What is a Good Debt and a Bad Debt?

October 30, 2020

There are some things that separate the two, but the distinction between good and bad debt may get blurry. Debt may be a helpful way to improve your earning potential, increase passive income, or otherwise invest in a future that is financially stable. Often, your health or wellbeing just needs ...

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There are some things that separate the two, but the distinction between good and bad debt may get blurry.

Debt may be a helpful way to improve your earning potential, increase passive income, or otherwise invest in a future that is financially stable. Often, your health or wellbeing just needs to be covered. This good debt will also help you increase your credit score when done carefully, such as student loans and mortgages.

Bad debt, by comparison, comes with high-interest rates and does not contribute in a meaningful way to the bottom line. Things such as car loans and credit cards can be costly to borrow and are not long-term investments.

Of course, there are a few grey areas, and whether the debt is good or bad might not always be obvious. Take a closer look at your finances to decide whether it is worth the risk if you are thinking of taking out a loan for something from small needs to a new vehicle.

What is the difference here?

There are certain items that help to distinguish the two, but the distinction between good and bad debt may get blurry. When comparing good debt versus bad debt, points to remember include:

Is this an investment that produces long-term returns, or is this just a short-term solution?
Can you get more than you put into it from the debt / expense?
After considering the overall loan rate, does the debt still make sense? ( costs, principal, interest, and any missed opportunities for investment)
Is there a better way, along the same lines, to spend or save money that will benefit you in the long term?

What is Bad Debt?

Bad debt does not yield long-term profits or boost your net worth in other respects. Bad debt offers fewer investment opportunities than good debt, often used to buy products or services that do not have enduring value. Bad debt is also associated with financing clothing, vehicles, electronics, and other consumer products and services that easily lose their value. Plus, bad debt also comes with higher interest rates, making it more difficult to pay off and more costly.

Cash Advance Loans

Owing to their elevated interest rates, penalties, and short payback periods, payday loans and cash advance loans are bad. Many of these loans target mainly those who are already strapped for cash and worried that bills and other needs will not be paid. Sadly, the same individuals are also the ones who can least afford the expensive fees and prices.

And, while payday loans at the time may seem like a good choice, they can send you quickly into a debt cycle that eventually lands you deeper in debt. With APRs ranging from 391 percent to over 521 percent, many borrowers are required to extend or roll over the loan for an extra fee and find the debt difficult to pay off within the loan period.

These prices are no doubt predatory. In comparison, at more modest but still high rates, about 30-50 percent, some payday loans are available to those with less than stellar credit. They are not perfect, but they are more sensible and are based on a fairer contrast with the risk taken on the part of the lender.

Consider asking your boss for a paycheck advance, borrowing money from friends and family, or partnering with a local credit union to find loan conditions that suit your needs if you feel strapped for cash and are considering a payday loan.

Credit Cards

Consumer credit card debt hit a record high of $829 billion at the end of 2019, with the average American facing credit card debt of $6,194. Unfortunately, credit card debt is commonly categorized as bad, especially when credit cards are used to pay for luxuries and other consumables that will not help the long-term finances.

This is because, like payday loans, whether you max them out or just make minimum monthly payments, credit card use will put you in a debt spiral. And it becomes more and more difficult to keep on top of those minimum payments as the interest builds up. What’s more, many individuals abuse credit cards by skipping payments or carrying a month-to – month balance in a way that can hurt their credit profile.

Credit cards, however, may still be good in certain, although minimal, circumstances. For example, to combine and pay off other debts, using a 0 percent APR(Annual percentage rate) credit card can be a great way to save money on interest while simplifying payments and paying down balances. Similarly, credit cards will bring money in the bank if you pay off your monthly balances on time and earn large cash returns or incentives.

Car Loans

Due to their high upfront cost and rapid depreciation once driven off the lot, cars are one of the most famously depreciating properties. For this reason, it is usually considered a bad debt to finance a new vehicle. In addition, some car loans come with high-interest rates, especially for borrowers with a low credit score or with limited down payment cash.

Notice that car loans, depending on the borrower’s needs, will fall into a gray area. You’re probably dealing with bad debt if you’re financing a sports car to be used on the weekends. However, you can think of a small car loan as an investment in your potential success if you live in an area without public transport or bikeable roads and need a car to get to your work. Only try to keep your interest rate down in that situation and purchase a used car instead of a new one that will depreciate on day one. Additionally, push it until the wheels fall off once you buy the vehicle, AKA get your use out of it! Stop succumbing as much as possible to lifestyle creeps.

What is Good Debt?

Although some might say there’s no such thing as good, it can still be a wise investment in your future to take out loans. Good is usually the one that boosts your net worth or otherwise helps to create value. Usually, good debt often comes with a lower interest rate than certain kinds of bad debt. This means you can pay off the loan more easily than high-interest loans and at a lower average rate.

However, bear in mind that, especially if you have aspirations of financial freedom or early retirement, you should always strive to keep even good debt to a minimum.

Type of Good Debt

Mortgages

The biggest loan anyone takes out in their life is always a home mortgage. Though overwhelming, it can be an investment in both your present and your future to shoulder this. Home mortgages are, for this reason, usually known as good. Similarly, investment property-related will place rent payments in your wallet every month while serving as a long-term investment, both indicators of good debt.

Building equity in a home also provides homeowners with access to a home equity credit line (HELOC) or home equity loan, all of which may be responsible alternatives to more costly debt forms.

It can be an excellent way of saving in your future to buy a home. But renting may still be the best choice for some, especially if you spend the cash instead of saving for a down payment. It is always best to assess the individual circumstances before signing on the dotted line, as with other types of debt.

Medical Debt

If you’re contemplating an expensive operation or trying to pay off a big hospital bill, you’ve heard the old adage: you can’t put a price on your health. This is particularly true. That said, medical debt is also categorized as good because it is an investment in your future, in essence. You will limit or lose your earning power without your health and will be less likely to enjoy your life.

Sadly, the price of medical care is so high that it might seem like the healthcare industry has done just that.

But bear in mind the distinction between surgery that is medically required and surgeries that are more elective. Your particular situation will finally come down to whether medical debt is good or poor. But it’s a worthwhile investment if you have to go into debt to fund a treatment that can save or enhance your life.

Also Read: Medicare Frequently Asked Questions

Students Loans

Education costs are generally categorized as good, particularly those related to postsecondary education. This is large to a degree boosts the long-term earning prospects, albeit costly at the time.

Some degrees have a higher value than others, however. Google , for example, provides inexpensive certificates in design and coding that can give you a six-figure salary, whereas a $200,000 degree from a conventional college could restrict the average student to considerably lower earnings. This doesn’t mean that one degree is better than another. Do not get me wrong. But it’s best to weigh the cost of a degree against your possible earning prospects from a debt perspective.

Business Loans

While never quick, it can be an extremely lucrative investment in your financial and professional future to start a small business. Plus, running your own company is one way to invest in yourself and limit the risk of being laid off, with more volatility in the job market than in recent history. In the aftermath of COVID-19, applications for new companies are growing more than they have since 2007. And the figures back that up.

If they increase your earning capacity or otherwise boost your bottom line, business loans are considered good. These loans can also reduce your dependency on an employer and have the ability to contribute to stronger and more sustainable earnings.

However, it can always be a risky venture to start a company and your investment is not inherently secure. When determining whether to take out a business loan and whether it will be more good than poor, stick to loans that will help you produce increased revenue for your company.

The Gray Area

Know that there is a grey area when deciding what constitutes bad debt. The true cost and worth of debt are probably different from individual to individual. Here are a few forms of debt that, depending on the factors, can be good or bad:

Lending against your 401(k).

In certain conditions, borrowing against your 401(k) can make a lot of sense. There is no lender, after all, so you don’t have the chance of defaulting. However, you have to pay the money back in full if you separate from work. Otherwise, it would be viewed as a distribution that is taxable and you may be subject to extra fees and penalties.

Consolidation Loans

It can be a perfect way to simplify loans, decrease your interest rate, and lower your monthly payments by using a new loan to combine your other debts. However, you can find yourself struggling to make payments if you don’t adjust your approach to budgeting and money management as well.

Borrowing to invest

Some people assume it’s a good debt to borrow cash at a low-interest rate and save it for a higher rate of return. And for seasoned investors who are able to track their portfolio and accounts closely, this may be true. However, stay clear to secure your long-term financial health if you do not have experience with this form of borrowing.

Thoughts

Debt also has a negative connotation, but since it can actually help you grow financially, certain items qualify as good. Buying a house, gaining a degree, or investing in a business or real estate can all be productive ways to broaden your assets and improve your earning potential. However, avoid bad debts, such as credit cards and car loans, to make the most of your cash, which can drain your financial capital without improving your bottom line.

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