Debt can be both beneficial and harmful. It can help you buy a home, pursue higher education, or start a business. However, excessive debt can lead to financial stress and mental health issues like depression and anxiety. This article will help you distinguish between good and bad debt to make informed financial decisions.
Key Takeaways
- Good debt helps improve your financial future by investing in appreciating assets or enhancing your earning potential, such as through education, real estate, or starting a business.
- Bad debt finances depreciating assets or unnecessary luxuries, such as cars, clothes, and other consumer goods, leading to financial strain due to high-interest rates and reduced value over time.
- Some debts fall into a gray area and can be beneficial or detrimental depending on how they are managed, such as consolidating high-interest debt into a lower-interest loan or borrowing to invest with calculated risk.
Good Debt vs. Bad Debt
Good debt typically involves borrowing for investments that grow in value or generate income over time, like education or real estate. Bad debt usually involves borrowing for depreciating assets or unnecessary expenses, like luxury items or cars. However, accumulating too much debt, even if it starts as good debt, can become a problem if your monthly debt payments become unmanageable.
Isn’t all debt bad?
Not all debt is bad. Debt becomes problematic when it’s unnecessary or avoidable. The mindset of trying to ‘keep up with the Joneses’ or believing ‘only the best will do’ can lead to unwise borrowing.
However, some types of debt can provide significant benefits, such as financing a home or investing in education. These types of debt can offer a good return on investment and help you improve your financial situation. It’s crucial to understand the difference between beneficial and harmful debt.
What is good debt?
Good debt is debt that helps you make money or have a home to live in. It could be beneficial In a literal sense (a return on investment) or figuratively (enhancing your skills and earning potential). Either way, good debt allows you to invest in yourself and your future.
Here are a few examples of good debt.
Education
Investing in your education is a strategic move that can enhance your future success. By gaining knowledge and skills, you increase your chances of securing better jobs and advancing in your career.
Many people experience a return on their educational investment within a few years, though this varies by industry. Before committing to a college or secondary education, thoroughly research the field you wish to enter. Consider average salaries, potential for career advancement, and typical career ceilings.
The value of student loan debt hinges on the earning potential associated with the degree you pursue. Make informed decisions to ensure your educational investment pays off.
Starting a Business
It takes money to make money, and starting a business is a prime example of this principle. Most businesses require an initial investment, and often it’s substantial. You can use a loan to launch your business and facilitate its growth.
Starting a business involves risks, just like any other investment. Conduct thorough research on your industry to understand what strategies have succeeded or failed for others. Evaluate the risks and decide if taking out a loan is a wise choice for your situation.
Be cautious of high-interest loans, such as payday loans or unsecured personal loans, as they can lead to financial strain due to their high repayment costs. It’s important to know how much you’re borrowing. Loans come with an annual percentage rate (APR), which represents the interest rate as a percentage of the principal amount borrowed. This rate determines how much you will pay for the borrowed money over time.
Real Estate
A great example of good debt vs. bad debt is real estate because you’ll see a return on your investment directly. Borrowing money to invest in real estate earns you equity in the property. Equity is the difference between the property’s value and how much you owe in debt.
Typically, real estate appreciates, but there’s always the risk of losing value, such as what occurred during the 2008 housing crisis. As long as you pay down your mortgage as planned or even ahead of schedule, you’ll build equity faster.
Investing in real estate can be for personal use, such as a primary residence, or for investment purposes, such as commercial or rental properties.
Like any investment, do your research and make sure you’re making a good choice before taking on real estate debt. Investing in an area where the property values don’t appreciate or buying a rental home in an area that isn’t rented often can lead to bad real estate debt.
What is bad debt?
People tend to assume that all debt is bad, but bad debt specifically refers to debt used to finance depreciating assets. Unlike investments in appreciating assets, this type of debt involves spending on items that lose value over time.
Here are a few examples of bad debt:
Cars
You need a car to get from Point A to Point B. That’s a given. However, you don’t need a luxury car or a car you can’t afford to pay for without financing. It’s best to pay cash for a car if you can because it’s a depreciating asset.
When you borrow money to buy a car, you pay interest on the loan and lose money on the value of the car. Most cars lose 20% of their value during the first year after you drive them off the lot.
When you don’t have the money to buy a car outright or your money isn’t enough to buy a reliable car, look for the best financing terms. Many manufacturers offer low interest rates or 0% APR for borrowers with great credit.
If you anticipate buying a car soon, it’s time to work on your credit before taking out a car loan to get the best deal. Auto loans require you to factor in different things before taking them.
Clothes and Other Necessities
Buying clothes is a necessity, but borrowing money for them is not advisable. Clothes often have inflated prices and do not increase in value, meaning you pay more than their actual worth. Consider shopping at overstock sales or second-hand stores, where items are often much cheaper than in retail stores.
Borrowing money for everyday expenses like food, household goods, and other consumer items is also not a wise financial decision. Using a credit card for convenience is fine, but it’s important to pay off the balance in full each month. Failing to do so can lead to accumulating high-interest debt, making it difficult to escape the debt cycle.
Luxury
You should not borrow money to purchase luxury items. Why not? Just look at the name—luxury. You don’t ‘need’ these items, but you buy them anyway.
There’s nothing wrong with spoiling yourself occasionally, but not at the expense of your future. Rather than racking up credit card debt to buy luxurious items, determine what you want and save for it. Set a timeline and divide the amount you’ll need by the number of months until you potentially buy it. Save that amount of money each month, and you should reach your goal within your desired timeline.
Yes, this requires a great deal of patience. But, when you purchase luxury items with debt, you rack up interest charges and end up paying much more for them than they’re worth.
What debts fall in the gray area?
Some debts don’t fit neatly into ‘good’ or ‘bad’ categories and depend on the circumstances. Here are a couple of examples.
Borrowing to Pay Off Debt
Paying off high-interest credit card debt with a low-interest loan can be a good idea, but here’s when it becomes a bad debt. If you consolidate your debt into a 0% or low-interest rate loan but do not allocate the “extra” money saved towards your debt, you’ll end up in the same situation.
The key is to pay the same amount of money to the debt but with a lower set monthly payment and interest rate. More of your payment will go towards the loan’s principal, paying it down faster. This means you’ll pay less interest over the life of the loan and have more money in your pocket in the future.
If you continue to make the minimum payments using your “saved” money, then it’s a bad debt, as it won’t benefit you.
Borrowing to Invest
Investing on margin may be possible for experienced investors with the right credentials. While leveraging in this way can be profitable, it’s not guaranteed. If the investment fails, you’ll lose more than you borrowed, resulting in significant debt.
However, if your investment performs well and generates profit after repaying the margin, then borrowing to invest can be considered a successful financial strategy.
Final Thoughts
Recognize the difference between good and bad debt. Use debt wisely by investing in appreciating assets, making timely payments, and avoiding high-interest loans. Develop a financial plan to manage debt and achieve your goals.
Managing debt wisely is essential for financial success. Prioritize timely payments, avoid high-interest loans, and focus on investments that enhance your financial health. By understanding and differentiating between good and bad debt, you can make informed decisions and achieve your financial goals.
Frequently Asked Questions
How can I determine if my education loan is good debt?
Education loans can be considered good debt if they lead to a degree or certification that significantly enhances your earning potential. Before taking out a loan, research the average salaries in your chosen field and the employment rates for graduates. If the potential income increase outweighs the cost of the loan, it can be considered good debt.
Are there any strategies for managing bad debt?
Yes, there are several strategies to manage bad debt. These include creating a budget to track and limit spending, consolidating high-interest debts into a lower-interest loan, prioritizing paying off high-interest debt first, and avoiding accumulating additional debt by making smarter spending choices.
What are some warning signs that my debt is becoming unmanageable?
Warning signs that debt is becoming unmanageable include missing payments, using one credit card to pay off another, maxing out credit cards, being unable to save money, and experiencing stress or anxiety about finances. If you notice these signs, it might be time to seek financial advice or consider debt counseling.
Can consolidating debt improve my credit score?
Consolidating debt can improve your credit score if it helps you make timely payments and reduces your overall credit utilization ratio. However, it’s essential to avoid accumulating new debt and to use the consolidation loan responsibly by sticking to a repayment plan.
Is it ever a good idea to borrow money for luxury items?
Borrowing money for luxury items is generally not advisable as it leads to bad debt. Luxury items do not appreciate in value and often result in high-interest payments if financed through credit cards or loans. It’s better to save up for luxury purchases and pay in cash to avoid unnecessary debt and interest charges.
How can I ensure that borrowing to start a business is good debt?
To ensure that borrowing to start a business is good debt, conduct thorough market research, create a detailed business plan, and have a clear understanding of your industry. Assess the potential return on investment and ensure that you can make loan payments without compromising your financial stability. Consider seeking advice from financial advisors or mentors in your industry.
What steps can I take to avoid falling into bad debt?
To avoid falling into bad debt, create and stick to a budget, live within your means, save for purchases instead of using credit, and avoid high-interest loans. Additionally, focus on building an emergency fund to cover unexpected expenses and regularly review your financial situation to make adjustments as needed.
