People often just think of debt as something they owe. And while that’s a concise definition, there are debts that can help you reach your goals (good debt) and debts that can work against you (bad debt).
Good debt
Usually, good debt is defined as debt that you 1) can afford, 2) that comes with reasonable rates, and 3) goes towards something that’s going to increase in value or at the very least provide lasting value. When you consider this, some debts should easily come to mind.
Mortgage for real estate. A real estate purchase offers the chance for you to own the place you’re living in with the potential for that property to increase in value over time. There are tax benefits to home ownership, and you have the comfort (with a fixed loan) of having a steady payment each month. Naturally, two keys are to buy in a good neighborhood and negotiate for the lowest possible interest rate and price.
Loan to start a business. Starting a business has long been a way for people to move up the income ladder while potentially providing revenue for future generations. Marketing your products or services while still earning a paycheck can help keep costs down. If you do get a loan, closely evaluate the amount and terms.
Loans to improve yourself. Most of these are student loans to go to college, grad school, or to take advantage of ongoing education in your field. Student loan rates are often lower than competitive personal loan rates. Try to keep these loans to only essentials so the debt isn’t a yoke around your neck when you finish school.
Bad Debt
Bad debt is easy to identify. It’s any debt that you can’t afford. Or any debt that has sky high interest rates. Or debt to make a frivolous purchase that may not last the length of the debt.
Consumer loans. Often charged to your credit card, these are loans used to buy clothes, go to restaurants, or overspend on Christmas presents. Using a credit card isn’t bad if you use it to track your purchases and pay them off monthly. It’s when these purchases keep increasing your long-term credit card debt that they cause issues.
Trip to Tahiti. Debt used for a vacation is bad debt. While you may enjoy lasting benefits from a trip, the trip won’t last longer than the amount of time it takes you to pay off the debt. Save up for – or take a lower cost – vacation.
Payday, car title, pawn shop loans. Astronomical interest rates. Losing something valuable to a pawn shop for 1/10 of the value. These just don’t make good financial sense. Steer clear.
Maybe debt
Car loans are considered bad debt by much of the mainstream press. And buying a new car for top dollar without negotiating the cost or securing the best loan (low rate, short term) probably adds up to bad debt. But if you need a car to get to work and can afford all aspects of ownership, a low interest rate loan for a quality long-lasting car isn’t terrible. But again – you have to turn this into a good debt situation. Buy a car that will last longer than the debt. Research interest rates online at local credit unions. Watch for year-end specials or fall clearance sales from the dealerships. And consider used. Even with a loan, by buying used you’ll lose much less to depreciation when you drive it off the lot.
Good debt may turn bad … bad debt may be the best short-term solution
Even with the parameters listed above, good debt can turn bad if you have too much of it. Maybe you bought a house that was too expensive or took out an extra $3,000 per year in college loans just to have a little extra. Whatever the case, having too much debt where you can’t make the payments or save for future needs can quickly spiral out of control.
In a crisis situation you may need a temporary loan to be able to pay your monthly bills. What if a check was delayed or your commission was held up? In this instance, paying for groceries or other necessities on a credit card may make sense. This isn’t a license to spend frivolously. Anyone who suddenly loses a job or sees their world turned upside down should have an emergency fund. If you don’t, start by canceling everything you don’t need – cable tv, any subscription, gym membership, etc. Make sure to use the lowest interest rate option you have (either a credit card or home equity line if you have it) for the shortest time possible. And pay it off as soon as you’re able.
If your gym or cable company charges you to cancel, see if you can change to a lower cost membership tier or put your account on hold for free. Many companies will work with you in a crisis.
Good debt may not work out
Even if you’re doing everything right and you buy the least expensive house in a great neighborhood with a low interest rate, you may lose money. Taking out a loan to improve yourself or pay for long-term assets is not guaranteed. You could end up failing out of school or your business may founder. Make sure you’re clearly evaluating the real estate, business idea, and yes, yourself, before you decide to sign for that loan.
Understand your debt
No matter if it’s good or bad, you need to be in control of your financial life. That means understanding your debt, knowing the interest rate and payments, and reading through all repayment terms. Can you afford it, given your take-home pay and any other loans you have? Perhaps more importantly, can you afford it if you have a $1,000 surprise bill (like repairing your car’s transmission)?
Consider the lowest debt option
One thing that has helped me through life has been taking loans for only the amount I absolutely need. I’ve bought new cars, but I’ve paid down the balance with cash to get the loan payment into an area in which I felt comfortable. When I was a student, my loans only covered necessities. When we purchased a home, it was the cheapest in the neighborhood and only after comparing loans with three companies. Lean toward the low side – having less debt is never a bad thing.