Good Debt Can Turn an Enemy into a Friend
If you think about debt, there can be an argument made that no debt is actually good debt. However, borrowing money and taking on some debt is usually the only way people can afford to purchase some expensive items, such as cars and homes. These loans are usually justified since they bring value to you. There is also another end of the spectrum that involves taking on debt that is considered careless spending, such as credit card debt. It can be easy to differentiate between two extremes but trying to determine between bad and good debt usually requires a deeper analysis.
What Is Good Debt and How It Can Help You
Good debt is considered debt that has the potential to increase your net worth. Good debt can allow you to manage your finances effectively, help you leverage your wealth, and buy things you need to handle some unforeseen emergencies. Good debt can be seen as an investment, just like a bond or stock.
It means you are spending money now with the expectation that you will be getting your money back in the future and even making a profit on top of it. Since you are spreading the payments out over months or years, you are able to buy what you are financing right away instead of having to save up enough money to buy it in the future. Good debt will usually have a low interest rate in the single digits. It’s important to remember that even with good debt, there is no guarantee of a return on investment. You may end up getting bad grades in college and never end up with the six-figure job. You may not get the promotion at work, despite your higher education. You could lose money on your home or a small business you founded could go under. This is going to be unique to every situation.
Examples of Good Debt
There are plenty of examples of good debt and some financial experts will argue that there are reasons to go into debt.
College or Technical Education
The more education you have, the greater your earning potential, and education has a positive correlation with being able to find a job. Better educated workers are more likely to have good paying jobs and also have an easier time finding new ones should the need arise. An investment in a college degree or technical program can pay for itself within a few years of you entering the workforce. In order to maximize the value of this debt, you do need to choose the degree program carefully. If there is little income to be earned or no career path then student loans can actually turn into bad debt very quickly.
Owning a Small Business
Making money is one of the main reasons why you would want to start a small business and being your own boss has a lot of advantages. Your earnings are directly correlated to your willingness to work hard and you don’t have to rely on a third party to hire you and provide your paycheck. While this is considered good debt, there are plenty of risks associated with taking on this type of debt. Many small businesses do fail so you have a better chance of success if you choose to work in a field you are knowledgeable and passionate about.
Homeownership and Real Estate
There are different ways to make money in real estate. One of the easiest strategies is to buy a home, live in it for a while, and then sell it for a profit. Residential properties can be used to create some income if you rent out the entire home or take in a boarder. Commercial properties can be also be used for capital gains and cash flow for investors. A home equity line of credit is basically an offshoot of a mortgage. This is a loan that has a low interest rate since it uses your home as collateral. A lot of consumers use these loans to pay off higher interest debt or make improvements to the home in order to increase the value so it can be seen as good debt. The only downside is that your house can be foreclosed on if you don’t make the payments.
What Is Considered Bad Debt?
While you may be able to increase your net worth with good debt, you will accrue bad debt if you are borrowing to purchase assets that depreciate.
Cars
New cars can cost a lot of money. You may need a vehicle to get yourself to and from work but paying interest on your car is a waste of money. Right after you drive off the lot, the vehicle will already be worth less than what you paid for it. Instead of taking on this debt, you should pay cash for a used car. If you aren’t able to pay cash for a used car then you should find the least expensive vehicle that is reliable and still pay it off as fast as you can. If you do insist on financing a new car, you should be on the lookout for a loan that has no to little interest. With this option, you are still spending a lot of money on something that will depreciate but you won’t be paying interest on it.
Clothes or Goods and Services
It only takes one look around a used clothing store to see that clothes are usually worth less than half of what you pay to purchase them. Other goods and services, such as groceries, gas, fast food, and vacations, can be purchased with borrowed money. Every cent you put toward interest on these items is money you could have spent elsewhere.
Credit Cards
Debt on credit cards is one of the worst forms of bad debt. The interest rates are usually much higher than consumer loans and the payment schedules are arranged so that the consumer pays the maximum costs. Keeping a balance on a credit card is hardly ever a good idea. The interest spent on any credit card debt can offset the value of any potential rewards you are getting.
Payday Loans
Credit cards are bad but payday loans are even worse. With a payday loan, you get short-term cash to get through a crisis but you have to a pay off your balance by the time your next paycheck arrives, which is usually in two weeks. The charges can range from $15 to $30 for every $100 borrowed, which is quite high.
Differences Between Good and Bad Debt
The main way to figure out the difference between good and bad debt is to ask one simple question. Does it increase your net worth or have any future value? If the answer is yes then it is considered good debt. If it doesn’t do this and you don’t have the cash to pay for the purchase then it is bad debt.
Debt that Requires Special Consideration
It’s not always easy to classify bad or good debt. It may depend on your own financial situation and some other factors. There are some types of debt that may be good for you but bad for others.
Consolidation Loans: For those who are already in debt, consolidating the higher interest date and using a loan with a lower interest rate can be useful. The key is to use cash that has been freed up by having more money to pay down debt and not get into more debt. Debt consolidation loans can be one of the many debt management solutions to consider.
Borrowing to Invest: Also known as leveraging, borrowing money at a lower interest rate and investing at a high interest rate may yield good results for some people. However, there are a lot of risks for those without experience. There is also the hazard of losing a lot of money and being required to compensate your broker for your borrowed funds. This should only be done by those with knowledge and who can afford to absorb the loss should the investment go sour.
Reward Programs on Credit Cards: There are a lot of great credit card reward programs. The money you spend on credit cards can also help you get free cruises, airline tickets, cash back, and other benefits. This is only beneficial if you have the discipline to pay off your balance every month. Otherwise, you lose out because of the interest on credit cards.
Is It Better to Have Good Debt or No Debt?
While older generations may have scoffed at the idea of owing any money, trying to live debt free can be very difficult. You may not even be able to borrow money in the future and it can cause other financial problems down the road. Unless you are taking on good debt, it can be hard to get a loan to get a college education or buy a home and these are investments that will help your income or net worth. If you are able to manage your debt responsibly then you can build up a good credit history. Your credit score can be a factor in everything from getting a job to renting an apartment so a good credit score can help provide you with more opportunities. While it may be better to have no debt at all, having good debt that you can manage wisely can actually be a smart financial move.
Whether the debt will be good or bad will be up to you. For example, if your mortgage eats up half of your salary, this probably isn’t good. If you have taken on a massive student loan debt so you can get a degree in Romanian poetry, this is also not a good debt. If you want to make your debt work for you then it needs to match your goals. You should also keep your debt-to-income ratio under control and not take on more debt than you are able to afford.
Signs You Are Using Debt as a Financial Tool to Achieve Goals
Using debt to your advantage can be easy if you are already using debt in a smart way. There are some ways to tell if you are using debt to achieve financial goals.
You Are Repairing or Building up Your Credit Score:
If you are seeing a positive increase in your credit score then you are on the right track when you are managing your debt.You Are in Control of Bills:
If you feel comfortable paying your monthly bills on time and in full every month, you aren’t likely drowning in bad debt.Your Total Debt Is Less than 40% of Your Income:
When you owe a lot less than what you make, this is a good sign that you are using debt in a way that is beneficial to you. Your debt-to-income ratio is a factor in whether or not you can get more credit.Your Credit Utilization Is Low:
You want to aim to use less than 30% of what you have as your limit on your credit cards. If you aren’t using more than you should then this is a good indication that you have enough savings and income to take care of your monthly expenses.You Have an Emergency Fund:
If you have saved enough money to allow you and your family to live for a few months in case your income takes a hit or expenses go up then this is also a sign that you have debt under control. The rule of thumb is to have three to six months of expenses set aside.
If you don’t have every sign described, it doesn’t mean you have a debt problem but you could be using your debt better.
Signs You Could Have a Debt Problem
There are some signs that could mean you have a debt problem, even if all you have is considered good debt. Realizing that you may have a debt problem can be the right step in building debt independence.
You Feel Like Your Debt and Finances Are Out of Control: It’s important that you don’t discount the toll that financial stress can take on your well being and debt can be a huge part of that financial stress. If you aren’t feeling in control, there are steps you can take to get there.
You Are Paying Interest on Top of Interest: This is known as compound interest and credit card companies don’t usually distinguish between the original debt and the interest owed when they calculate next month’s interest. If you are paying extra on your debt because of minimum or late payments then this could indicate a problem. This is why, if you are only paying the minimum payment, you could be in debt for years. Look at your credit card statement to see when you would be able to pay of your debt.
If these signs sound familiar, you aren’t alone. Debt is a part of life for many people but you can take control and learn to better manage your bad and good debt.
Know Your Debt.
Fight Your Debt.
Reach
Financial Freedom.
Getting Out of Debt
Whether you have bad or good debt, you may still want to get out of it at some point and pay attention to debt management. One of the easiest ways to get out of debt is to have a budget so you can pay attention to what you are spending and then save enough money to pay off your debts. In order to create a budget, you want to carefully record monthly spending. Pay attention to fixed expenses that happen each month, such as your rent and utility bills, and then variable expenses, such as dinners out. Figure out what you make in take-home income each month and then subtract your fixed and variable expenses. What you have left over is how much you should spend on getting your debt down. You can increase the amount you have to spend on your debt by eliminating items from variable expenses that aren’t necessary or are costing you too much to keep.
Debt consolidation can be another way you can get out of debt. It’s called consolidating because you are taking several debts with high interest and then consolidating them under one loan with a lower interest payment. It may not be the most ideal way to reduce debt, and you are still better off creating a budget, but it’s a way to help pay off your debt. Keep in mind that you are technically incurring debt to pay off debt you already have. People can also use a second mortgage or home equity loan to consolidate debt
Final Thoughts
Debt can actually be a good thing as long as you manage it correctly. Good debt is going to be different for every person and there can still be some risks associated with good debt. Debt management is still important, even for good debt, and there are signs that you are in good financial standing and some signs that may mean you are in over your head. Getting out of debt should still be the ultimate goal, even if it is good debt, and there are different ways to do so depending on your financial situation.