versa)
Some debts are good for you and bad for others, and vice versa. This depends on your personal financial situation, including your current level of income and short and long term goals.
If there’s any gray area – such as debt that’s good for one person but bad for another – consider how it’ll affect your finances now and in the future. This will allow you to categorize it as good or bad.
It doesn’t matter if you have good debt, bad debt, or a combination of the two, a consolidation loan can save you money and help you better manage your finances. For example, a personal loan is a common type of consolidation loan, as it allows you to bring many types of debt under the same roof.
The key to success is consolidating your debt at a lower interest rate as a means of lowering your overall monthly liability.
Borrowing Money to Invest
This fits into the “good for you, bad for others” category for one reason: it takes knowledge and experience to make it work. The goal of borrowing money to invest, also known as leveraging, is simple: you borrow money at a low-interest rate in hopes of investing the funds at a higher rate of return.
But if the strategy backfires, such as your investment returning less than you expected, or nothing at all, you could be left owing more money in the end.
Home Equity Loan or Line of Credit
Depending on how much equity you have in your home, you may qualify for a home equity loan or line of credit. While interest rates on this type of loan are lower than many others, there are risks. For example, if you don’t repay the loan based on the terms and conditions, the lender has the legal right to repossess your property.
This type of loan can fit into either debt category, so take caution and have a plan for using the funds before you sign on the dotted line.
Good Debt is Bad Debt if You Have Too Much
Don’t let the term “good debt” fool you. Some debt is necessary, and some debt is better for you than others. But just because it’s a good debt doesn’t mean you should take it on. For example, a small business loan is considered good debt, but too many of these can take a toll on your company and your personal finances.
Keep your good debt in check, or else it will turn into bad debt – and that’s not what you want.
Pay Off Bad Debt First
If you have extra money to put toward your liabilities, pay off bad debt before good debt. By clearing this out of your life, you’ll stabilize your finances, free up cash flow for other expenses (such as tackling good debt), and provide yourself with a clear view of the future. Just the same as bad debt, good debt requires a monthly payment.
However, eliminating bad debt will make you feel good about your progress, thus giving you the confidence to proceed.