While no one likes being in debt, the truth is that the majority of us need debt to finance our day-to-day lives. But here’s the good news: not all debts are created equal. Understanding the subtle differences can be the difference between using debt to strengthen your financial life or falling into the abyss of immense debt.
To make this distinction, debts are broadly classified into two: good debt and bad debt. Yeah, sometimes some debts are prudent to get. This post explores when debt can be a good or bad thing. Let’s dive right into it.
Good debt is any debt you take that helps you generate income or increase your net worth. As the adage goes: “You need money to make money.” Therefore, taking out the debt that will contribute positively to your financial situation, in the long run, is considered good debt.
Examples of Good Debt
There’s no better way to understand this than to examine some examples of good debt.
- Student Loan
College education in the United States is insanely high. As a result, many people cannot afford it. So, you’re left with two options: take out a student loan or forego college education. Unsurprisingly, many people opt for student loans. Do you know that the total federal student loan debt in the U.S. is $1.5 trillion? That’s about $500 billion higher than total credit card debt.
A college education is positively correlated with earning potential. Moreover, with a college degree, you’re more likely to get good-paying employment and lead a better quality of life. So, it makes sense to take a student loan.
However, there’s one major caveat: the discipline of study makes a crucial difference in determining if a student loan is good or bad debt. For a student majoring in Petroleum Engineering, with the potential to earn $80,000 yearly, a student loan might be a great idea. On the other hand, if a student studies a course with low earning potential or low demand, they may be unable to repay their student loan.
- Small Business Ownership
Being an entrepreneur is a great thing. Aside from being your boss, your potential for earning becomes uncapped. If your enterprise becomes successful, you can become an instant millionaire. You might even be lucky enough to go public, earning a lot in the process.
But starting a business requires capital. Borrowing can be a great way to secure funds necessary to scale your business. In that sense, getting a loan to start a business is good debt. However, take note that up to 90% of new startups eventually fail. So, do well to have a robust and viable business plan to avoid getting into needless debt.
It’s the dream of the average American to own a home. This dream will be unattainable for many if there weren’t mortgages. Mortgages are loans given to help you purchase a home. However, you have to make monthly payments for a specified period until you pay back the principal plus accrued interest.
Purchasing a home gives you a ‘permanent’ roof over your head. Moreover, it adds to your net worth as the average value of your home is expected to rise. Therefore, a mortgage is good debt.
As you can probably figure on your own by now, bad debt is when you borrow money to purchase depreciating items that do not generate income for you. As a general rule of thumb, you should stay away from bad debts as they are guaranteed to have a net negative impact on you.
Examples of Bad Debt
Here are some examples of bad debts:
- Auto Loans
Who wouldn’t like to drive a Tesla Model X or a Mercedes? But before you proceed with that auto loan, ask yourself if you can afford to pay for the car in cash or easily make monthly payments? If not, then taking that loan is simply a waste of money.
But why? By the time you leave the dealer’s shop, the car is already worth less than the amount you paid for it, and it will continue to depreciate as time flies by until it eventually becomes worthless. For this reason, auto loans are generally considered bad debt.
If you insist on purchasing a car, then buy one that is well within your means, maybe fairly-used, and you should seek a low-interest auto loan. In general, you should never purchase a car you would struggle to make payments for.
- Credit Cards
Credit cards are like little demons. They give you the ability to spend what you don’t have until your card gets maxed, and it dawns on you that you’re in debt. To lure you into getting one, many credit card companies offer zero interest rates for a grace period, after which predatory interest sets in. The truth is that the majority are unable to repay their debt before the grace period expires, and so, they end up in debt.
So, before you purchase that $1,000 shoe or that gorgeous designer’s cloth with your credit card, ask yourself if you can truly afford it.
Recognizing a good vs bad debt is dependent on the particular circumstance. A debt that is good for person A might be bad for person B. For instance, if student A can secure a high-paying job after college, then a college loan is good debt. If that student cannot find a good job after graduation, then it becomes a bad debt.
Similarly, if you’re taking an auto loan to purchase an expensive personal vehicle, then it’s bad debt. On the other hand, if you’re purchasing that vehicle to aid your business – maybe for quicker delivery – then it becomes a good debt because it is generating income for you.
But as a heuristic, stay away from bad debt if possible. If not, try to limit the amount of bad debt you acquire.
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