Good vs. Bad Debt: Is There Really a Difference?
It’s never been easier to get into debt. And while most of us would like to get through life as debt-free as possible, this is very difficult to do. For most people, any major life change—from buying a car or house to getting married or earning a degree—requires some kind of loan. Many financial advisors will tell you that there are two types of debt, however: good and bad debt. Here’s a look at what they mean by that.
Good debt is an investment with an eye toward a future payoff. An investment in a new business is seen as “good debt,” because the business is, theoretically at least, supposed to make money in the future. A mortgage is also good debt, because your home will hopefully increase in value and you can sell it for more than you bought it for.
A student loan for a traditional or accredited online degree is also considered “good debt.” That’s because an investment in your education is supposed to pay off. Statistics show that this is usually the case, a person with a Bachelor’s degree makes an average of $x more over their earning lifetime than someone with only a high school degree. A person with a Master’s degree makes an average of $x more than someone with a Bachelor’s alone, and a Ph.D. makes the most—an average of $x more than those with a Bachelor’s. Some forms of “good debt”—including mortgages and student loans—are also tax-deductible.
However, it’s important to mention that what is considered “good debt” doesn’t automatically pay off. Your home could very well decrease in value—as many people found out during the recent economic recession. A large percentage of business startups do not become profitable, so investing in a new business is also not a guarantee.
In addition, despite the statistics about the high average earnings of Ph.D.’s, many people with doctoral degrees do not make large amounts of money. Some fields pay much more than others, and a Ph.D. is not always a good bet. Whether or not financial advisors label your debt “good” or “bad,” if your investment doesn’t work out, it could be just as devastating financially.
Bad debt is debt that does not increase in value. It’s also debt that comes with high interest rates. Examples of bad debt include credit card debt and other forms of regular consumer debt, as well as payday loans.
In general, bad debt carries an increased risk that you’ll ultimately wind up overpaying for what you bought with the debt. High credit card interest rates, for example, mean that you’ll pay significantly more for whatever you bought with your credit card than you would have if you’d paid the whole amount up front. While this is also true for things like student loans and mortgages, the interest rates for these types of debt are not as high—and what you bought is supposed to pay you back in the long run.
Credit card debt isn’t necessarily always bad debt—for example, if you used a business credit card to buy supplies for your company, that might be construed as “good debt.” However, you’ll usually get better terms with a business loan from a bank.
Loans That Are Both
Some finance experts categorize auto loans as “good” debt—and others as “bad” debt. Cars depreciate dramatically in value, which is why auto loans are often lumped in with other “bad” types of loans. However, buying a car can also be an investment—for instance, if you need the car to go to work.
In general, because they depreciate so much in value, it’s always a good idea to pay as much as possible up front for a car so that your loan isn’t too expensive.
Home equity loans are often categorized as “good” debt, but they can also fall under the “bad” label. When you take out a home equity loan, your lender counts your house as collateral. Usually, home equity loans are relatively low-interest, and borrowers sometimes consolidate other, more high-interest debts under a home equity loan to reduce the overall interest rate. However, this is risky, as you lose your home if you fail to pay the debt.
It’s very difficult to get through life completely debt-free. However, you can minimize the amount you owe by being smart about the types of loans you take out. Avoid racking up large amounts of credit card debt, and stay away from payday and cash advance loans. Use your credit as an investment in your future—with student loans, mortgages, and other loans meant to pay off later. With careful research, you should be able to keep your finances in good shape even while you’re in debt—and hopefully stay in it as little as possible.
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