What is “Good Debt” vs. “Bad Debt” and what makes them different? Millions of Americans each day use debt, which can be defined as money borrowed from one party to another, to pay for a wide range of products and services. Whether you have a car loan, a home mortgage, or a credit card – you have participated in taking on debt in exchange for immediate cash flow. We’ll take you through the various types of debt, and together explore a platform for decision making when it comes to debt.
Good Debt or Bad Debt?
If you are like millions of Americans, the list of different types of debt is reminiscent of a personal experience – or an ongoing issue that you are currently battling. Don’t worry – you are not alone. While most debt feels like a burden or obligation, some types of debt provide a chance to either build credit or provide purchasing power that you wouldn’t have otherwise. So, let’s take a look at what might be considered “Good Debt” or “Bad Debt” so you can prioritize your financial decisions and possible payment plans for your current debt.
To keep it simple, let’s define “Good Debt” as any type of debt that helps build your income or overall net worth. You’re probably thinking, wait – are you telling me there is debt that can allow me to improve my income and my net worth? The answer is, YES – but it has both its pros and cons. Let’s take a quick look at what many would consider to be “Good Debt” and why this would be the case.
Home Mortgage – Many would consider a mortgage to be at the top of the list for “Good Debt.” Not only does this debt provide you the purchasing power to get into a home, it is often an asset that appreciates over time. Said another way, by securing debt for a home you have the opportunity to see the value of your home rise over time and become a positive growth asset.
Student Loan – While this type of debt is debatable among Americans, it continues to be considered an opportunity to experience higher-education and grow your earning power. Have you ever heard of the term “The more you learn, the more you earn?” This is typically the case for those who secure a degree. There are many options for higher education, whether you choose a trade school, community college, or a state university. If you keep an eye on where you go to school, the overall cost, and where you plan to secure post-graduation work – a student loan can be a great decision.
Small Business Loan – This type of loan can have significant upside, but an equal amount of risk. As noted prior, many businesses have trouble surviving in their first couple of years – so the risk and reward need to be weighed appropriately. If a small business owner has the ability to secure a loan, which is hard to come by, and successfully run a profitable business – the original debt secured to run the business can mostly be considered good debt.
The bottom line is this – if you secure debt that can potentially lower your income and net worth, it can be considered “Bad Debt.” Many items we purchase in our life immediately depreciate after purchase, like clothes and other consumables, and the vehicles we drive each and every day. While many of these types of debts are necessary to acquire, the best bet is to limit your exposure to these expenses and maximize your potential with appreciating assets. Easier said than done, right?
Car Loan – While a vehicle is essential, it is even more important to secure a reliable manufacturer and a healthy vehicle report. The smart play is to be vigilant in your approach to purchasing a vehicle so you don’t overextend yourself with your preferred mode of transportation.
Credit Cards – Credit Card companies have made it unbelievably easy for Americans to charge an expense with ease and speed. Since most consumers know exactly what their limit is, the spending control as a behavior is tough to manage. Carrying a balance month-to-month accumulates with high-interest rates and compounds with late fees if a minimum payment is not made. It is very easy to over-utilize the all-important credit utilization rate, and in turn damage your credit score – which is one of the main health indicators for lenders.
Late Utility and Cell Phone Bills – This expense should be an obvious “Bad Debt” flag, but many people still put off payments on these bills month after month. At the end of the day, a timely payment to a utility bill or cell phone company can improve your credit score and your borrowing ability. If you sacrifice your timely payments to these companies, you can find yourself quickly in a bind with collection agencies and lower credit worthiness in the eyes of many lenders. Stick to an on-time payment and find other areas in your financial life to negotiate when the rubber meets the road.
If managed correctly, both “Good Debt” and “Bad Debt” can be utilized to provide you the lifestyle that suits YOU. According to the Consumer Financial Bureau, if you keep your debt-to-income ratio under 43%, you put yourself in a good position to show lenders that you have the ability to pay off a loan. As a good practice, keep paying your bills and debt obligations in a timely manner, and allow yourself the ability to improve your credit score over time. When considering future financial decisions, take a moment to evaluate if your new debt will provide you with greater income and net worth. Even the best “Good Debt” choices can work against your financial situation, so take care in your decision-making process, and keep these borrowing basics in mind.