For many of us, the word “debt” is terrifying. If you’re ”in debt”, it means you owe someone else something (generally money), which isn’t a pleasant feeling. It has become a way of life for the majority of people. We don’t enjoy paying interest yet saving enough money for major purchases like a home or a college education isn’t always achievable. In some circumstances, it isn’t even monetarily feasible.
So, if you’ll almost certainly be forced to take on debt at some time in your life, how can you know when it’s worthwhile? How do you know when the interest expense is justified by 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.
‘’Good” debt is defined as money owed for things that can help build wealth or increase income over time, such as student loans, mortgages or a business loan. “Bad” debt refers to things like credit cards or other consumer debt that do little to improve your financial outcome. These are oversimplifications. The distinctions between “good” and “bad” debt are a lot more nuanced.
Determining whether a debt is good or bad sometimes depends on an individual’s financial situation, including how much they can afford to lose.
There certainly also exists an argument that no debt is good debt. But borrowing money and taking on debt is the only way many people can afford to purchase important big-ticket items like a home. While those kinds of loans are usually justifiable and provide value to the person taking on the debt, there is another end of the spectrum that involves debt that’s taken on carelessly. While it’s easy to differentiate between these two extremes, some other debts are harder to judge.
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The #1 Debt Question
Whether you’re borrowing for a degree, a home, a car, or a new business, the end result for whether the debt you’re taking on is beneficial is this: Will this debt pay me back more than I put in?
It appears to be an easy question, yet it may necessitate some consideration. Is the loan still reasonable after considering principal repayment, interest payments, and alternate uses of that money? Is it true that you’re getting your money back in full and then some? Could you have done something more productive with your time and money?
This thought process will help you assess whether any debt is more burdensome than advantageous, and when you think about it, credit cards can be more advantageous debt than bad debt in some circumstances.
The idea is to consider what the debt does for you rather than what you do for the debt.
What is Good Debt?
Good debt is often said in market’s language as “it takes money to make money.” If the debt you take on helps you generate income and build your net worth, that can be considered positive and good debt has the potential to increase your net worth or enhance your life in an important way.
Good debt can help you lift yourself up
Buying a home, student loans or investing in a business expansion can be good debt. If a loan helps you make a personal or professional leap so you earn more, or lets you invest in something that may grow, it most likely is good debt as long as the underlying investment is sound. Even for good debt, shop around. Mortgages, lines of credit or loans can have variable interest rates and costs, and some products offer increased flexibility and potential tax benefits.
Examples of Good Debt
Here are some examples of how taking on debt could actually make you better off in the long run:
- Student loan: A lot of people point to student loans as a classic example of good debt.
Taking out a student loan to pay for college will assist you in graduating. Workers with a higher level of education are more likely to be employed in well-paying positions and have an easier time finding new ones if the need arises. Within a few years of entering the workforce, a college or technical degree can often pay for itself. However, not all degrees are created equal, so it’s vital to analyse both the short- and long-term possibilities for any subject of study that interests you, especially given the interest rate is minimal and you only have to repay the loan after you start making money.
Borrowing money was necessary because it made the college education possible — and college unlocked the ability to achieve additional financial goals.
Makes sense, right?
- Investing in your own business: A small business loan, which permits the borrower to establish or expand a firm, is another common example of good debt. It is typically both financially and psychologically satisfying to be your own boss. It can also be incredibly demanding. Starting a business, like paying for education, has risks. Many businesses fail, but your chances of success are higher if you choose an area in which you have a strong interest and knowledge.
As long as you have a solid and practical business strategy, a loan to assist you establish your own firm can be a good debt. If your firm succeeds, it will be worth significantly more than the amount you took out initially. Once again, the positive outcome — a successful, profitable enterprise that would justify the cost and risk of borrowing and would be termed “good debt.”
- Your home or other real estate: There are numerous methods to profit from real estate. On the residential front, the most straightforward approach is taking out a mortgage to purchase a property, living in it for a few decades, and then selling it for a profit. Meanwhile, you have the independence that comes with owning a house, as well as a variety of potential tax benefits that aren’t available to renters.
If you know what you’re doing, residential real estate can also be used to produce income by renting it out, and commercial real estate can be a source of cash flow and ultimately capital gain. Once the mortgage is paid off, the house will be a valuable financial asset that will likely appreciate in value over time, and the monthly mortgage payments may be less expensive than renting.
According to the good debt philosophy, the increase in your home’s value will justify the expense and risk of borrowing money.
What is Bad Debt?
It’s generally considered to be bad debt if you are borrowing to purchase a depreciating asset. In other words, if it won’t go up in value or generate income, you shouldn’t go into debt to buy it.
Bad debt involves borrowing money to purchase rapidly depreciating assets or only for the purpose of consumption.
Bad debt can weigh you down and hold you back
High interest, inflexible terms and no equity – the unholy trio for debt. When you use debt to buy things that will decrease in value, in general that’s a bad thing, you end up paying more for something than it’s worth, and it’s too easy to fall behind and get penalized.
Worst case: Using high-interest debt like credit cards for regular monthly expenses.
Shop around for credit cards, lines of credit or loans with the best terms possible. Some items, like cars or certain business equipment, cost more than most people or businesses have lying around in cash. These items will depreciate but are necessary. Maintain a high credit score by managing debt over time, and when these necessary expenses come up you’ll get better terms.
Examples of Bad Debt:
Here are some examples of things you should think seriously about getting into debt for-
- Cars: While you may find it impossible to live without a car, borrowing money to purchase one is not a good financial decision. The vehicle is already worth less than it was when you bought it when you leave the car lot. If you need money to buy a car, seek for a low-interest or no-interest loan. While you’ll still be investing a significant amount of money in a depreciating asset, at the very least you’ll be saving money.
- Clothes and consumables: Clothing is frequently stated to be worth less than half of what buyers spend for them. If you go to a used clothing store, you’ll notice that “half” is an exaggeration. Of course, you need clothes as well as food, furniture, and a variety of other items but using a high-interest credit card to acquire them isn’t a sensible use of debt. For convenience, use a credit card, but make sure you’ll be able pay off your full balance at the end of the month to avoid interest charges. Otherwise, try to pay cash.
- A luxury holiday you can’t afford: a luxury holiday can be a trip of a lifetime but is best avoided if it’s accompanied by a lifetime of debt. Instead of getting into debt, try and save up first, if necessary reworking your plans so you can still take a holiday, but one you can afford.
- Sometimes, bad debts are just good debts gone awry. Credit card debt is an example of this: Credit card debt is one of the worst kinds of debt because the annual percentage rates tend to be so high and because of their revolving balances. When you buy groceries, gifts, gas, clothes, books, and the like with a credit card, you’re simply putting off paying for your items and paying a huge amount of interest for this convenience. Credit cards do offer rewards like cash back on purchases, but your outgoing interest payments will likely dwarf your incoming rewards unless you always pay off the credit card’s balance each month.
Try to stay away from this kind of bad debt.
Not all debt can be classified as good or bad so easily. Often it depends on your own financial situation or other factors. Certain types of debt may be good for some people but bad for others:
- Borrowing to pay off debt: Taking out a debt consolidation loan from a bank or another reputable lender might be useful for consumers who are already in debt. Debt consolidation loans often have lower interest rates than most credit cards, allowing you to pay off previous obligations while also saving money on interest payments in the future. The trick is to make sure you use the money to pay off debts rather than for other purposes.
- Borrowing to invest: If you have a brokerage account, you may be able to open a margin account, which allows you to borrow money from the brokerage to buy assets. Buying on margin, as it’s known, can either make you money (if the security appreciates in value before you have to pay back the loan) or cost you money (if the security declines in value before you have to pay back the loan) (if the security loses value). Obviously, inexperienced investors or those who can’t afford to lose some money should avoid this type of borrowing.
THERE IS NO ‘GOOD DEBT’ GUARANTEE
Any kind of debt is or can become a liability.
To be “good debt,” the end result of the loan has to outweigh the costs of borrowing and unless you can see the future, you can’t know for sure whether this will be true when you borrow.
In short: No single kind of debt can guarantee its rewards will outweigh its risks.
I think we can agree most people get into debt out of necessity. In other words, most people wouldn’t take a student loan if they had the money set aside to pay for school.
CAN BAD DEBT EVER BE GOOD?
Arguably bad debt can help you manage your finances and achieve a positive outcome.
If you are disciplined and pay off your credit card debts at the end of the month you have used the credit card as positive way to manage your cash flow. This might enable you to keep your money sitting longer in a savings account, for example, where it may earn you interest. Credit card debt becomes bad when you purchase luxury goods that you cannot afford and begin to live beyond your means. This can result in high monthly interest payments accruing over time, which may become increasingly difficult to pay off.
SHOULD I TAKE ON NEW DEBT?
Taking on debt is a big decision. Before applying to borrow money, here are some questions to ask yourself.
- How much of a monthly payment can I afford?
- Will my repayments affect other financial goals like building an emergency fund, buying a home or saving for retirement?
- What happens if I can’t make the payments?
- How much total interest will I pay over the life of the loan?
- After paying off the debt, what’s the final outcome? Will it boost my earning power? Will I own a valuable asset like a home?
Choosing the Right Debt. 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.