What’s the difference between good debt vs bad debt? Now, before we get into this, you may be asking yourself the following questions:
- How is debt anything other than “bad?”
- What’s “good” about owing money to anyone?
- There are different types of debt?
- Does this mean that I CAN take my Visa to the mall this weekend?!”
First of all, no. Put the credit card down and slowly step away from it. You’ll thank us at the end of your next billing cycle.
Next, read on to get a better understanding of credit and good debt vs bad debt, and how knowing the difference can help you make the best plans for getting rid of both.
What’s Good Debt?
Good debt is debt that has a lasting, positive effect on your life in the long run. Typically, good debt is present in financial situations that are created to generate income and ultimately build wealth. This type of debt has a sole purpose: to make you a better, richer person.
Here are some examples of good debt:
Student Loans
Student loans are considered good debt because they are used to improve a person’s employment opportunities and earning potential. These loans are typically issued at a low interest rate, and in some instances, the interest can be tax-deductible. They also tend to have lower interest rates than many other loans. For many people from lower or middle-income households, going into this type of good debt is the only way to pay for higher education. Broadly, student loans are viewed more as an investment.
But be careful! If the terms of the student loan are violated by the lendee, or repayments become irregular, student debt can transform into bad debt. To avoid this, careful consideration should be made when considering a student loan – particularly the amount of money borrowed. Many times, people can borrow more money than they can effectively payback, putting them into a cycle of debt that is difficult to escape.
Some experts say you should try to borrow only as much as you’d want to make in your first year after completing your education program. If you follow this advice, we suggest that you don’t aim for that million-dollar salary right after school. You know, just to play it safe.
Mortgages and Real Estate
Owning your home or other property is considered good debt because it can provide you with opportunities to either save or make money. With a mortgage loan, a person could buy a home to live in now and then sell it years later at a profit. Or, the property can be rented out to tenants and generate steady income. Additionally, homeowners can avoid many fees and receive tax breaks that aren’t available as a renter. Commercial real estate, when leased to well-performing businesses, can also create a strong cash flow.
Mortgages can also position you to generate another source of wealth: home equity.
Home equity is the difference between the fair market value of the property and the amount of the mortgage loan and is the portion of the property’s value that isn’t attached to the mortgage itself. It can also be considered the “amount” of the property that you own.
It’s important to note that equity is not a value that can be liquidated into cash. The $120,000 home you bought a few years ago that is now worth $200,000 does not mean there is a check for $80,000 somewhere waiting for you.
The real advantage in equity comes from the ability to leverage its value for a loan. Secured by real estate, these loans are pretty easy to qualify for and are usually issued at a low rate.
Renovations, upgrades, and the simple passage of time can increase the market value of a home. During that same span of time, the size of the homeowner’s mortgage loan decreases as they continue to make regular mortgage payments. That means that the longer you own a property, the greater the equity can be.
All that considered, these loans should be reviewed with the same care as a mortgage loan, so that you understand how they work, and how repayment can fit into your budget and not harm your credit.
Ideally, your mortgage payment (with insurance) should be no more than a quarter of your gross monthly income. It is also important to pay attention to the details on the loan interest; while some rates can start low, they can increase over time, which will result in unexpected increases in mortgage payments. As one of your most important living expenses, your mortgage should be considered a long-term necessity that will have to weather the unfortunate pitfalls and changing circumstances of life – like the loss of income, or an increase in the size of your family.
What’s Bad Debt?
Bad debt is debt obtained by borrowing money to purchase a depreciating asset or something that will neither increase in value nor earn any money. Debt can also be considered bad when it is attached to something that provides little to no return on the investment. When you carry a lot of it, bad debt will almost always have a negative impact on your overall credit score.
Here are some more examples of this type of debt:
Credit Cards (of Course!)
It’s no surprise that having credit card debt is bad. With easy application processes and high interest rates, they are an easy financial trap to fall into. Unless you are planning to pay off the credit card’s full balance at the end of every billing cycle having a credit card is an expense that will greatly exceed your investment. Put simply, credit cards can get you into some financial trouble if you’re not careful. Easy-to-use and high interest rates don’t work out well for your financial situation.
Many credit card companies offer rewards or “cash back” programs that advertise some level of overall savings on your purchases as a “thank you” for using the card. Often, these incentives do little to offset the interest payments on credit cards. Just remember that these credit card companies are working to get you to use their product as often as possible, so be wary of any programs that seem to promote the idea that your purchases will be covered by other purchases. Very rarely can you get out of debt by getting into more debt.
The bottom line is that credit cards can rack up high-interest debt very quickly. And credit card debt is not an easy thing to navigate. If you’re currently dealing with unmanageable credit card debt, there are ways out. You could consider a consolidation loan, or even refinancing your credit card debt onto a new card with a zero-interest introductory offer. This could help pay off your high-interest debt without worrying about accruing more.
Cars (aka The Not-So-Bad Debt)
Have you ever heard that saying about how a car loses value the moment you drive it off the lot? Surprisingly enough, it’s true; every inch of road you travel makes the car less valuable than it was at the moment you purchased it! This is why they’re considered bad debt.
Although auto loans are bad debt by definition, they can also be considered a good debt for a couple of reasons. First, having a car means access to a reliable means of transportation, which could be critical in maintaining the career that funds your entire life. Secondly, since car loans are so common, many creditors don’t consider it as too high of a risk.
Because of their virtual necessity in the lives of many people (like those without access to mass transit), borrowing money for a car is essentially the bad idea that many of us make.
If you have to consider an auto loan, the smartest move you can make is to find a loan with the lowest interest rate available (remember, those rates can be determined by your credit score and other factors).
And when you do find an auto loan that works for you, never missing payments will keep this bad debt looking good.
Good Debt vs Bad Debt: What Should You Pay Off First?
It’s a smart move to pay off any debt as soon as you can. Generally speaking, taking on debt should be done cautiously, and you should avoid bad debt whenever possible. If you have high-interest loans like payday loans then those should probably be the focus. Since payday loans and other short-term options tend to carry high interest rates, it’s always best to start there.
Also, it’s important to remember that no matter what situation you are in, borrowing money is really neither good nor bad. Anyone could experience a change of employment and need a payday loan to cover the car payment or a couple of week’s worth of bills. Later on, that same person could find themselves looking to finance the purchase of their dream home or the creation of a new business.
Every debt comes with some form of risk to both the borrower and the lender. This means that taking on debt should involve a lot of research. Whether it’s good debt, bad debt, or any other financial obligation, what matters most is your complete understanding of those risks. In order to effectively manage your repayment schedule, it’s crucial that you develop a solid plan to stay on track to keep payments steady and on time.
With a focused effort, all debts can be handled. Even if you feel like you have too much debt. Setting up a budget that includes a plan for paying down debt will help you prioritize your spending and help you avoid repeating financial missteps. And knowing the difference between good debt vs bad debt will help as well.
No matter what kind of loan or credit you’re considering, it’s important to make your monthly payments, pay off your balance over time, and pay on time whether it’s good or bad debt. And now your knowledge of good debt vs bad debt can greatly improve your financial situation and make you a master of personal finance.
