What is Good Debt vs Bad Debt?
You might think that all debts are the same, that debt is debt, and no matter how little you might have, it’s all bad for you. Though your financial health has a direct connection to your relationship with debt, not all debts are the same.
Some debts may have a positive effect on your overall financial well-being. So, what is good debt vs bad debt?
High interest revolving debt, like credit cards and credit lines, is a burden on your financial well-being and is often associated with assets (things you own) that don’t add to your net worth (how much money and assets you have).
They increase your debt ratio (the ratio of total debts to assets) and can rob you of the opportunity to make critical investments, like purchasing a home.
Other debts, like mortgages and business loans, are investments that not only add to your quality of life but allow you to increase your net worth. These are the quality debts borrowers should focus on pursuing.
Not every debt is bad, especially if it increases your wealth. Borrowing at a low-interest rate to invest at a higher rate of return can be a smart use of a good credit score.
As are mortgages, since they have a relatively low-interest rate, and the value of the asset will increase exponentially over the 25+ years, resulting in a very high rate of return.
Taking out a home equity loan (a loan on your house) can be an excellent way to pay off any high-interest debts, as they charge a lower interest rate.
Rolling them into your mortgage at a much lower rate not only decreases your monthly carrying costs but also puts more money back in your pocket, as does using the funds to reinvest through home improvements and energy-saving upgrades. Both of which increase the value of the home and the owner’s equity.
Another smart way to borrow is to mortgage a property you are renting to others. The renters are paying your mortgage monthly, so the property increase consistently adds to your net worth.
Other quality debts include borrowing to invest in your future economic welfare, like acquiring a college loan or funds to invest in your business.
Debts That Are Burdens
Auto loans are a poor financial investment. The asset, even when new, devalues so quickly that you end up owing more for the vehicle than it is worth the moment you drive it off the lot. Instead, it is better to save the total purchase price, purchase a pre-owned car, or lease a new one.
Using your credit cards to purchase clothing and other consumable items is fine if you pay off the balance each month. Otherwise, this is a poor use of credit. Paying cash for these items means you are not overpaying for a thing you may only have for less than a year.
The worst type of debt is payday loans. The interest rates are incredibly high and have added penalties if you miss a payment. Borrowers often get caught in a financially dangerous cycle of paying off the loan, only to need it again the next month.
Should I go Into Debt?
The main point of the story is that not all debt is bad debt. If you can responsibly use debt to make financially sound investments or purchase something that will increase your quality of life but not put the burden on you, it may make sense to go into debt.
Some of the factors to consider prior to going into debt are: Why are you going into debt? How much will that debt cost you? Will this debt earn you money over the long term? Will this debt save you money? And how long will this debt take to pay off?
When considering what is good debt vs bad debt, if you give honest answers to these questions and find them to make sense for your situation, perhaps your debt is not a bad one.
That trip to Fiji that you’ve always dreamed of? We’ll leave that decision up to you, but evaluate what it’s worth to you and how much it will cost you by the time the debt is paid off.
For the sake of finances, it’s usually a better idea to save the money first than take the trip of a lifetime.
If you’d like to read more about ways to use debt positively, check us out along with other resources on Feedspot’s Millenial Money Blogs. This list will get you some great content.
By: Robert Puharich | November 2, 2021 |