Good Debt Versus Bad Debt

The best time to borrow money is when you don’t need to do it, but choose to do it. When you’re financially stable with great credit and high net worth (especially if you have a lot of liquid assets, which can be quickly converted to cash), lenders will trip over themselves to offer you loans. 

That means you’ll be in the strongest possible position to negotiate terms that benefit you, mainly very low-interest rates. Since you don’t need to borrow money to cover your expenses, you’ll use loans for leverage to build up your wealth more quickly. 

That involves using other people’s money to purchase productive assets, which will either produce steady income or come with the potential to grow significantly in value.

Borrowing Versus Debt

When it comes to debt, the type makes a big difference. Good debt goes toward building your net worth by investing in assets (including yourself); the goal of this debt is to increase your fortune or your fortune-growing ability. 

Bad debt eats away at your net worth and jeopardizes your current and future financial health. This type of debt is used to buy things that won’t add value to your nest egg or boost your income. Some debt falls into the middle (like car loans) and doesn’t fit neatly into either the good or bad category. 

Understanding the differences can help you make better borrowing choices. But don’t beat yourself up over bad debt; you can’t always avoid it. 

In fact, it’s nearly impossible for most people to get by without racking up at least a little bit of bad debt. The key is to minimize it and pay it off as quickly as possible before it takes over your finances completely.

Learn more about different types of debt.

Good Debt

Good debt works for you, helping achieve goals, boost income, and improve your overall financial situation. This type of debt normally comes with lower interest rates and better payment terms, which is also better for your net worth. 

Still, too much good debt is bad for your finances. That’s why it’s important to not take on more debt than you can realistically pay back without straining your budget. This is especially true of student loans, which many young people enter into without fully realizing the long-term (sometimes devastating) financial implications.

Student Loans 

Borrowing to fund your education falls into the good debt category; it’s an investment in yourself and your future. Choosing the right degree program plays a crucial role in this conversation. When your education will be funded (even partly) by loans, the degree has to lead to the possibility of an income-producing career path, or the debt could quickly become unmanageable. 

The dividing line that keeps student debt in the good category involves the amount you borrow. While most people look at the question as “How much in student loans can I get?” the right question is “How much in student loans can I pay back?” 

To keep these loans affordable, the rule of thumb is to borrow (in total) no more than your (realistically) expected starting salary when you graduate, and less is even better.

Home Mortgage Loans

Your mortgage will probably be the single largest good debt you ever take on. These loans offer the most direct path to owning a home, both a functional and usually appreciating (growing in value) asset. 

As these loans run hundreds of thousands of dollars, it’s important to fully understand how the loan terms and the interest rate will affect your current and future financial picture. Go into these loans knowing how much of a monthly payment fits easily into your budget and avoid the temptation to go bigger.

Small Business Loans

Funding a business opens the possibility for a more secure financial future, where your financial success is limited mainly by your own determination and motivation. With a lot of drive and some luck, you’ll be able to turn your business into a reliable income stream for your family and a source of retirement funding when you’re ready to stop. 

The key to keeping this type of loan in the good pile is starting with a complete business plan, whether you’re in prelaunch or expansion mode. Know exactly how you’ll use the money to expand your company and your chances of success improve instantly.

Learn more about good debt. 

Bad Debt

Borrowing money to pay for discretionary expenses (things you want but don’t really need) counts as bad debt. High-interest debt also belongs here, even if it’s used for needs, because it will make whatever you use it for two or three times more expensive than if you’d paid for it outright. That can trap you in a cycle of relying on loans to cover your basic monthly expenses that can be extremely hard to escape.

Credit Card Debt

Using credit cards and having credit card debt are not the same thing. Credit card debt involves a balance due that can’t be cleared with a single payment. This tops the list of bad debt for three important reasons:

  1. High interest rates
  2. Payment schedules designed to keep you in debt
  3. Often used to buy consumables, services, and goods that immediately lose value

Paying off this debt will lead to a huge improvement in your immediate financial situation, your long-term financial security, and your net worth.

Personal Loans 

Taking out personal loans to buy big-ticket items like a new wardrobe or a vacation counts as bad debt. 

This form of unsecured debt normally comes with fairly high interest rates (sometimes as high as credit card rates), adding an extra layer of cost to the purchase, especially if you don’t make consistent, on-time loan payments.

In addition, you may have to cough up money for fees (like loan origination fees) on top of the loan interest. In specific cases, personal loans can move to the medium debt category. Using a lower-high-interest personal loan to pay off higher-interest debt (like payday loans) would be a better use of this type of debt.

Payday Loans 

Payday loans fall into the toxic debt category, as they come with frighteningly high interest rates—some as high as 500 percent a year—and are virtually impossible to pay back. The goal of payday lenders is to keep you borrowing constantly; it’s how they make money. 

These short-term loans are supposed to keep you afloat until your next paycheck, but borrowing even a small amount at these unconscionable rates can cost a fortune. For example, a single $500 payday loan could come with a $75 fee, which converts to 15 percent interest for two weeks. 

That comes out to an annual interest rate of 360 percent, ten times more than the highest-rate credit cards. Worse, you have to pay that loan back with your next paycheck, even if you need that money to pay for your living expenses like rent and food. 

That forces you to take out another payday loan over and over again. If you have any options other than a payday loan—even a super high-interest credit card cash advance— use them. These toxic loans are the worst kind of bad debt.

Medium Debt

This middle zone of debt covers everything that doesn’t fall squarely into either the good debt or bad debt category. This debt covers things that you absolutely need, even if you can’t afford to pay for them in full with cash.

Debts that fall into the medium category include:

  • Car loans. If you need a car to get around, which many of us do, you may have to borrow money to get one. To keep this medium debt from turning into bad debt, stick with good quality, affordable used cars; keep the loan term to four years or less; and shop around for rates before you sign up for seller financing.
  • Medical debt. No matter your financial situation, protecting your and your family’s physical and mental health is worth any cost, even if that includes taking on debt. Many healthcare providers will negotiate balances or provide you no-interest payment plans, a key reason to not pay for medical expenses with credit cards.

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