Good Debt vs. Bad Debt

Debt– Its one of those things we all hate. It keeps most people up at night, makes us stressed and often pushed into uncomfortable positions to be able to pay it off. No one wants to be in debt. There is definitely a negative connotation that comes along with being in debt. When you look at your bills each month, you may feel overwhelmed by the amount of money that you’re spending on debt. Sometimes debt might seem like an endless trap that you can’t escape. In actuality, not all debt is bad.

When a lender looks at your credit report to see what kinds of accounts you have, they’ll look at some debts more favorably than others. If you’re focusing on getting out of debt, you first need to understand which debts are considered bad and which are considered good. That way, you can prioritize your debts so that you get rid of the bad ones first.

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Good Debt

Yes there is something that is considered good debt. Some of your debt might be considered an investment. If the debt is there to purchase something that will increase in value and can contribute to your overall financial health, then it’s possible that debt is considered good debt. Some examples of good debt are:

Student loans: Student loans allow you to get an education and increase your long-term earnings potential. People with a bachelor’s degree earn 66% more in their lifetime, on average, than those without a degree. And those who take on a small amount of debt to complete trade school also significantly increase their earnings potential, especially with today’s current shortage of tradespeople.

Mortgages: Mortgages are also generally viewed as a source of good debt. You have to live somewhere, and by taking on a mortgage, your living expenses build equity in an asset, instead of just going to a landlord. Also, it gives you the security and stability of owning your own home.

Small business loans: These loans can allow you to start or grow a profitable company to increase your future cash flow. And while not all new businesses are thriving, Small Business Association (SBA) loans do require you to create a comprehensive business plan – forcing business owners to consider both their goals and risks. If you want to get really, really rich, your chances are much better if you start your own company and work for yourself. Small business loans are tougher to get because they are riskier to the lender.

Almost one-third of small businesses fail to survive their first two years, according to the Small Business Administration. But if you have enough ambition, savvy and luck, borrowing money to start your own business could be the best investment you’ll ever make.

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Good debt can also be about long-term arbitrage. The long-term returns of the stock market have historically outpaced today’s low mortgage interest rates. So, even if you could pay cash for a home, your financial future might be brighter if you left that money invested.

Student loans, mortgages, and small business loans are the most common forms of good debt. But even good debt has its risks.

When we take on good debt, we’re making assumptions about the future based on our own goals and typical results in the past. But there are no guarantees. A college degree doesn’t guarantee a great job after graduation; taking on more mortgage than you can afford can make it difficult to save for the future; and yes, new businesses can fail.

Before taking on any debt, it is always smart to carefully consider what return you expect to get. How do you expect life to look after taking on this good debt? And where could things go wrong?

For example, understanding what your student loan payments would be upon graduation allows you to determine whether entry-level jobs in your chosen field could comfortably cover those payments, or if you would be better off in a different major or pursuing a lower-cost education. A good rule of thumb is to limit your borrowing to 1.5 times your expected first year salary.

Similarly, nearly 40 million households  in the U.S. are “house poor”– meaning they own a home they can’t easily afford. Their high mortgage and property tax payments make it hard to cover other expenses, save for emergencies, or invest for the future.

Too much of a good thing is bad. And that is indeed the case with debt. Just because it can be good, doesn’t mean it is for you. Whenever taking on debt, be sure to think through how it will impact your life and how you can pay it off

Bad Debt

When you use debt to finance things that can be consumed, you’re taking on bad debt. It is the kind of debt that creates an unhealthy financial situation. Some examples of bad debt are:

Payday loans: The most prominent example of bad debt is payday loans. These are usually small-dollar loans, under $500, that are due at your next payday. Fees are significant, typically ranging to $10 to $30 for every $100 borrowed. That can mean an annual percentage rate of just under 400%. This is some of the most expensive debt in the U.S., which is why some states regulate or prohibit these loans.

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Credit cards: While the APR for credit cards pales in comparison to payday loans, the 12% to 30% rates are nothing to scoff at. Credit card debt, especially when taken on for nonessential purchases, is undoubtedly bad debt. Making only minimum payments with a 22% APR credit card, $500 in credit card debt would take over four years and almost $280 in interest to pay off.

 Credit card debt is often considered bad debt because of the nature of items that credit cards are used to purchase. You should never use debt to purchase everyday items like clothes or food. If you use a credit card for these types of purchases, it should be intentional, e.g., for better financial management or to earn rewards. You should pay the balance in full each month

Auto loans: You may need a car to get to work, but the type of car you choose to buy can make an auto loan a grey area for debt –- or straight up bad debt. New cars depreciate as soon as you drive them off the lot, which could result in being underwater on your loan. And paying interest for years on an asset that is continually falling in value is harmful for your financial future. If you can’t afford to pay cash for your car, choose well maintained used vehicles that won’t see the same decline in value as their new counterparts

Credit card debt is often considered bad debt because of the nature of items that credit cards are used to purchase. You should never use debt to purchase everyday items like clothes or food. If you use a credit card for these types of purchases, it should be intentional, e.g., for better financial management or to earn rewards. You should pay the balance in full each month.

Even debt used to finance a vacation is bad debt. Also though it might help you feel better and be more productive once you return, a vacation does not appreciate in value. Don’t use debt to pay for a vacation and especially don’t use it to pay for a vacation you can’t afford.

Making Wise Choices

Good debt is obtained by making wise decisions about your future, not for the sole purpose of having good debt. For example, you might make the decision to obtain your Master’s degree to increase your earning potential. Taking out a student loan, if you have no other way of financing your education, is a valid reason for taking on additional debt. Furthering your education is almost a guaranteed way to find a better career once finished and therefore amore solid income stream.

Let’s say you’re analyzing your financial picture, trying to decide how to pay off your debts. It’s usually a good idea to focus on paying off your bad debts first. Since they provide no value, they’re more costly than your good debts. You definitely should pay off credit cards and auto loans before tackling mortgages or student loans.​

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Some people consider using good debt to pay off bad debt, like getting a mortgage for $110,000 instead of $100,000 and using the extra to pay off credit card balances. It isn’t a good idea for several reasons. First, repaying debt with debt is never a good idea. Second, it ends up taking longer to pay off the mortgage than it would have otherwise. Third, the higher mortgage increases your monthly payments, and the time it takes to build equity in your home. Use cash to repay debts, not more debt.

You must still be careful that you don’t take on too much debt, even if it’s good debt. If you’re overloaded with debt, then it doesn’t matter whether the debt is good or bad, it still hurts your financial health.

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For most people, debt is a part of life. None of us like making those interest payments, but saving enough cash for really big purchases – say, a home or college education – isn’t always possible. And in some cases, it isn’t financially smart.

So, if you’ll probably have to take on debt at some point in your life, how can you tell when it’s worth it? How do you know when the cost of interest is worth the benefits? Well, good debt benefits your financial future, while bad debt harms it. And luckily, what you’re buying often makes that distinction clear.

By always being conscious of the type and purpose of the debt you’re taking on, you’re protecting your future self. The right amount of good debt can increase your ability to save for the future, build wealth, and responsibly afford the things you want in life, without bad debt.

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