Good Debt vs. Bad Debt
How many of you didn’t know there was such a thing as good debt? If you’re like many of us, you’ve been taught your whole life that debt was bad and you automatically equate it to something negative. But, that’s not entirely true.
Some debt is a good thing. Let me explain. When you look at your credit history, it actually a report of how well you handle debt and that history is a factor in you getting approved to take out loans for things like cars and homes.
But how many Americans are living with more bad debt than good debt? Mortgage debt far outweighs any other kind of debt for Americans, however, 75% of adults carry a credit card balance from month to month. And consumer debt grew by 6% in 2020 and continued to grow during the pandemic, and that was before inflation began.
Some people take out debt or loans to build their credit, but I encourage you to know the difference in good and bad debt before you do this so you will know how it can affect your finances.
A good general rule for good credit is something that increases your net worth, is an income generating tool or has future value. Those things are good debt.
Most likely if it doesn’t meet this criteria and especially if you are buying something because you don’t have the cash to pay for it, then it’s probably going to be bad debt.
First, let’s talk about examples of GOOD DEBT.
1. Student loans
Your education is absolutely an investment in your future and taking out a loan to pay for it is very common.
Student loans are the number 2 kind of debt for Americans.
The cost of going to school has recently been on the rise, but there are several reasons student loans are considered good debt:
o Some federal loans may be subsidized
o Student loans generally have lower interest rates
o The interest is tax-deductible
o Most come with a variety of repayment plans
These loans can turn into bad debt if you don’t make the payments though! So, make your payments as soon as you can and make them on time.
NOTE: Taking out a student loan to buy things like cars and pay for vacations is a bad idea. Loans should not be a form of income. It can take years to pay off a student loan AND the part many don’t realize is if you ever default on a student loan, it will never leave your credit report.
2. Small Business Expense Loans
Starting your own business is great investment in your future. Especially if your business grows and is successful.
Starting a business comes with many costs. And sometimes you have to get creative to pay for it all and that may include a loan.
Here are just a few things that you will need to consider to open your business:
o Getting an inventory of your products
o Any Equipment you need
o The furniture, supplies and tech you need to get an office set up, not to mention rent on office space
o There will also be Taxes
o Any Certifications or accreditations that are needed may have fees with them
o Hiring Staffing
o Marketing to grow the business
Businesses can be tricky and one-third fail in their first two years. Hence a business loan can be a big risk to a lender. Be prepared with a good plan before you go in for the loan. You may also consider looking for personal investors before a loan.
3. Mortgage Loans and Real Estate Investments
A home mortgage is always good debt. Generally a home will retain its value over time or even increase in value. You can also make money with real estate by buying a home, living there for a time, then selling it for a profit. You could also rent the home for income.
There are even tax benefits for home owners.
Commercial real estate can be a source of income as well, but it’s a little trickier.
Just like your student loan, don’t let your mortgage turn into bad debt by getting behind on payments. Also make sure you are taking care of the property so it doesn’t depreciate in value.
Now let’s get into bad debt which is probably a little easier to recognize. These are debts that take away from your net worth. Often, they will lose value immediately, or at the very least over time and they don’t contribute to your income in any way. I bet you already guessed that they often have high interest rates attached which costs you more. Another unfortunate thing is, we are talking about many of the things we use in our daily lives like clothes, cars, and electronics.
BAD DEBT
The truth is, some bad debt it truly unavoidable but if you know how to recognize it, then you can decide if it’s worth it or a best-case scenario that limit your loss.
1. Credit Card Debt
It’s the most common type of bad debt. Having a credit card is not necessarily the bad thing. They can be a great way to build credit, and if you are disciplined in your usage, they are a great tool. Unfortunately, that’s really not how many people handle theirs. Many cards come with a high interest rate, and spending on a card can get out of hand quickly.
So if you have a credit card, use it carefully and not for purchases you can’t afford.
2. Auto Loans
Even though buying a car is often necessary and it may seem worthwhile, an auto loan is actually bad debt. The main reason, the value of a car depreciates over time. In fact, the value drops 20% almost immediately when you leave the car lot.
What causes your car to depreciate?
o Mileage
o Number of owners
o Service history
o Fuel economy
o Length of warranty
o General changes in condition
Now, if you are buying a car that’s considered a collectible and therefore that would be considered an investment.
One other thing. With the depreciation any interest you’ve paid over the term of the loan is basically eaten up. You can help yourself by making as large a down payment as you can. it not only helps how much you have to finance for the loan, it could help you get a lower interest rate on your loan.
3. Personal Loans
For a personal loan, it really depends what you are using it for if it’s considered good or bad. Like credit cards, personal loans can push you deep into debt quickly if you aren’t careful.
The interest rate on a personal loan can vary widely. They can be as low as 5% interest or as high as 36%. These are installment loans which means they are paid monthly and the term will probably be anywhere from 2-5 years.
Personal loans can be used for a variety of reasons, like:
a. Consolidating debts
b. Making investments
c. Purchasing big-ticket items
d. Travel
e. Emergencies
Sometimes things can feel like an emergency and feel like the only option and that is understandable but it’s best not to make loans like this a habit.
Using a personal loan instead of a business loan because perhaps you couldn’t qualify is considered good debt. Remember what we said before, this is an investment in your future income if it is for business.
Another example of it being good debt is if the loan is for debt consolidation. This allows you to create a more manageable monthly payment and the result is a pay off of other debts.
Less debt is always better. If you can use a personal loan as an option to pay off debt and then use discipline moving forward so that you don’t accumulate debt again, then it is truly a good move.
4. Payday Loans
These are worse than credit card debt and generally used in a time of crisis. They are short term, unsecured loans that can have extremely high interest rates. Some as high as 400%!
Of course, there are service and late fees as well, which encourages borrowers to pay back the loan quickly. And missing your due date can create even more debt. We see it all the time. People take these loans out, then take another one out because they are behind on the first one and before you know it you are in a cycle of debt. If you find yourself in a crisis, this type of loan should be an absolute last resort. Please consider your other options first.
Don’t want you to get discouraged! Good debt can have a positive impact on your finances and your credit report.
Bad debts can be delt with. There are many options to get out from under your bad debt and get you into a better financial situation. No matter what your situation, there are always answers and solutions. We are always available at First Pioneers FCU to help you create a plan to get you moving in a better direction.