Contrary to what you’ve probably heard in school, not all debt is bad debt. There are different types of debt, and depending on your financial situation and how you manage that debt, each type can have positive and negative impacts on your personal and financial life. Unfortunately, the line between good debt vs. bad debt can blur, but generally, there are certain types of debt that are considered good and some that are considered bad.
It all comes down to whether you’re benefitting from the debt beyond the influx of cash, and how (if at all) it sets you up for success in your financial future.
What Is Good Debt?
Good debt is an investment that increases your net worth or sets you up for financial success in the future. Unfortunately, good debt is still debt, so it will initially be a financial burden. However, the assumption is that good debt will allow you to make purchases and decisions whose value will increase over time.
This also assumes that you have a clear and specific reason for taking out the debt and have laid out a strict repayment plan. If you do not manage your monthly payments, good debt can become bad debt in the blink of an eye.
Common types of good debt include:
You have to live somewhere. If you’re planning on staying in one place for a significant period of time, taking out a mortgage to buy a house can make sense. It puts a roof over your head and also allows you to put your money toward something that appreciates. If after a few decades you’re ready to sell that property, you could turn around a profit about two or three times what you initially paid for it.
There are downsides to owning a home, such as heading up repairs and paying property taxes. But as a homeowner, you also have access to tax breaks that renters do not have, and if you do not plan to live in the house for the duration of your ownership, you could rent it out for an additional revenue stream.
Home equity loans or lines of credit
A home equity loan is a loan that allows you to borrow money and use the value of your home as collateral to finance another personal goal. How it works is this: An appraiser from the financial institution visits the property to determine its value. The financial institution then determines your loan amount based on the value of the home.
Many homeowners take out home equity loans to pay off debts with higher interest. They may also invest the money back into the home by updating or adding features. Think: finishing a basement or adding solar panels.
Home equity loans are risky, though. Slip up and miss a payment, and your house is on the line.
Small business loans
If you have a strong business plan, a small business loan can get your company off the ground. Granted, small business loans are more difficult to acquire than other types of loans because the lender is taking a big risk on your plan. But if you keep an ambitious spirit and maintain a positive cash flow, your business will be worth a lot more in several years time than it is now, which means that the initial debt was worth the reward.
The jury is still out as to whether student loans are a good investment. Student loan debt in the U.S. grows six times faster than the U.S. economy, currently totaling about $1.75 trillion, according to Educationdata.org. Whether or not you want to take on the burden of student loans is an important, personal decision.
In general, investing in higher education increases your chances of getting a well paying job out of college. You’ll also be able to leverage that education for promotions in the future. If you are confident that higher education will lead to a well paying career, it can be wise to take out a student loan.
On the other hand, you’re not guaranteed a well paying job out of college. And you can even find lines of work that pay exceptionally well and don’t require a college education. If you’re unsure that your future salary will support your monthly student loan payments and personal goals, you should carefully consider whether student loans are the right decision for you.
No matter in which direction you are leaning, think about how student loans fit into both your short-term and long-term financial plans.
What Is Bad Debt?
If you purchase something with credit that depreciates over time or does not generate income for you, it is generally considered bad debt. Bad debt drains wealth and doesn’t have the prospect of paying itself off.
Common types of bad debt include:
Credit cards are great for earning cash back, travel rewards, dining points, and other perks. That’s, of course, assuming that you use your credit card responsibly. Consumers often charge goods and services that they cannot afford to their credit card, vowing to come up with a plan to pay it back at a later date. A lot of times, that date never comes and interest accrues, leading to credit card debt. This is one of the primary reasons that credit cards are considered bad debt.
Paying with a credit card can be convenient, but it’s important to be aware of your interest rate. If you’re paying for a high-dollar item that you need, such as furniture for your home, a credit card can help in a pinch, but make sure that you have a plan to pay it off. Otherwise, it’s better to charge these items to a debit card or pay cash.
When it comes to charging things that you want to a high-interest credit card, it’s best to err on the side of caution. That goes for spendy vacations, stylish new shoes, or other things outside of your price range. If you do not have the money on hand now to pay for these things, you should save up until you can so that you do not amass credit card debt and end up in a sticky financial situation later.
Sure, cars can be considered “good” because they help you get from here to there quickly and easily. However, when you take out an auto loan to pay for a car, it’s bad debt because as you continue to drive the car, its value depreciates. After it’s run its course, or when you go to sell it, you’ll have to account for the miles and wear that you’ve put on it when calculating the new price.
If you do need to take out a loan to buy a car, it’s best to find a loan with a low interest rate or no interest rate at all. You’ll be investing in something whose value dwindles over time, but at least you have a car to help you get around and you’re not having to spend top dollar in interest to own it.
Sometimes there’s no way around it — you need to get paid, and you need to get paid now. Debit, credit, and savings are not always a solution for people, and so they resort to payday loans.
Unfortunately, payday loans are notorious for being easy to get into and difficult to get out of. In fact, about a dozen states have made them illegal.
The repayment term on payday loans are short — usually a few weeks tops — and they come with hefty fees if you miss your repayment. Worse yet, they can do a number on your credit. The loans don’t show up on your reports if they are in good standing, but if you miss your payments and the account gets sent to collections, it could hurt your score for years.
No one can really expect to need to take out a payday loan, but if you’re able to start building your financial cushion now, it can come in handy if an emergency arises.
What Are the Benefits of Borrowing?
Debt, when used responsibly, does have some benefits. That goes for both good debt and bad debt. It can help you:
Finance your personal and professional goals
Whether you’re taking out a mortgage, home equity line of credit, small business loan, or student loan, credit can help you achieve your objective. It provides you with the funds that you need (and wouldn’t otherwise have) to kickstart your journey.
You need credit in order to build credit. And the more credit that you have, the more credit that you have access to. In case it’s not clear, credit is cyclical.
Some of the most impactful components of your credit score include: payment history and credit utilization. In other words, lenders want to see that you’ve taken out loans and other lines of credit, used them responsibility, and made on-time repayments. If you can show lenders that you are a good borrower, you’ll have access to a lot more financial benefits and opportunities, like lower interest rates, better terms, higher likelihood of loan approval, and lower insurance premiums.
Diversify your portfolio
Another component of your credit reports and scores is your credit mix. Lenders like to see that you have a wide array of credit types in your financial history. If a lender sees that you have a variety of accounts, they may be more likely to approve you for products and services, such as loans with lower interest rates. In the eyes of the lender, if you have an established history with a variety of account types, that means you will pay off your debt responsibly.
Pay off debt
It might seem counterintuitive, but you can use debt to pay off debt. Better yet, it can help you pay it off quicker so that less money is going toward interest.
For instance, many people use balance transfer cards to transfer several credit card balances to one card and pay it off with a low introductory rate. However, after the introductory period, the interest rate on the card tends to spike to levels even higher than standard credit cards. If you do not develop and stick to a plan to pay off your debt during the introductory period, you could end up paying more than you would have by leaving it on the initial card.
In other words, be careful when you use debt to pay off debt. It requires strong money and time management skills.
What Are the Risks of Borrowing?
While good debt can help you accomplish your goals, there is no guarantee. Unfortunately, the risks of borrowing can outweigh the benefits. Debt can lead to:
The thing with many types of debt is that once you start accruing interest and building your debt, it’s difficult to escape. This is most common for types of revolving credit, or credit that you can use, pay off, and reuse on a recurring basis. Credit cards are a popular form of revolving credit.
To overcome this risk, it’s important to manage your spending and stay on top of your payments. Building out a budget can help with the former. Ensure that you are getting your bills and other necessities paid before moving on to discretionary spending. And before you swipe your credit card, ask yourself whether the purchase is within your means. If you pay for something with credit, you should be certain that you’ll be able to repay it in a timely manner.
Making on-time payments is crucial if you want to stay financially healthy. Making full payments, while less crucial, can help you avoid insurmountable debt. If possible, try to pay off your credit card balances in full at the end of each billing period. At the very least, make the minimum payment and come up with a plan to start chipping away at whatever interest accrues.
Once interest begins to accrue, you’re burdened with paying off not only the principal balance that you charged to your card but also the interest. The money that goes into repaying interest can end up doubling or tripling what you initially spent. And the time that you’ve spent wrestling with interest is time not spent on saving, investing, and planning for your financial future.
Credit score damage
When borrowing money from a lender, there’s always a risk that you won’t be able to repay it. Life is unpredictable — emergencies happen, unforeseen payments arise. If you have to take care of other payments and your loans or credit card balances fall behind, you’ll have to deal with more than just a late fee. You may end up with a negative mark on your credit report and credit score damage.
A missed or late payment gets reported to the credit bureaus. Several missed payments could land your account in collections. Collections accounts also get reported to the credit bureaus, and they do a lot more damage than just a single missed payment. Unfortunately, they stay on your credit report and affect your credit scores for up to seven years.
If you are struggling with payments, there are a couple of places that you should start. Re-evaluate your budget and spending habits. See if there are areas that you can cut down on until you can get your credit card balances to a manageable level. You should also contact your lender and be open about your situation. Lenders have programs built out for people experiencing financial hardship. If you can get ahead of the problem, you can avoid significant damage to your credit.
Things to Consider Before Going into Debt
Taking on debt is a big decision and one that shouldn’t be made lightly. Before applying for a loan, credit card, or other line of credit, there are a few things to keep in mind.
- Can you afford the debt? Are you in a stable financial position to take out a loan or open a credit card and make consistent on-time payments to your account, regardless of whether the debt is considered good debt or bad debt?
- Can you afford the temporary ding to your credit score? Opening a new credit account causes your scores to take a temporary dip due to the inquiry on your credit file. Will this temporary dip be an issue?
- Is it the right time? Is your credit in the position to be taking out the loan or opening a credit card? Are there things that you can do now to increase your credit score so that you can earn better rates and terms when you do decide to open a new account? Are you planning to take out a larger loan in the near future? Will opening an account now hurt your chances of getting approved for that larger loan?
- Do you have negotiating power? Are you a strong borrower with a good credit score? Do you have other accounts with the financial institution that are in good standing? Can you use these things in your favor to negotiate a lower interest rate or better terms?