When you think about going into debt, there is definitely an argument to be made that all forms of debt are bad debt. But when you think about owning a home or a business, borrowing money is the only way you’re able to make those large life purchases.
While certain types of loans are usually justifiable and can help you improve your quality of life, there are other kinds of loans that can ruin your finances if taken on carelessly.
This article breaks down different types of debt and considers which types of debt are appropriate. Conversely, we will also take a look at the kind of debt that can be catastrophic to your financial wellbeing.
What Is Good Debt?
Good debt is often described as any type of debt that can improve your life in a significant way. If the debt you take on helps increase your net worth or generates income, it can be considered a positive thing. Here are three prime examples of good debt:
1. Mortgage Loans
The safest and most beneficial debt to take on would probably be a mortgage loan. Borrowing money to buy a house can improve your life and finances in countless ways. When you purchase real estate, you are acquiring an asset of significant value. Homes can be worth hundreds of thousands or even millions of dollars.
When you take out a loan for homeownership, the value of your home is directly tied to your net worth and becomes an asset that you own. Buying a home is an excellent way to save money over time and boost your net worth.
Owning a home increases your net worth because the asset is in your name and generally appreciates over time. Because interest rates are relatively low when borrowing for a mortgage, it makes a lot of sense to have a certain amount of your net worth allocated to that asset.
As long as you are making the monthly payments, you are gaining equity in that asset over time and can sell for a profit after its value has gone up over time. Taking out a mortgage loan can temporarily hurt your credit score, but once you’re able to prove your ability to pay it back your score will increase. In fact, it can give lenders more confidence that you are not a high-risk borrower if you are making monthly payments on time over a long period of time.
2. Student Loans
While student loans usually carry higher interest rates than mortgages, they are still relatively low interest in comparison to credit cards. They also have the added benefit of being money spent on the betterment of your future.
When taking out a loan to continue your education, you are investing in the ability to get a better job. You’re also sharpening your skills and overall knowledge which can only help your finances long term.
If you’re investing in your education, it is important to consider if the field you’re getting into is in demand on the job market. Degrees in computer science, engineering, finance, medicine, and law will always be highly sought after and in demand. If you’re considering advancing your education, it is safe to say that you are likely to get a return on that investment once you become employed in your desired field of study.
3. Business Investments
Another form of good debt could be making an investment into your own business. While starting your own business could be a major risk, at least it is an investment in yourself and your own abilities.
Taking out a loan to start a business that could provide for you and your family falls into the category of good debt because it is money borrowed to secure a better financial future for you and your loved ones.
Before taking out large sums of money for your own business, do your due diligence and be sure it’s something you believe in. It can be a risky decision, but it can also have a huge payoff if successful.
With all of this in mind, it seems like low-interest-rate loans on a home, continuing education, or investing in your own business could be considered good forms of debt.
Taking on these types of debt can improve your future earning potential, increase your net worth, and oftentimes save you money long term. Taking on debt to fund appreciating assets isn’t always a bad idea. On the other hand, there are certain types of debt you should definitely try to avoid.
What Is Bad Debt?
Unlike the good types of debt discussed in the previous section, bad debt is money borrowed that can seriously hurt your credit score and put you in a situation that can be difficult to dig out of financially.
Bad debt mostly falls into the category of frivolous borrowing to pay for cars or other consumer goods. It is money borrowed to buy depreciating assets. Here are two examples of bad debt:
1. Credit Card Debt
It’s crucial to always remember that credit cards are a form of debt. Oftentimes people get into a cycle where they spend too much on their credit card and do not take the steps necessary to pay off that credit card.
Each month that your balance is not paid off in full, you will receive interest charges. The longer you keep a balance on your credit card from month to month, the more interest you will have to pay.
Almost anything you would buy with your credit card will not bring you any long-term financial stability. Credit card debt does not increase your net worth or provide you with anything worthwhile. It only leads to stress and compounding interest.
It can be tempting to splurge on flashy expensive things, but if you’re planning on doing that with a credit card, and don’t have money to support those purchases, you are getting into bad debt.
2. Luxury Cars
Even if you can afford the monthly payments on an auto loan to pay for a luxury car, remember that your car will lose value as soon as you drive it off the lot. The value of a car can depreciate by up to 30% within the first year alone.
To avoid bad debt, you may want to take a measured approach in buying big-ticket items and resist the urge to overspend. A car is often considered to be an essential means of transportation to get to work. However, this doesn’t mean that you should take on a high-interest rate loan to get the newest Mercedez Benz.
If you absolutely need a car, buy one that is within your means with low-interest rate financing. The last thing you need to do is overspend on a depreciating asset you can’t afford. It also may be worth your time to consider whether you want to buy or lease a car. Check out our breakdown of the subject here.
Noteworthy Considerations to Make
Oftentimes debt isn’t always black and white. What may be beneficial for you may not be for someone else. It’s all dependent upon your specific financial situation. Here are some examples of debt that could be considered good in the right circumstances.
1. Borrowing Money to Pay Off Debt
If you’re already in debt, taking out a debt consolidation loan from a bank or other lender may prove to be beneficial to you. These types of loans usually come with lower interest rates and can help you pay off your debt faster.
When taking on this kind of debt, it is crucial to make sure that you put all cash towards paying down your debt and not on more personal spending.
2. Borrowing Money for Investments
If you have a stock brokerage account, you might be eligible to invest using a margin account. Margin is money loaned out from your brokerage account to fund the purchase of securities.
While this can be great if the underlying security you bought goes up, it can lead to outsized losses if the investment goes down in value. Taking on margin debt should only be considered if you’re an experienced investor who understands the risks involved. If you’re just beginning to learn about investing, it is advised to stay away from margin until you have a better understanding of the market.
Having gone over what could be considered good and bad debt, it’s clear that some forms of debt are better than others. Investing in your home, education, or business using borrowed money can many times be beneficial because you’re investing in things that have the potential to earn you a return on your investment.
Conversely, bad debt is money borrowed to buy things you don’t need and can’t afford. Getting into this kind of high-interest-rate debt can quickly eat away at your finances, and is not advised.
As long as you understand the risks involved in taking on debt, you will be better suited to take advantage of low-interest-rate borrowing opportunities. These opportunities will ultimately allow for your finances to flourish. Overall, it seems undeniable that good debt does exist. In fact, if utilized properly, it can help you reach your financial goals.