Good debt and bad debt are terms used to describe different types of debt and their effects on your financial health. Good debt is debt that improves your income or net worth, can be repaid responsibly, and has a good return on investment.
Bad debt, on the other hand, is debt that you are unable to pay, does not provide a return on investment, loses value after the transfer of ownership, and negatively impacts your credit.
It can be challenging to avoid debt entirely when making large investments. However, it’s crucial to choose debts that will improve your credit score rather than hurt it.
It’s also essential to consider if the debt will help you reach your financial goals or hold you back. This topic looks at the difference between good and bad debt and provides tips on how to manage debt to improve your financial well-being.
What is Good Debt?
To determine whether a debt should be considered “good”, ask yourself the following questions.
- Does it improve your income or net worth?
- Can you repay it responsibly?
- Is financing something that will bring a good return on investment?
In simple terms, good debt is money owed towards wealth creation.
Mortgage Loans and Real Estate Investments
Mortgages are a way to pay for a home with the expectation that the property will be worth more by the time the mortgage is paid off. Some mortgages may also have tax benefits and low interest rates.
Additionally, loans can be taken out to invest in real estate, such as buying and selling properties for a profit, renting them out, or adding value through businesses like a car wash on the property.
Student Loans
Student loans are typically considered good debt because they have low interest rates, some are subsidized, the interest is tax-deductible, and there are various repayment options.
Loans for education are also considered an investment because higher education is often associated with better job opportunities. With education, you can usually pay off the loans once you secure employment.
Auto Loans
Auto loans are often considered good debt because they typically have lower interest rates. It’s important to get a car at a reasonable interest rate that you can afford and that will retain its value after loan repayment.
Auto loans can also be considered an investment as they can enable people to take jobs that pay more but are farther away, increasing their net income. To avoid turning it into bad debt, it’s best to make a large down payment and make loan payments on time.
What is Bad Debt?
It’s simply debt that you are unable to pay, does not provide a return on investment, loses value after the transfer of ownership, and negatively impacts your credit.
Let’s discuss several examples of bad debts.
High-Interest Credit Cards
Although owning a credit card is the best and easiest way to build your credit score, it can attract a high interest rate of more than 20%, making your debt expensive.
Consequently, this attracts late payments which ultimately affect your credit score negatively.
Personal Loans
These are loans with a repayment period of 2-5 years. They require monthly payments and have an interest rate that can be as high as 36%.
They are generally considered bad debt if they are taken out for non-essential expenses such as a vacation or clothing. The high interest rate can make it difficult to repay on time, which can negatively impact your credit score.
Payday Loans
These short-term unsecured loans are considered the worst type of bad debt due to the high interest rate which is usually running as high as 400%. They also accrue multiple service and late fees.
Late payments can cause your debt to shoot up leading up to a high risk of managing any control of your debt. In the long run, your credit score is heavily and adversely affected.
Avoid taking these loans or take them in cases of extreme emergencies after looking into other alternatives first. A payday loan should be the last resolution for any financial trouble.
The Takeaway
Just like the saying goes, too much of anything can be harmful. Even though debt can present opportunities, having too much of it can become bad debt. The way you use the debt also plays a role in determining if it’s good or bad. Therefore, it’s important to consider the long-term benefits, and affordability, and make sure to always make payments on time.
