Debt is a double-edged sword. It’s used for many good things, like home buying and student loans for college education. However, getting into too much debt can be very stressful and lead to a host of mental health issues like depression and anxiety.
Sometimes borrowing money is necessary, but there are times when you should stay away from taking on debt. To help you make informed financial decisions, we’ll discuss what separates good debt from bad debt.
Good Debt vs. Bad Debt
The key to understanding the difference between good and bad debt lies in the impact that debt has on your overall financial health and future prospects. While the term ‘debt’ often carries a negative connotation, not all forms of debt are detrimental.
Isn’t all debt bad?
It may surprise you, but not all debt is “bad.” Debt is really only “bad” when it’s unnecessary or avoidable. The mentality of ‘keeping up with the Joneses’ or ‘only the best will do’ can lead us into bad debt.
But, certain debt can give you a great rate of return (like a house) or help you invest in yourself (like college), offering various benefits. Either way, it’s essential to be aware of both good debt and bad 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 an indirect investment that increases your chances of success in the future. You educate yourself and gain knowledge that you need to get better jobs or climb the corporate ladder.
Many people see a return on their investment within a few years, but it depends on the industry. Before you invest in a college or secondary education, do your research. Check out average salaries in the industry you wish to enter. Is there room for advancement? Where do most people ‘top out’?
Student loan debt can either be good debt or bad debt depending on how much potential someone with the degree you seek has.
Starting a Business
It takes money to make money, and there’s no better way to show that than starting a business. The majority of businesses can’t be started without money, and sometimes it’s a lot of money. You can use a loan to get your business off the ground and help it grow even more.
Starting a business has risks, just like any other investment. Research your industry and see what other businesses have done that worked or failed for them. Analyze the risk of investing in your own business and determine if borrowing money is a smart choice.
As you borrow, keep in mind the high-interest loans which could include payday loans or unsecured personal loans. This can be considered bad debt because the high-interest payments can be difficult for the borrower to repay and often puts them in a difficult financial situation.
It is also important to understand the cost of your debt. It is typically denoted as an annual percentage rate (APR). The interest rate is the percentage of the principal (i.e., the amount loaned) that the lender charges the borrower for the use of their money.
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?
Most people assume that all debt is bad, but its true definition is debt that finances a depreciating asset. Above, we compared good debt vs. bad debt and showcased appreciating assets, whereas bad debt invests in assets with no chance of appreciation.
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 may feel like a necessity, and it can be, but you shouldn’t borrow money to buy them. Clothes are often overpriced and they don’t appreciate, so you end up paying more than they’re worth. Check out overstock sales or second-hand stores. Most clothing items sell for a fraction of what they sell for in retail stores.
Even buying food, household goods, and other consumer items is bad debt if you borrow money to buy them. If you use a credit card because it’s easier or safer, that’s one thing. But if you don’t pay the credit card balance off in full each month as if you paid cash, it’s bad debt. It’s a hard cycle to get out of, too.
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 from time to time, 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?
Not all debts can always be categorized into good versus bad. Some are a mix, and it depends on the exact 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 like this can be profitable, it’s not a sure thing. In the event that the investment fails, you’ll lose more than you borrowed, and you’ll have bad debt.
But, if your investment performs well and makes money after paying back the margin, then borrowing to invest was good debt.
Final Thoughts
It is important to distinguish between good and bad debt. Almost everyone has some kind of consumer debt, whether it’s a mortgage, credit card, or auto loan. Using debt appropriately, paying it off fast, and buying appreciating assets is the best way to use it.
It’s critical to make monthly payments on time and in full to improve your credit score. Keep your financial goals on track by avoiding debt with high interest rates. Additionally, managing debt and understanding what terms to look for are key to financial success.
