The word “debt” is plagued with negative connotations; however, it is more often than not an important – and, arguably, inevitable and necessary – component of an individual’s financial life. Because debt plays a significant role in our finances, not all debt is considered bad, and some types of debt are even classified as good and somewhat essential, given your financial situation.
When we use the term “debt,” we are referring to an amount of money that is borrowed from one party by another. Debt is most commonly leveraged by the borrowing party to make a purchase – often a quite large one – that the borrower would otherwise be unable to afford. When the borrower assumes debt, he or she is agreeing to pay the borrowed amount back, usually with interest. The most common types of debt are loans, including car loans and mortgages, personal loans, student loans, and credit card debt, to name a few of the main ones that we often interact with at some point in our lives. Most loans come with a specified term and date by which the loan must be repaid or a minimum monthly payment that must be made towards the loan total. Interest is used on loans as the lending party’s way of guaranteeing repayment and appropriate compensation for the risk assumed in providing the loan, while also ensuring the borrower is held accountable for repaying the loan. Interest also encourages the borrower to repay the loan as quickly as possible, as interest payments can rapidly add up.
Although in an ideal world, we would classify no debt as good debt, the reality is that borrowing funds and assuming some debt is the only way most people can afford large purchases like cars, homes, and educations. While loans for such investments are often warranted, the opposite end of the spectrum involves accruing debt through careless and unnecessary spending. Let’s take a look at what we classify as the “good” versus the “bad” in the debt arena.
Good debt can be viewed as a long-term investment in yourself. In other words, if the debt you assume increases your net worth and has the potential to generate income for you in the future, the debt can be justified and considered a positive transaction. You can think of good debt as an investment like a stock or a bond: You’re spending money now with the expectation of getting your money back – hopefully, with some profit – at some point in the future. Forms of good debt are also usually characterized by relatively low-interest rates in the single digits, which means the overall costs of these loans are considered cheaper.
- Mortgages and Home Equity Loans: There are many ways to monetize real-estate investments. When you purchase a home, you can usually guarantee that your investment will grow in value over time, due to factors like population growth that increases demand, increases in cost-of-living, and the development of nearby infrastructure that can augment the house’s location value. Residential real estate can also be leveraged as a rental property to generate income.
- Education Loans: In general, having a higher-education degree increases an individual’s earning potential and helps an individual find employment. An investment in a college degree is likely to pay for itself once you enter the workforce; however, we would be remiss to not acknowledge the student-debt crisis that also looms over our nation. With that in mind, if you assume debt for an education, especially graduate education, make sure to evaluate the potential within the career path you are aiming for to ensure your loans do not amass to bad debt.
- Small Business Loans: These can be tricky, as not all small businesses succeed, but many of them do. If you have a sound business plan and have carefully evaluated your finances and feel confident that taking on a loan to push your business to the next level is the right step, then such a loan can be viewed as good short-term debt well worth the long-term business growth and earning potential.
The difference between good debt and bad debt: Good debt has the potential to return value and increase your net worth over the long term, while bad debt involves making purchases that will most likely depreciate in value and will result in you losing money once interest is factored in. Put simply: if you don’t anticipate what you are looking to assume debt on to generate income or increase in value, you should not assume debt to purchase it.
- Credit Cards: You should always aim to pay your credit card balance in full every month to avoid racking up a higher balance fueled by interest rates. Interest rates on credit cards are notorious for being high and costly if you carry a large balance. That being said, you should not put large purchases on your credit card(s) that you cannot pay off before the end of the month (or when your payment period ends). Overall, avoid credit card debt as much as possible, as credit card spending habits can easily amount to bad debt that spirals out of control.
- Auto Loans: This one is difficult because most of us can justify needing a car for commuting to work, running errands, etc. The most important thing to remember is to not purchase a pricier car because you can obtain a loan to do so. Remember, cars (unless you are buying a collectors’ edition to hold on to) are one of the most quickly depreciating purchases you can make. Your car depreciates in value every time you drive it and put miles on it, so if you can purchase a used car with cash or via a smaller loan, consider doing so. A car purchase may be a necessity for your life, but assuming excessive, unnecessary debt to make the purchase is not. Make sure to research your options and aim to leverage a smaller loan with the lowest interest rate you can find.
- Payday Loans: These are arguably the worst types of loans you can take on. Payday loans, also called cash advance loans, are short-term forms of borrowing that yield immediate credit but also come with very high-interest rates. People tend to seek these out as a quick solution to a personal financial hardship; however, the finance charges on these loans are notoriously high. Some lenders charge borrowers interest rates that can range up to 500% in annual percentage yield (APR), meaning the annual rate of interest charged.
The theme – albeit cliché – to stick to: Make good, educated, financially sound decisions. The line between good and bad debt is easily blurred, and what may be seen as good debt for one person can be viewed as a bad debt commitment for another. Good debt is about creating positive opportunities for your future that can be easily justified, while bad debt often involves an unnecessary expenditure that will only bog you down financially in the coming years. Always take the time to thoroughly evaluate your options before making a decision that impacts your financial life. You may feel a little bummed not buying a brand new flashy car or splurging for a pricey new dress to wear to a wedding (that will inevitably sit in your closet, untouched, for years), but your future self will thank you when you’re able to purchase your dream house or enroll in a career-altering graduate program further down the road.
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