Good debt vs bad debt: know the difference
Can debt be good? Many people think borrowing money means sacrificing financial freedom. But in reality, debt could be one way to gain it. Understanding the difference between good and bad debt can help you make informed financial decisions.
What is good debt?
Some debt may be a smart investment in your financial future if utilized wisely and you can afford it. It's geared toward leaving you in better financial shape after you pay it off than you were before taking it on. This type of debt shouldn't hinder your financial state or lead to stress.
Benefits of good debt include:
- Builds or improves your credit history
- Potential tax breaks
- The opportunity to build equity
- A return on investment (ROI)
Examples of good debt:
- Home mortgage
- Student loans
- Business loans
More than 50% of Americans view mortgages as good debt. The reason some people are afraid of mortgage loans is the big figures associated with them. However, there are some benefits.
A home mortgage has all the elements of good debt because it could
- Increase net worth
- Be better than renting
- Build equity over time
- Offer tax breaks
- Bring long-term financial gains as the property value increases over time
When you take out a mortgage, you get immediate benefits — a place to live. Once you pay your mortgage loan off, you own a property that could increase your net worth.
Mortgage interest rates are generally lower than other debt types and amortize longer. This works toward helping you maintain a stable financial situation.
Student loans are often the only way to get the level of education you desire. They’re an investment in your future and can pay off once you get your first job.
Student loans have all the necessary elements of good debt and then some. They can:
- Provide a high return on investment (ROI)
- Offer flexibility
- Come with low interest rates and fees
A student loan offers you the opportunity to receive top-notch higher education.
Small business loans
Starting your own business usually requires a substantial financial investment. The reason why some startups fail is often lack of sufficient funding. Taking out a small business loan is a serious investment in your financial future.
Of course, starting a business comes with a variety of risks. Paying off a loan could be tricky unless you succeed. However, with the right business plan and financial literacy, you have an excellent chance of getting the most out of a business loan.
A small business loan comes with the following elements of good debt:
- High return on investment (ROI)
- Reasonable interest rates
- Possibility of long-term financial gain
- Increase in net worth
To take out a small business loan, you need to create a comprehensive business plan. This allows you to measure all risks and benefits to help make the right decision.
Risks of good debt
Good debt comes with its own set of risks. For example:
- A property may unexpectedly lose value due to a natural disaster, neighborhood neglect or economic factors.
- An Ivy League degree doesn't necessarily mean you'll get a high-paying job right after graduation.
- Your startup might take long to show profits.
That's why it's important to weigh the pros and cons before taking on debt. Just because it's generally good, it may not be right for you at the time.
What is bad debt?
Bad debt offers a temporary relief to your financial situation and doesn't have a sufficient return on investment. This kind of debt is likely to worsen your financial state and cause stress.
Debt is considered bad when it:
- Has high interest rates
- Isn’t affordable
- Doesn’t have realistic repayment plans
- Makes your debt-to-income ratio too high
- Negatively impacts your credit score
Examples of bad debt:
Debts that can be considered bad are payday loans, cash advance loans and certain types of personal loans. These debts are costly short-term fixes and don’t improve your financial future. Whether a debt is good or bad depends on what you can realistically afford, and how it’ll affect your financial health.
How to tell if a debt is bad for you
Before deciding to take on any kind of debt, you need to evaluate your personal circumstances. Bad debt generally lasts longer than the things you acquired by taking it on. For example, taking out a personal loan to go on a vacation can be bad debt if you’re still paying it off years later.
The benefits of good debt, on the other hand, are long-lasting. For example, a mortgage gives you and your family a place to live long-term, while building your net worth.
Good debt can turn into bad debt unless you assess your capabilities before taking it on. Borrowing more money than you need without a clear plan for paying it back can turn any debt into a bad one.
How to avoid bad debt
To avoid bad debt, it's important to do in-depth research and:
- Know what you can afford
- Shop around for the best deal
- Think about the possible risks
- Calculate the debt-to-income ratio
- Review all terms and conditions of the debt agreement
- Ask yourself how the purchase benefits you in the future
- Have a rainy day fund for unexpected expenses
Is debt the right option for me?
Debt can become an efficient tool in your journey for financial growth and independence. Knowing the key differences between good and bad debt can help you make the right decision.
It's worth remembering that every situation is different. Without considering your personal circumstances and financial abilities, it's impossible to tell if a certain type of debt is good or bad for your needs.
Speak to a Home Lending Advisor to learn more about whether a home mortgage or refinance is a good debt option for your financial goals.