Having debt can be a good thing. Your credit history – the biggest factor that allows you to purchase big-ticket items like cars and houses – is based around how well you handle your debt. That said, many Americans are living with more “bad debt’ than what’s considered “good debt.”
According to the Northwestern Mutual’s 2018 Planning and Progress Study, the average American is approximately $38,000 in debt. Collectively, the total U.S. consumer debt level reached more than $13 trillion in 2019.
Generally, debt is qualified as either good or bad. Before you start taking out debts to build up credit, you should know the difference between good debt and bad debt so that you know what to expect from taking on either.
What Is Good Debt?
Put simply, good debt is a debt that adds value to your life — you want to take on these debts. This can be in the form of an increase in your net worth or as an income-generating tool.
Good debts are investments for your future. Although the amount may seem steep, these debts pay for tools that will help you create a brighter financial future.
Examples of Good Debt
Student Loan Debt
Paying for education with student loans is one of the most common forms of good debt. Although the cost of going to school has recently seen a rise, graduates of universities, colleges, or technical schools are more likely to qualify for higher-paying jobs. There are several reasons students loans are ideal good debts:
- Some federal loans may be subsidized
- Student loans generally have lower interest rates
- The interest is tax-deductible
- Most come with a variety of repayment plans
To keep these loans from turning into bad debt, begin making payments as soon as possible. The more you pay, the less risk you run of falling behind.
Small Business Expenses
Starting your own business is another investment in your future. If your business succeeds and increases your income over time, your business investments are seen as good debts.
Starting a business comes with many costs. You may find yourself dipping into savings and taking out loans to pay for:
- Office supplies
- Certification or accreditation fees
- Office space
- Marketing campaigns
However, if you’re wise with your money and have a keen sense of business, these debts will be repaid over time. With a little luck and hard work, your small business can transform into one of your most lucrative assets.
Mortgage Loans and Real Estate Investments
Taking out a mortgage to pay for a house is also considered good debt. Homes can retain or even increase value over time, adding to your net worth or even simply providing a roof to live under.
Despite being long-term loans, mortgages typically come with lower, tax-deductible interest rates. If your home increases in value over time, the interest payments you’ve made can be considered repaid.
To maximize the profitability of your loan, consider real estate investment. This includes:
- Renting out properties
- Buying properties and selling for a profit
- Encouraging real estate appreciation
- Adding non-rental income sources, such as laundromats, to properties
To keep your mortgage from turning into bad debt, make payments on time and take care of the property. Avoiding depreciation on your assets and staying on top of your loan payments are the biggest factors in keeping the debt a positive influence on your finances.
What is Bad Debt?
Bad debt takes away from your net worth. These are debts used to pay for things that lose value over time and do not contribute to your income. These debts often come with high interest rates, costing you more out of pocket.
As a rule of thumb, anything you cannot afford or make money from is considered bad debt. While it may be difficult to avoid taking on bad debts, you should be aware of the most common types to determine whether or not taking on the debt is worth it.
Bad Debt Examples
Credit Card Debt
Owing money on your credit card is one of the most common types of bad debt. Credit cards are issued by lenders and allow you to make purchases on credit. These cards can come with high interest rates (often with a rate of more than 20%) and can get out of hand quickly.
However, owning a credit card is not bad in itself. Credit cards are one of the quickest ways to build up credit, particularly if you have none. A little discipline and strategic usage can make your credit card one of the biggest credit tools in your arsenal.
Buying a car might seem like a worthwhile purchase, but auto loans are considered bad debt. A car’s value depreciates over time, so it’s important to know when to sell or trade in your car. Your car depreciates due to changes in:
- Number of owners
- Service history
- Fuel economy
- Length of warranty
- General changes in condition
This depreciation flushes all of the interest payments you make over the length of an auto loan right down the drain. To avoid spending more than necessary, pay as much as you can up front. Large down payments can lower your loan’s interest rates.
Like credit cards, personal loans can push you deep into debt quickly if you aren’t careful. What you use the loans for will determine if the debt is good or bad.
Personal loans come with interest rates that are based on your credit and range from 5-36%. Unlike credit cards, they are installment loans that require monthly payments to completely repay the loan within a 2-5 year span.
Personal loans can be used for a variety of reasons, including:
- Consolidating debts
- Making investments
- Purchasing big-ticket items
Despite the risk that comes with taking on with interest, there are several cases in which personal loans can be considered good debt. If you do not qualify for a business loan, personal loans are often used as an alternative. They can also be used to consolidate multiple debts into a single, manageable monthly payment.
Payday loans are one of the most notorious types of bad debt. These short-term, unsecured loans gain their bad reputation from their extreme interest rates, often running as high as 400%.
Combined with multiple service and late fees, these high rates are intended to encourage borrowers to pay their loans off as quickly as possible. Missing your due dates can cause your debts to skyrocket, and you may find it difficult to gain back control.
Payday loans should be considered your absolute last option. If you are tight for cash, there are several alternatives to payday loans that you should consider first.
Loan Shark Deals
Like the name implies, loan shark lenders are dangerous for those looking for financial help. These types of lenders are individuals you may know professionally or through your network that offer to lend money without background checks or credit reports. Similar to payday loans, you may be required to pay loans back within a short period of time. You may also be charged an interest rate high above the legal standard. In many cases, working with these lenders is against the law.
These often illegal and financially strenuous dealings are not worth the stress they bring. While payday loans should be your absolute last option, loan sharks should be avoided at all costs
Get Help With Bad Debt
Being in debt is not as bad as it’s painted to be. The right sort of debts can have a huge positive impact on your financial wellbeing. Even bad debts have value if handled correctly.
No matter what sort of debt you have, there is a solution for you. If you’re looking for help on how to handle your debts, talk to one of our expert debt coaches for help setting up a budget that makes paying your debts back simple and manageable.