Contrary to popular belief, not all debt is bad debt. Some investments have the potential to grow in value and generate long-term income, while others depreciate without improving your financial situation; hence the saying, “not all debt is created equal.”
For most people, debt is a part of life. A small percentage can purchase a home without a mortgage or afford a six-figure college education without student loans. In fact, 77% of American households carry some type of debt.
The difference between good and bad debt depends on what the money is used for and whether it provides some type of value in the long run. Here are the key differences between good and bad debt and common examples of each.
What is good debt?
Generally speaking, if it increases your net worth or has the potential to grow in value, it’s good debt. Good debt is low-interest debt that can help build wealth or increase your income over time, such as student loans, mortgages, or business loans.
This type of debt is geared towards leaving you in better financial shape after you pay it off than you were before taking it on. Additional benefits of good debt include building or improving your credit history, the opportunity to build equity, a return on investment (ROI), and potential tax breaks.
For example, interest paid on mortgages, student loans, and business loans can be deducted from your annual taxes, effectively reducing your taxable income for the year. However, of course, certain criteria must be met to qualify for the aforementioned deductions.
Let’s look at how student loans, mortgages, and business loans can help to increase your income, build wealth, and lead to financial success.
Student loans: Typically regarded as an investment in your future, student loans allow you to get an education and increase your long-term earnings potential. Bachelor’s degree holders earn 66% more in their lifetime, on average, than those without a degree. If you’re going to take out student loans, your focus should be on maximizing the return on your investment. That means getting the highest salary possible for the lowest amount of student loan debt.
Mortgages: Taking on a mortgage is likely the biggest financial decision you’ll make in your lifetime. Thankfully, there are countless financial benefits of homeownership, such as building equity, home appreciation, tax benefits, and generating long-term wealth.
You gain equity in two ways – when your home increases in value or when you pay down your mortgage principal. Typically, home values appreciate over time. For example, real estate in Charlotte, NC appreciated by 70.9% over the last ten years. Paying down your mortgage principal while your home appreciates will gradually shift your debt into an asset, essentially acting as a “forced savings account.” This is unlike virtually any other asset purchased with a loan, such as automobiles, which lose value while you pay them off.
Furthermore, homeowners can use a HELOC, home equity loan, or cash-out refinance to conduct capital improvements, or home renovations, to build more equity and qualify for additional tax breaks. With today’s low interest rates and record home equity growth, a mortgage is a prime example of using (good) debt to build wealth. With this in mind, It should come as no surprise that the net worth of a homeowner is 44x greater than a renter.
Business loans: Like paying for student loans, starting your own business comes with risks. However, with research and careful planning, business loans can help you achieve your entrepreneurial goals and be both financially and psychologically rewarding. Business loans provide business owners with fast access to funding, low interest rates, and the opportunity to pursue growth or high-interest debt consolidation. Whatever the reason, a business loan can increase your future cash flow, lead to a high ROI, and increase your net worth.
Student loans, mortgages, and business loans are the most common forms of good debt, but even good debt has its risks. Now that we’ve covered good debt, what is bad debt?
What is bad debt?
If your purchase doesn’t increase in value or generate income, you may be taking on bad debt. Bad debts are typically depreciating assets, such as cars, with high interest rates that can negatively impact your credit score.
Generally, if the debt won’t bring you future income or wealth, it’s bad debt. Additionally, unlike good debts, interest paid on bad debts, such as personal loans and credit cards, are typically not tax deductible.
While it may be difficult to avoid taking on bad debts, you should be aware of the most common types of bad debt: payday loans, credit cards, and auto loans.
Payday loans: Payday loans are short-term loans with high interest rates and fees. Shockingly, the average annual percentage rate (APR) for payday loans is 396% and every year, $9 billion is paid in payday loan fees. On average, payday borrowers pay $520 in fees to borrow $375. This is some of the most expensive debt in the U.S. and the most prominent example of bad debt.
Credit cards: If you pay them off every month and aren’t accruing interest, credit cards can be considered good debt. However, with an average APR of 20.46%, credit cards are typically the most expensive debt you can take on, behind payday loans. Because of its incredibly high interest rates, nearly half of America is carrying credit card debt and 15% of Americans have been in credit card debt for 15 years. Keep in mind that unless you pay your balance in full every month, the interest charges may more than offset the value of your rewards.
Auto loans: New cars depreciate almost immediately after you drive them off the lot. According to Bankrate, a car will lose between 15% and 20% of its value each year. Paying interest for years on an asset that is continually depreciating is harmful to your financial future. If you need to borrow to buy a car, look for a used vehicle with low or no interest.
Choosing the right debt
Simply said, good debts put money in your pocket and bad debts take money out of your pocket. Keep in mind that too much debt can turn good debt into bad debt. Bad debts may be good debts that have spiraled out of control. For example, credit cards.
If you use debt strategically, it can help you achieve your short and long-term financial goals. The right amount of good debt can increase your ability to save for the future, build wealth, and responsibly afford the things you want in life, without bad debt.
Understanding the key differences between good and bad debt can help you make informed financial decisions. Before taking on debt, ask yourself: Will this debt pay me back more than what I put in?
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