What Is “Good Debt” Versus “Bad Debt”?
Debt, credit, and financing – words that can make many squeamish. Financing, unless you have piles of cash laying around most need it to help make purchases, both big and on the smaller scale. Credit, you need a good credit score and credit history to get affordable financing offers. Debt, it’s what you get when financing.
But it’s not necessary to look at debt negatively all the time. Debt is something most people carry. It’s pretty much required to get some of the major staples we need in life, such as a mortgage for your home, loan for a car, and more. Let’s explore what is “good debt” and what is “bad debt.”
Types of “Good Debt”
In a nutshell, “Good Debt” could be considered a good investment when financing something that will maintain or increase in value over the life of the loan. Some of examples of good debt are:
1. Mortgages
Historically speaking the value of a home tends to increase by 3-5% annually. Meaning, if you purchase a home today for $200,000 in several years or when you pay it off, the value of your home should be worth significantly more than you purchased it for. Now there are obviously numerous factors that will influence that such as the climate of the housing market at that time. But generally, a home purchased at a fair value is a wise investment, or “good debt.”
Now, this statement isn’t always going to be true. There are many factors to consider like the economy, neighborhood, condition of house,etc. But since we know that homes generally increase in value a mortgage tend to be “Good Debt.” As with any purchase, however, there is always the opportunity to go overboard and purchasing a new home is no different. Only buy a home you can afford and take all your expenses into consideration. Typically your housing payment, mortgage or rent, should not exceed 35-36% of you monthly household income.
2. Home Equity
Similar to a mortgage, a Home Equity Loan or Line-of-Credit can be considered “good debt” depending on use of the funds. As you make your mortgage payments you begin to build equity as your mortgage balance decreases and home value increases. This equity can then become available to borrow on. Home equity financing can be “good debt” when used to add more value, typically by reinvesting in upgrades to your home. But if you use the funds for just pleasure and fun you can quickly turn this into “bad debt.”
3. Auto Loans
Auto loans are one of the most common forms of financing consumers use. While vehicles do depreciate (lose value) year over year, they tend to hold their value longer, well after a typical auto loan is paid off. Depending on where you live, a vehicle can be a required asset to get you to and from work, to shop for necessities, to transport your family, and more.
While auto loans can be considered “good debt,” there are some considerations to keep in mind to help minimize the level of debt. Try to put down cash if you can. Any funds you have available to put towards it as a down payment will help reduce the amount being financed.
Consider buying a used car. Sure, it’s nice to get that brand-new car, but it comes with a price. Often you can find a car comparable to the new model that is a couple years older for less. And you may even get more features and options out of the pre-owned car that you wouldn’t have been able to afford in the new model. Plus, your price should be lower and more affordable.
Pay attention to the term of your loan and try to keep it to 60-months or less. You may be able to get that car you want to a monthly payment within your budget by extending your loan term out to 74 or 84-months. But by extending the loan term you are extending the amount of debt and paying more for the vehicle due to the added interest expense
4. Student Loans
Student Loans are good? How do they increase in value? Those are certainly valid questions. No, you don’t get any tangible assets like a home or vehicle when you finance your education. However, when you do earn a degree that is your asset. Depending on the degree you earn and the field you choose should put you on a path towards higher income earning potential that should help you pay off that student debt sooner and put you on a path to sustained financial well-being by providing you a means of finding a strong career path.
Some may consider this “Good Debt,” others see it as “Bad Debt.” But with all financing, it depends on how much you take out, how long it takes you to pay it off, and what it gets you in return. Will the field of study you select, length of time you are pursuing that degree, and ultimately the career opportunities that exist after college set you up for success with ability to pay back your student loan? But for most it does, and is therefore “good debt.”
Types of “Bad Debt”
As we have highlighted, not all debt is bad. However, there are plenty of financing types that can be more troublesome and riskier. These should be avoided or used on a limited basis as necessary and be well managed. Here are a few examples:
1. Credit Cards
The number one form of “Bad Debt” is credit cards. Credit cards provide great value and help with purchasing needs. However, they should be used cautiously and responsibly as debt can quickly build up beyond what your budget can afford.
Credit cards can actually help you. They are a great way to build you credit. In fact, it’s usually the first way many start to build their credit. When used responsibly and paid off regularly they can improve your credit. However, when you rack up and carry high balances, you become a riskier borrower and drops your credit score.
When you use a credit card, be sure to pay off your balance when the bill comes in each month or within about 3-6 months. Anything longer and the interest you are paying probably was not worth the purchase you made.
2. Personal Loans
Personal Loans are used to help make larger purchases and are available without collateral like a vehicle or house. Because there is no collateral that a lender could collect if you default on the loan, the rates tend to be higher to compensate for the risk.
Personal loans are considered “bad debt” depending on what the funds are used for. If used to help pay for a project that adds value to something such as a deck on your house, a home renovation or new key appliances, then they can be “good debt.”
A personal loan tends to be “bad debt” when used in ways that don’t build value, such as an expensive vacation, a new “toy,” and more. Personal loans should be used responsibly to keep from becoming “bad debt.”
3. Pay Day Loans
The ULTIMATE form of “Bad Debt” is Pay Day Loans. In almost all cases a payday loan just is not a good idea. The fees and rates are sky-high just to receive fast cash. Avoid these whenever possible. There are ways to get your cash in a timely manner without having to pay to do so. Don’t give up your hard-earned money just to get access to cash. Bring your paycheck to AFFCU or a financial institution for easy access without the costs involved.
While some of what we covered is identified as “Bad Debt,” it does not mean you shouldn’t use it. It just means you should be sure to use it with more caution and control, while effectively managing the debt you take through these financing options. When used responsibly, this “bad debt” or risky financing can end up being advantageous for you.
Financing and debt are often unavoidable aspects of life. We all have different experiences and events happen that will require us to need to consider some form of debt. All that matters is the financing you choose, and how you use and control it to determine if it becomes “good debt” or “bad debt” in your life. But when you need safe and affordable financing options, you can always count on and turn to your partner, Atlantic Financial Federal Credit Union.