You may have been told that there is a difference between good and bad debt. Depending on your money philosophy, you may think that all debt is bad debt or that some debt is normal.
The truth is, you are typically paying a lot of interest regardless of your debts, but some are worse than others. To better understand if there is a difference between good and bad debt, here’s what you need to know.
What Is A Good Debt?
Before you knock on the door of a bank or a credit card company, it’s essential to know the basic differences between good debt and bad debt. Some debt is good and can bring a positive change in your life. It can increase your income or help you to create opportunities in your life. An example of this is a mortgage that allows you to build equity and become a landowner. Remember, too much of a good thing can be negative, so too much good debt can turn in to bad debt if you are unable to repay it.
On the other hand, bad debt can push you towards a financial mess and make you bankrupt. An example is credit card debt that accrued interest faster than you can pay them off. If a debt has a very high-interest rate, you may want to do everything you can to avoid it, refinance it at a lower interest rate, or pay it off as quickly as possible.
Good Debt – A Friend
You can think of good debt as a friend who can help you grow in the long run. It’s a sensible investment that can leave you in a better financial position after some time. People usually have a valid reason and specific goals for taking out good debt. Plus, they have a practical and affordable repayment plan to pay it off.
Student loans and mortgages are examples of good debt. This is because they can both help you to grow in the long run.
Mortgages help you buy a home. You can live in that home with your family, build equity in your property, and eventually sell it for a profit. Once you pay off the mortgage, you become the true owner of your home. Even if you don’t want to live in that home after several years, you can either sell it to potentially receive a good return on investment or rent it to create a new stream on income. Again, it’s important to note that too much of a good thing can be negative, so only purchase as much home as you can afford.
Education is costly, but a student loan helps you become a graduate. Graduates have a higher chance of getting a high-paying job. Therefore, student loans are an investment in yourself. The interest rate on a student loan is low and you can start making payments after finishing your studies. Additionally, the interest you pay on your student loans is tax-deductible, so you will receive a higher tax return that you can then reinvest into your business or help you pay off your student loans.
Bad Debt – A Devil in Disguise
Bad debts are designed to eat away at your wealth. In simple terms, bad investments are bad debt that doesn’t give you benefits in the long run. These debts are expensive due to high-interest rates.
One example is payday loans. Some payday loan lenders charge a 400% annual interest (APR) or more. Most people can’t afford to pay such a high rate of interest and get into a bigger financial mess.
The most common example of bad debt is credit card debt. Some credit cards carry an interest of 30% or higher, but the average is closer to about 20%. This means that the outstanding balance can double in just two and a half years. Imagine if you had put something unnecessary on a credit card. For example, let’s say that you went shopping and spent $1,000. In less than three years, you would owe $2,000. Not only that, but you wouldn’t have anything to show for it at the end of those three years. Credit cards are bad debts.
Often, people incur bad debt when they make impulsive purchases. They buy unnecessary things beyond their financial ability. For example, clothes they don’t need, kitchenware they can’t afford, books they never read, etc. Bad debt is not a personal investment. Instead, they are high-interest wealth vacuums.
Here are a few examples of bad debt and why you may want to avoid it.
- An expensive vacation – A luxury trip should be avoided if it keeps you in debt for a long time.
- An expensive payday loan – This is the worst form of bad debt. Many states have banned payday loans for this reason.
- Unnecessary credit card debt – If you can’t afford a purchase outright, it’s not wise to put it on credit. However, if you can afford it, you may want to use your credit card to receive extra points of rewards for your purchase. You can then pay off your credit card right away.
Case Resolved: Opt for Good Debt and Shun Bad Debt
Bad debts can destroy you financially. Try to avoid bad debt in your life or pay down your existing debt as fast as you can. Additionally, don’t borrow money if you can’t afford the monthly payments.
If you are considering a good debt, ask yourself if it would help improve your finances in the long run before taking out a loan. This will help you discern if it will be good debt or bad debt. Shop for the best deal in town and evaluate the pros and cons of taking out a loan. Remember, it’s about building a strong financial future.
If you’re unsure of how to move forward with your finances, our Navalign team is here to help guide you. Contact us to schedule time with a financial planner today. We will take the time to understand your goals and help you to make the most advantageous decisions for you.