When you hear the word ‘debt,’ what is your immediate reaction? Do you get a chill down your spine? Do you get a bit anxious, or feel overwhelmed? Perhaps you feel neutral about debt – maybe because you don’t carry a lot. Or, it’s possible you feel good about your debt, and that’s probably because you agree with the old adage, “it takes money to make money.”
Simply put, debt is money owned by one party to another. Debt involves a repayment, and terms for repayment usually include interest (the cost a lender charges for borrowing money). Nearly 60% of American consumers feel burdened by debt, according to a 2020 LendingTree survey. If you fall into that percentage, it may help to determine the difference between “good” debt and “bad” debt, as it could provide a sense of control, or a knowledge base for making future financial decisions.
Before jumping in, it’s necessary to point out that determining whether a particular debt is “good” or “bad” varies person to person, and depends on an individual’s financial situation.
“Debt certainly isn’t always a bad thing. A mortgage can help you afford a home. Student loans can be a necessity in getting a good job. Both are investments worth making, and both come with fairly low interest rates.”Jean Chatzky
What is “Good” Debt?
Simplified: Good debt has the potential to increase your net worth or enhance your life in a particular way.
If a debt helps generate income and build net worth, it can be considered positive. So can debt that improves your and your family’s life in other significant ways.
Good debt can also be linked to long-term arbitrage. For example, the long-term returns of the stock market have historically outpaced today’s low mortgage interest rates. So, even if you have enough cash laying around to pay for a home in full, your financial future might be more successful if you opt for a mortgage and leave that lump-sum of money invested.
Examples of good debt include, but are not limited to:
Student Loans for Education
In general, the more education an individual has, the greater their earning potential. Education has also proven to have a positive correlation with the ability to find employment. Better educated workers are more likely to be employed in good-paying jobs and tend to have an easier time finding new ones should the need arise.
Therefore, an investment in higher-education or a technical degree can often pay for itself within a few years of entering the workforce.
Where Student Loans Can Go Bad
To keep within the standard 10-year repayment window, you shouldn’t borrow more (in total) than you expect to earn in your first year on the job, says Carrie Schwab-Pomerantz, a financial advisor, board chair and president of the Charles Schwab Foundation.
Related: Understanding Federal Student Loans and Other Borrowing Options
Mortgage for Home Owners or Other Real Estate
There are a variety of ways to make money in real estate. On the residential front, the simplest is taking out a mortgage to buy a home, living in the home for a few decades, and then selling the home at a profit. Mortgage debt has historically been considered one of the safest forms of good debt, since your monthly payments eventually build equity in your home and in the meantime, you also enjoy an assortment of potential tax breaks not available to renters.
Residential real estate also can be used to generate income by renting it out, and commercial real estate can be a source of cash flow and eventual capital gain — if you know what you’re doing.
Where Mortgages Can Go Bad
Home prices don’t always rise indefinitely, and borrowing more than you can afford – or using mortgage terms that you don’t fully understand, such as adjustable rate mortgages (ARMs) – can be risky.
Related: How to Analyze Real Estate Investment Opportunities
Business Loans for Entrepreneurs
Money that you borrow to start or expand your business can fall under good debt, as growth of a profitable company can increase your future cash flow. Being your own boss is often financially rewarding, but – like paying for education – starting your own business comes with it’s own risks.
Small Business Association (SBA) loans require business owners to create comprehensive business plans, which can be beneficial as it forces entrepreneurs to consider goals and risks.
Where Business Loans Can Go Bad
Many ventures fail, but your chances for success are greater if you choose a field that you are passionate and knowledgeable about.
What is “Bad” Debt?
Simplified: Bad debt involves borrowing money to purchase rapidly depreciating assets, or is done only for the purpose of consumption.
In general, bad debt exploits your desire for instant gratification, or is a result of poor financial decision making. As a rule of thumb, try to avoid debt for consumer goods and entertainment, or debt that carries high-interest.
Examples of bad debt include, but are not limited to:
Credit Card Debt
Credit card debt, especially when taken on for nonessential purchases, is undoubtedly bad debt. According to The Federal Reserve, only 48% of Americans with credit cards pay their bill in full every month. That means the remaining 52% of credit card holders carry debt and accumulate interest, and the average annual percentage rate (APR) on credit cards is 17.13%.
While credit card reward programs give cardholders benefits and extra incentives to swipe, unless the balance is being paid in full every month, interest charges may offset the value of rewards.
Related: How to Improve Your Credit Score
For many Americans, it is impossible to live without a car – it’s their mode of transportation to get to work, or necessary for driving their children to school and various other activities. Not all auto loans are bad debt, but the type of car and the terms of the loan make it a grey area for debt. By the time you drive the car off the lot, the vehicle already is worth less than it was when you purchased it, which could result in being underwater on your loan. If you need to borrow to buy a car, look for a loan with low or no interest. You’ll still be investing a large amount of money in a depreciating asset, but at least you won’t be paying interest on it.
You can also opt for a well maintained, used vehicle that won’t see the same depreciation as their brand new counterpart.
Not all debt can be easily classified as “good” or “bad.” Certain types of debt may be good for some, but bad for others, including (but not limited to):
Borrowing Money to Pay Off Debt
For consumers who are already in debt, taking out a debt consolidation loan can be beneficial. Debt consolidation loans typically have a lower interest rate than most credit cards, so they allow you to pay off existing debts and save money on future interest payments. The key is to use the cash to pay off debts, and not for other unnecessary spending.
Borrowing Money to Invest
If you have an account with a brokerage firm, then you may have access to a margin account, which allows you to borrow money from the brokerage (buying on margin) to purchase securities. Buying on margin can make you money – if the security goes up in value before you have to pay the loan – or cost you money – if the security loses value. This kind of borrowing isn’t for inexperienced investors, or those who can’t afford the risk of losing some money.
Related: How to Create Infinite Wealth Using Infinite Banking