Debt. This little word often gets a bad rep. But what if I told you not all debt is bad? In fact, good debt can benefit your financial future.
What Is Debt?
Debt, as we’ll be referring to it, is simply money owed by one party to another party.
What is Good Debt?
Good debt is any debt that benefits your financial future. But, there are no guarantees in life, so any “good debt” you assume is based on assumptions about the future. Based on historical data and market trends, we can assume certain types of debt are good debt because we know that over time, the borrower’s finances will improve as a result of incurring the debt.
Here are three types of debt commonly regarded as good debt:
When you borrow money to purchase property you are building equity. CoreLogic’s fourth-quarter Homeowner Equity Report showed homeowners gained an average of $55,300 per borrower in 2021.
But be careful not to overextend yourself. If your mortgage and property tax payments make it hard for you to cover other expenses and save money over time, this good debt turns into bad debt because it’s no longer benefiting your financial future.
2. Student Loans
The common belief is that financing your education will eventually allow you to earn more money in the future.
However, similar to a mortgage, you must be mindful of how much debt you’re taking on in the form of student loans. Forbes Advisor reports, “A good rule of thumb is to limit your borrowing to 1.5 times your expected first-year salary.”
3. Small Business Loans
A small business loan is another example of investing in your future. This type of debt can help you start or grow a profitable business leading to considerable financial gain in the future.
You should consider when you’re likely to see a return on this investment and how certain are you of the returns. All of these unknowns can quickly switch good debt to bad debt so carefully evaluate your current and your projected financial situation before taking on a small business loan.
What is Bad Debt?
Any debt that comes with a high-interest rate or does not help to improve your financial future will likely be considered bad debt. Why? Well, a higher interest rate is costlier and signifies a lack of trust in the investment on the part of the lender.
Here are three of the most common sources of bad debt:
1. Payday Loans
These short-term loans are offered in small amounts and they usually come with a very high-interest rate. In addition to a high-interest rate, many payday loans also come with considerable fees.
These high rates and fees combined with the short terms make these loans very hard to repay. The result is an endless cycle of ever-increasing debt. If you find yourself unable to repay the loan, it will go to collections which will affect your credit.
These loans are so problematic that some states have banned them entirely.
2. Credit Card Debt
Credit cards themselves are not bad. However, not paying your balance in full and incurring credit card debt is typically a bad idea.
Credit card debt is one of the most expensive forms of debt. Interest rates for credit cards can land above 20%, that’s more than double the average interest rate for good forms of debt like mortgages or student loans.
More importantly perhaps, is that credit card debt doesn’t represent an investment. By incurring credit card debt you aren’t improving your financial future, in fact, you may be irreparably damaging it.
3. Auto Loans
Unlike homes, over time, cars lose their value. Ramsey Solutions reports that after 5 years a new car loses 60% of its value. Simply driving a new car off the lot causes it to depreciate by around $3,000.
When you understand depreciation, it’s clear why a long-term loan for a rapidly decreasing item doesn’t make sense. The average length of a car loan is 72 months. If you factor in the interest rate and depreciation you’re likely to be upside down on your investment by the time it’s paid off.
For most of us, debt is inevitable. But it doesn't have to be bad. Using debt to invest in your future is a great way to secure your long-term financial success.