People may come across the term “good debt and bad debt” several times in their lives without fully understanding the difference between the two.
In most cases, debt can seem like a never-ending trap that is difficult to escape, but not all debts are bad. If you take a loan for investment purposes or to raise your income potential, it is not a bad debt. That distinctive feature sets good debt apart from bad debt.
When a lender evaluates your credit history to see your account, he considers some debts more significant than others. If you want to focus on escaping debts, it is imperative to understand the difference between good and bad debt. This way, you will be able to prioritise eliminating the bad debts first.
Good Debts Vs. Bad Debt – What is the Difference
As mentioned above, not all debts on your credit report are bad. In fact, creditors consider some of them as an investment. Perhaps you’re wondering how a” debt” or “borrowed money” can be an investment?
When you take on debt to invest in or buy something that increases its value over time and contributes to your financial health, it’s “good” debt. It is because debt money helps you build wealth over time.
Simply stated, good debt is about taking on money to make more money. Some examples of good debts include;
Student Loans (College or Technical Education)
Generally, the more educated you are, the higher-earning potential you have. Higher education correlates with the ability to get high-paid jobs. Well-educated people tend to find new employment opportunities easily.
An investment in the form of a student loan pays for itself within two to three years. When a student enters the workforce, he/she likely returns the loan or pays the debt off. This debt typically helps to increase income potential, justifying the need to lend the money.
According to the US Education Department, individuals with a bachelor’s degree are likely to earn over $1 million more than a worker with a high school education over the course of their lifetime.
However, you must choose a degree program carefully to maximize the debt’s value for your education. If you think your degree program will not add to your career path or overall earning, a student loan taken for it may become a bad debt.
The mortgage is an example of investment, and that is why it falls in the category of good debt. It helps you build equity in a property and make money when you pay for it as an investment. People often view renting a home as an insignificant option, but it may allow you to build equity through other avenues, if the property market is not for you.
The decision may also turn into a bad one if you lend too much and overextend yourself or you continually use the equity in your house (top ups) to spend on wants rather than needs.
Entrepreneurship or Business Ownership
You start a small business with an aim to make profits or money. You’re your own boss and can make decisions independently, which is a positive outcome of your endeavor. You can also avoid reliance on any third party to employ you and pay you. A startup or a business improves your earning potential, especially when you’re willing to work hard.
With luck, dedication, and hard work, you can be a successful owner of a self-sustaining enterprise, resulting in significant wealth. And taking a loan to expand your business to boost profit makes it an example of good debt.
However, this may entail risks like those of a poorly chosen student loan. You must choose to work in the field you’re knowledgeable and passionate about to make your small business a success.
Car or Auto Loans
Car or auto loans only make a good debt if your purchased vehicle maintains a reasonable value even after paying off the loan or you are using it for work, to increase to your income. Think carefully about what type of car best suits your needs
Of course, having a car loan to buy a car may open the possibilities to get the better-paying jobs you could not opt for because of commuting issues.
Real estate also offers plenty of ways to earn profits. One of the simplest strategies on the residential front is buying a property, renovating, and selling it at a good profit.
You may also improve your potential income by renting your entire property. If you own a commercial property, it can also become a source of capital gains and cash flow for investors.
Bad debt refers to borrowed money that you use to buy depreciating assets. Unlike good debt, it doesn’t increase your net worth or wealth. That is to say, if a loan is not going to help you generate income, it is better not to take it or go into debt because of it.
Loan with High Interest
A lot of personal and payday lenders charge people high-interest rates. According to the Consumer Financial Bureau, a payday loan may charge APRs up to 400% when people account for the fee they pay to take a loan.
Depending on the country you live in determines the average interest rate you would expect to pay but it always pays to do your homework or to use a broker, they do all the hard work for you and work to get you the best deal on the market. Don’t forget to ask for the total payback of the loan. It will often surprise you.
Consumables and Services
Did you know consumables such as clothes and shoes are worth half the price you pay to buy them?
When you pay for fast food, gasoline, groceries, and vacations with borrowed money, it adds to your bad debt. The money you spend in paying interest on these consumables can save you hundreds of dollars.
Expert economists consider credit card loans a bad debt due to the items people purchase using them. Purchasing everyday things like food or clothes with credit cards is not wise. The card companies charge high-interest rates on these items. Try using a credit card only for intentional purchases that can help you earn rewards.
For instance, vacation paid from a credit card doesn’t have any appreciable value though of course it has some legitimate benefits.
What Else - Could Be Good Debt or Bad Debt?!
You can’t classify all debts as good and bad. We say this because it depends on plenty of factors, including your financial situation. While some debts are suitable for many people, for others, they are a bad choice.
Some examples include;
If you’re a consumer who is already in debt, taking out a consolidation loan at a lower % rate may benefit you. This will allow you to pay down the debt quicker.
Credit Card Reward Program
As mentioned above, credit card companies offer some excellent credit card programs to consumers. From free cruises, airline tickets to cashback, you can avail many things. But if you don’t have the discipline or cash flow to pay off the balance, it is not worthwhile. The interest you spend on your credit card debt will offset the reward’s value.
Borrow Money to Invest
You can leverage money at a low-interest rate and invest it at a higher rate for profits (with an adequate margin account). It appears like an excellent way to obtain financial gains.
However, it may entail numerous risks for the new investors. It has a potential hazard to lose a significant amount. Plus, you may need to compensate your creditor for the funds.
That means you shouldn’t opt for this if you’re not a knowledgeable investor and afford to bear losses in an investment event.
Tips to Avoid Bad Debt
Avoiding bad debts requires a change of your approach and developing a habit to take on good debt.