Ahh debt! It’s something we all try to avoid and end up with anyway. But did you know there’s such a thing as bad debt and good debt? Taking on good debt could help you build generational wealth. While bad debt can end up costing you more for things that won’t bring you any value or wealth.
Let’s explore the difference between the two types of debt, examples of each and how you can apply your new knowledge to build a fitter financial future.
What’s Considered Good Debt?
Good debt is defined as money you owe that will build your net worth or increase your income. Examples of good debt are mortgages, student loans and small business loans.
Each requires planning to achieve a positive outcome. Good debt isn’t something you create when you take out a loan. You have to make sure you can afford the monthly payments, you don’t exceed a healthy debt-to-income ratio and loan payments are paid on time so you get the long-term benefits.
Buying a home is a major milestone. It requires establishing a good credit score, saving for a down payment and building up finances to afford the home. It’s a lot of work that can offer big benefits.
Homes typically appreciate, or gain value for the borrower. In fact, when homes gain enough value, homeowners can access funds like home equity loans to improve their home, pay off debt or use on anything they want.
However, homeownership comes with risks, too. Specifically, you risk losing your home, all the money you’ve paid into your mortgage and any money you invested in the property if you default. Planning ahead and determining how much house you can afford is the best way to ensure this type of debt stays on the good side.
Everyone’s financial situation is different. For many families, the only way to access a college degree is by borrowing student loans.
The student loan system helps people access an education, but it comes with capitalizing interest that starts accumulating the moment you take out the loan.
Because of this, borrowers should try to plan ahead by picking a degree with an earning potential to help them pay off the loan amount within a standard 10-year repayment period.
For example, if you get a degree in education and first-year teachers make $40,000, you shouldn’t take out more than $40,000 in student loan debt. The idea is that as you make more money, you’ll be able to pay down the loan without cutting into too much of your income.
Small business loan
Student loans are considered good debt because it’s an investment in future profits from a job. The same reasoning applies to small business loans. You’re taking out the loan to build profit for your business and yourself as the owner.
Just like with student loans, there are risks associated with owning a business and paying off the loan.
What Is Bad Debt?
Basically, anything that’s considered “consumer debt” is bad debt. Examples of bad debt are credit cards, personal loans, payday loans and auto loans.
Paying interest to build a business or gain a marketable skill is one thing. Paying interest on consumables or taking out a loan for your vacation are not great ways to build wealth.
High-interest credit cards
It’s so easy to spend with a card swipe. But credit cards often come with high interest rates that burden your budget and financial future.
Let’s say you buy some new patio furniture and spend $1,800 on your credit card, which has an interest rate of 16%, plus fees. Assuming you only make the minimum payment of $65 a month, the new table and chair set will cost you $2,261.42 – or $461.42 more than you paid for it – and will take 35 months to pay off. That’s assuming you don’t use the card for anything else.
That’s a lot of interest for something that won’t hold its value, which puts it in the bad debt category. Plus, it can hurt your credit score by increasing your credit utilization ratio if you’re carrying a credit card balance each month.
The best way to stay financially fit is to save for that big purchase instead of putting it on credit. And if you do spend with your credit card, plan to pay off more than the minimum balance each month.
Personal loans for consumer spending
Just like credit card debt, personal loans come with interest rates, turning what you bought into a more expensive item which depreciates and won’t give you a return on the investment. Lenders base interest on your credit score, but the interest rate for most loans range around 10% and can go as high as some credit cards.
Though personal loans have lower interest rates, the amount borrowed tends to be higher for things like loans for weddings or vacations.
Again, the best way to avoid tacking interest onto your expenses is to save in advance and avoid borrowing if you don’t have to.
We’re just going to come out and say it: payday loans are not the best option to pay for anything. Before going this route, consider other finance options. Payday loans often come with high interest rates and other tactics so you can never pay it off.
Payday loans are considered bad debt for this reason.
Although most people need reliable transportation, loans for vehicles are considered bad debt since cars depreciate in value so quickly. Once you drive it off the lot, the car has lost value.
Saving for a larger down payment and finding a loan with a lower interest rate can help you avoid paying unnecessary interest on a depreciating asset.
Borrowing To Pay Off Large Debt
Borrowing money to pay off larger debt balances and reduce overall payments doesn’t necessarily fall into the good or bad debt category. The goal here is to, at the very least, make bad debt less bad. If you own a home and have enough equity, you can do this by borrowing against your home’s equity using a HELOC or home equity loan.
Debt consolidation loans or high balance transfers are another great way to pay down bad debt and reduce monthly payments. However, this still isn’t creating long-term value like a business, education or home can.
Good Debt Benefits Future You
How you handle debt will ultimately determine if it’s good or bad for your financial health. But some debts – like payday loans, credit cards and auto loans – land in the bad debt category because they don’t bring any return on the investment.
When looking at debt, the best question to ask is whether it will eventually bring in money or depreciate. If it won’t appreciate, it’s a bad debt and will only lose value. So think twice before you take it on.
National Credit Union Administration. “Credit Union and Bank Rates 2022 Q3.” Retrieved January 2023 from https://www.ncua.gov/analysis/cuso-economic-data/credit-union-bank-rates/credit-union-and-bank-rates-2022-q3