Good vs. Bad Debt: What’s the Difference When Managing Debt?
Debt can be a complicated or sensitive topic, but it’s important to discuss because it’s crucial to our personal finances. Your credit score is impacted by the amount of debt you have, whether you are paying off your debt on time, your credit card balance(s), and more. Debt can also have you spending significant sums on interest alone. According to financial data from Zillow, Forbes, and TransUnion, the average American will pay just under $900 a year in interest on their credit card debt.
However, not all debt is bad. Sometimes debt can help to improve your credit score, make a sound investment in your future, and more. Understanding the difference between good debt and bad debt can help you determine what debts to pay off first or avoid going into certain types of debt.
WHAT IS THE DIFFERENCE BETWEEN GOOD AND BAD DEBT?
First, it’s important to recognize that your financial situation would be at its best if you had no debt at all. However, having no debt is almost impossible since living expenses can be high and not everyone has money on hand to make significant purchases like a home or car.
Since nearly all of us will take out a loan at some point, how can we know which is good and which is bad? Debt is categorized based on how the purchase effects your net worth. Your net worth is the value of your assets (what you own) minus your liabilities (what you owe). The current value of your home, car, and the balances of your credit cards, loans, and bank accounts make up your net worth.
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Bad debt is associated with items that lose value at the time of purchase. As a result, your debt becomes greater than the value of what you bought. Bad debt usually comes with a higher interest rate. Because you’ll be paying more in interest, bad debt should be the first kind of debt you try to pay off.
Good debt will help grow your net worth over time or at least has the potential to increase your net worth because the asset will either maintain or increase in value. However, good debt can turn into bad debt if the purchased item starts to lose its value.
To help illustrate the difference, let’s look at some specific types of good and bad debt.
Mortgages are typically considered good debt. The value of the home usually rises over time, meaning you are building equity in your home. Home equity is the difference between what you owe on your mortgage and the value of the home. This is what increases, or decreases, your net worth.
If your home loses value, like what happened in the 2008 housing crisis, then your debt on the house can start to be categorized as “bad.” Mortgages can also be bad debt if you buy a house that you can’t afford.
Despite there being no tangible item associated with a student loan, this is another example of good debt. Going to school can increase your chances of having a higher salary in the future and earning more income during your career. Of course, for student loans to be good debt, the borrowed amount should be reasonable. You will want to think about the earning potential that your degree gives you, which can enable you to afford your monthly payments.
Car loans are considered bad debt simply because the vehicle loses value the moment that you drive away from the dealership. Meanwhile, you end up paying more than the sticker price because of the interest on the loan.
Don’t choose not to buy a car because it’s considered bad debt. Having a car can get you to school or your job, which ultimately allows you to earn more and make your payments on time. You can also consider buying a used car, which is more affordable and doesn’t lose as much value when you leave the dealership.
CREDIT CARD DEBT
Credit card purchases generally create bad debt. Most items purchased with credit cards, such as subscription services, gaming equipment, and cleaning supplies, don’t contribute to your net worth. Credit cards also often have high interest rates that can cause financial stress if you can’t pay your monthly bill. (Credit card interest rates can be up to 20%, while mortgage rates are generally less than 5%.)
Think of the 60-inch television you’ve been wanting to buy. Do you have the funds in your bank account to make the purchase? If not, you might want to reconsider the purchase. A television doesn’t increase your net worth and, unless you can pay your credit card bill in full, you will be paying interest on the credit card you used.
That said, credit card debt can be beneficial if you’re able to pay off your credit card each month. Earning rewards by immediately paying off credit card balance(s) is a good way to use credit card “debt” to your advantage.
Any high-interest loans, such as payday loans, are also bad debt. Payday loans not only usually have high-interest rates—often higher than credit cards—but you are borrowing money assuming you’ll be able to pay it back soon. There are other ways to get help with your expenses when you really need it—talking with your creditors and debt counseling, to name two—but just don’t fall into the payday loan trap.
Personal loans can also have high-interest rates. Like credit cards and payday loans, these can be used for almost anything. You should avoid using personal loans for things that don’t contribute to your net worth, like vacations or new house decorations. However, personal loans generally have lower interest rates than pay day loans. If you need to borrow for necessities, they are a better alternative to help you make ends meet.
Debt can be hard to categorize since it depends on a person’s situation. Because lenders will favor different types of debts over others, it’s good to know the difference between good debt and bad debt. You can categorize and manage your own debt more effectively to impress lenders, improve your credit score, and grow your net worth.
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