A guide to good and bad debt
In previous articles, I’ve used the terms “good debt” and “bad debt,” and the latter term no doubt seemed like an oxymoron to some. Getting into debt is considered a cardinal sin for many who give advice in the world of personal finance. But, while some high-interest debt, like credit cards, can be bad and lock you into a cycle of debt for many years, not all debt is necessarily “bad.”
Getting into debt can be handy if used as a tool and within your financial capabilities. Getting into debt can be daunting if done under the wrong circumstances, but if you view it as an advantage and use it pragmatically, it can be a powerful tool.
“Bad” debt versus “good” debt
To better understand how to take advantage of debt, it is essential to first understand the differences between good and bad debt.
“Good” debt generally refers to debt whose purpose can help increase or create wealth over time. Examples of good debt can be mortgages, student loans, or business loans. “Bad debt” often refers to a type of debt that has little purpose in terms of building wealth or income. Examples of bad debts are credit card debt and other types of consumer debt.
It is a general rule. The classification of what is good debt and bad debt is not as black and white as these definitions. The actual disparities are much more nuanced and an individual’s overall financial portfolio must be considered. For example, student loans taken out can certainly be used to open doors leading to higher paying careers. However, they can also be expensive, putting tens of thousands of dollars in debt right out of college with high monthly payments.
Leveraging good debt successfully depends on a multitude of factors.
Gravity towards good debt
Many of us have learned to avoid debt, and many people are suspicious. However, taking on debt prudently can help you achieve your financial goals and increase your net worth. The ability to borrow money can be a powerful tool if done wisely. Good debts are worth more than they cost.
Stick to taking on debt to finance the purchase of something that will increase in value. Good debt improves your life, while bad debt prevents you from reaching your financial goals. Mortgages and student loans are often cited as good debt. Since the value of your home can appreciate and a college degree can lead to better paying jobs, both are often considered good debt. However, borrowing more than you can afford or not understanding the terms of the mortgage can be risky. Likewise, if your chosen major doesn’t translate into a job that pays enough to pay off debt, college debt can certainly be a cause for concern.
Investing in small business loans is often considered good debt, assuming the business can be successful and profitable. Small business loans are similar to student loans in that the goal is to help you earn more money in the future.
Of course, there are still risks inherent in these loans. And the ultimate success or failure of the loan depends on the success of the underlying debt-financed project, whether it’s a small business or a career (post-graduation). However, “good debt” can certainly be a great option if your debt burden is manageable.
Avoid bad debt entirely if possible
A bad debt is debt that costs more than it is worth and can have adverse consequences, such as bankruptcy. In simple terms, a bad debt is generally any debt that can never be repaid by the activity originally financed by the debt. Bad debts often do not provide a good return on investment and negatively impact credit ratings.
Credit card debt is perhaps the biggest source of bad debt for people. Credit cards charge high interest rates and their fees can continue to accumulate to unmanageable levels. If you pay down your balance every month, credit cards can be great tools for building credit, managing cash flow, and earning rewards points and bonuses.
Payday loans target people who don’t have good credit and who otherwise wouldn’t qualify for credit cards or other types of loans. These people often seek short-term financial help through payday loans or check-cashing stores. However, these services often come with exorbitant interest rates and fees that leave them in worse shape. These services are often used by people in great financial difficulty. Avoid them at all costs, as the cost far outweighs the short-term benefit.
In short, be extremely wary of loans with high interest rates or loans with unusually long terms. These predatory loans target people who have no other legitimate alternatives. They come with astronomical interest rates, confusing payment terms and a plethora of penalty fees. Payday loans can fall under these predatory loans, although other loans, such as tribal loans and even some car loans, can also be predatory (some car loans have terms longer than 84 months). While the lower monthly payments may appeal to some, the result of the extended term may be that you pay far more than the value of the car or the original amount.
Decide if the debt is worth it
Debt is an essential aspect of modern life. It can certainly have disastrous financial consequences if improperly or dangerously structured. However, if structured strategically, calculated debt can set you up for a healthier financial future.
The first question to ask yourself is how the purchase benefits you. Think long term rather than short term. Does incurring this debt provide a tangible, lasting benefit that ultimately outweighs the cost of the debt, or is it simply something that satisfies a short-term impulse or desire that you can’t afford?
Credit cards are often the biggest source of bad debt. If structured accordingly, these credit cards can be a great way to build credit. However, people often use credit cards in an emergency and find themselves in a hole that is hard to get out of. Having an emergency fund available for these situations is a great way to avoid overpurchases on your credit card, saving you from incurring excessive bad debt.
Paying your bills on time and maintaining a low debt ratio (how much you owe relative to the total amount of credit you have) is imperative for a healthy financial situation. If you do, you will benefit from more favorable conditions if you decide to take on new debt. Avoid frivolous purchases and make sure any debt you take on is conducive to increasing your net worth: this is of paramount importance when taking advantage of any type of debt.
The Epoch Times Copyright © 2022 The views and opinions expressed are those of the authors. They are intended for general informational purposes only and should not be construed or construed as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or other personal finance advice. Epoch Times assumes no responsibility for the accuracy or timeliness of the information provided.