Debt is a scary word for most people. We’re taught from a young age that debt means you owe someone money, and depending on who you owe, this amount may need to be paid back with interest that is constantly accruing. When a risky debt is taken on, it can prompt you to lose control of your financial freedom.
However, contrary to popular belief, not all debt is negative or bad. When used correctly, debt can provide you the leverage you need to get closer to your goals. Let’s discuss good debt and bad debt — knowing the difference can help you evaluate your financial ambitions and make smarter moves with higher yields.
Table of Contents:
- What is Good Debt?
- Examples of Good Debt
- What is Bad Debt?
- Examples of Bad Debt
- How to Avoid Bad Debt
- Final Thoughts
What is Good Debt?
Good debt is money you borrow to help build important things in your life. It helps you obtain something useful and thus creates wealth and happiness. If debt can increase your net worth or future value, then it can be considered positive and advantageous.
When you utilize good debt, you can manage your finances more effectively. Whether you choose to buy things you need, create a nest egg for unforeseen emergencies, or leverage your current money to build wealth, good debt affords you a lot of options. All the examples below share a common theme. Initially, you’ll be required to borrow money, but they’ll produce a return in the long run that typically outweighs any of the initial financial implications you felt.
Examples of Good Debt
As noted above, good debt allows the borrower to take on debt temporarily and use it to leverage themself into a better financial position. Here are some examples of debt that can be positive when managed well.
Mortgages can be a positive type of debt to take on. Instead of paying rent each month to a landlord, you make mortgage payments that build equity. When you finish making payments, you’ll have a higher net worth. Another bonus to mortgages is that the interest you pay can sometimes be tax-deductible, which lowers your tax burden.
Although purchasing a house is technically taking on debt, don’t ever be afraid to buy a house you can afford! This is only positive for your financial portfolio.
To determine how much house you can afford, use the 28/36 rule. This rule states that your mortgage should be…
- No more than 28 percent of your total monthly gross income
- No more than 36 percent of your total debt
2. Student Loans
Student loans are a common stressor. About 1 in 5 Americans have student loan debt, and it’s for good reason. Taking on student loans can allow you to finance your education. The degree that you get out of the program will allow you to increase your income. Additionally, student loans often have lower interest rates compared with other credit lines. The interest that does exist is tax-deductible.
3. Small-Business Loans
Small-business loans are often necessary to jump-start a business idea or company, and they can allow the borrower to build wealth overall. However, this can also be a risky move, so spend time thinking through your business idea, plan, and all other factors that will affect your success.
4. Personal Loans
Borrowers often turn to personal loans when they need help consolidating debt at a lower interest rate. This benefit is what makes it a good type of debt. That said, it’s important to be careful when using personal loans. If you opt for a secured personal loan, you may need collateral (like your home) to secure the financing. This is riskier than an unsecured option, so just be sure to weigh your options.
5. Auto Loans
Like personal loans, auto loans can be good or bad depending on the type you take on. Certain auto loans carry a high-interest rate influenced by factors like credit scores and the type and amount of the loan. At a certain point, an auto loan may be necessary for you. You may need a car to get you to and from a job. Yet, before you obtain an auto loan, make sure you consider how it’ll contribute to your debt-to-income ratio as well as what it’ll do to your credit score.
6. Credit Cards
Credit cards are a form of good debt when used correctly. You can use them as tools to build credit, which is necessary to get a mortgage or rent an apartment. However, credit cards can also cause a lot of issues for borrowers who don’t manage them the right way. They walk the line between good debt and bad debt because the long-term risks can outweigh the benefits if users don’t stay on top of them.
To remain in the clear, always pay your minimum payment (or the entire balance) on your credit card on time. This will ensure your account remains in good standing.
Additionally, you should try to keep your credit utilization low at around 30 percent (10 percent is even better, if possible!).
What is Bad Debt?
Bad debt is any debt that doesn’t offer the borrower long-term benefits or one that the borrower is unable to repay. Often, this debt is accompanied by high-interest rates or unfavorable repayment terms.
Examples of Bad Debt
You now know the type of debt that you can use to build your financial portfolio and create the lifestyle you desire. Here are examples of debt you should beware of.
1. Unaffordable Debt
You should only take on smart debt that you’re able to pay back on time. For instance, if you want to purchase a house, a mortgage can be a way to do this. However, you must be able to make the monthly mortgage payments.
Another important aspect to keep in mind is your debt overall. One common metric used to monitor how much debt is the “right” amount is your debt-to-income ratio.
To find your ratio, add all your monthly debt payments together and divide them by your monthly gross income. Note: This is not just your take-home pay. The result will give you your debt-to-income ratio.
Here’s an example:
- Monthly mortgage: $1,200
- Car payment: $400
- Credit cards and other bills: $300
- Monthly debt: $1,900
If your gross monthly income is $3,500, this means your debt-to-income ratio is 54 percent. This number is a red flag to potential lenders because it surpasses the 43 percent debt-to-income ratio benchmark that they look for.
Evidence demonstrates that borrowers with a higher ratio are more likely to have issues making monthly payments. Staying below this 43 percent ratio is essential if you want to get a mortgage — most lenders won’t give you one if you’re above it!
2. Payday Loans
A payday loan is a small amount of money that is lent on two conditions. First, there is a high rate of interest, and second, it must be repaid when the borrower receives their next paycheck. Because payday loans are so short-term, they are often made without requiring a credit check.
Payday loans are risky because of the high-interest rates. If you aren’t able to pay the loan back by your next paycheck, you can be on the hook for a lot of cash. However, it’s worth noting that they don’t get reported to the major credit bureaus. Whether you make on-time payments or not, your credit score won’t reflect it.
3. Debt That Affects Your Credit Scores
When debt isn’t managed correctly, it can impact your credit score. The top way this occurs is when the borrower falls behind on their payments or they have high credit utilization. This example is particularly important to keep in mind because good debt can turn into bad debt if you don’t manage it properly. Watch out for this one!
How to Avoid Bad Debt
While debt gets a bad reputation, there are plenty of good aspects of taking on debt if you’re purposeful about it. It’s a nuanced topic in the financial world for the right reason. You can take on good debt and see it transformed into bad debt with poor management. Still, it’s important to consider how you can skirt bad debt whenever possible.
- Ask yourself how this debt will benefit you in the long-term
- Build up an emergency fund for unexpected expenses to avoid putting them on credit cards
- Keep your debt-to-income ratio as low as possible
- Always pay your bills on time every time
It’s time to re-frame your mindset around debt! Debt is a tool you should use in your financial portfolio. Good debt will improve your financial situation and allow you to build wealth. Bad debts are financial obligations that don’t offer long-term benefits. Remember that debt is fluid as well — good debt can become bad if you don’t manage it properly. It’s up to you to enter each transaction with a critical eye, deduce whether it’s smart to borrow money, and evaluate whether that transaction will move you closer to your financial goals.