When you hear the word debt, your first thought might be “panic”. Let’s face it – having debt is naturally perceived as being negative. However, some debt can actually be beneficial for your finances. The truth is, there are two kinds of debt
, and while “bad debt” may result in financial problems, there is also “good debt” that can potentially help you to achieve your financial goals.
Let’s take a closer look at the two kinds of debt:
The Difference Between Good Debt and Bad Debt
Debt is typically categorized as good or bad
based on whether or not it has the potential to improve your financial future. Good debt is often viewed as an investment, such as money that is borrowed to help increase your earning power, improve your credit score
, or build wealth. Good debt can improve your net worth by helping you build equity and accumulate valuable assets. In many cases, you'll also find that good debt comes at a lower interest rate than bad debt.
Bad debt does not have the same long-term benefits as good debt. Bad debt typically refers to money that is borrowed to pay for personal goods and services, or assets that are expected to lose their value. If you’re borrowing money to live above your means, the debt you’re racking up can almost certainly be considered “bad debt”. Bad debt has the power to negatively impact your financial situation and credit history. Bad debt is often, but not always, marked by higher interest rates than good debt. Bad debt can easily snowball into a significant problem
if not managed correctly.
Types of Good Debt
Types of Bad Debt
- Mortgage Loans: Mortgages are one of the most common types of good debt. Homeownership not only provides housing security, but a home is also viewed as a valuable asset. As you work toward paying back your mortgage loan, you will continue to build home equity, which has a direct positive impact on your overall net worth. One caveat though is that you should not take out a mortgage for more home than you can afford. Make sure your monthly mortgage payment is reasonable for your budget. You should also try to save up money for a down payment so you can avoid having to pay private mortgage insurance, and so you’ll start with positive equity in your home.
- Student Loans: Another common type of good debt is a student loan. Student loans act as an investment in your future and can help provide you with the tools you need to achieve your future career goals. Often, these loans come with a relatively low interest rate, especially if you choose a government affiliated loan.
- Auto Loans: Although a large auto loan or one with a high interest rate can be seen as bad debt, if the car is truly within your budget it can be considered good debt. Most people need a vehicle to get to and maintain a job, so it can certainly be considered an investment for your future. For many, taking out an auto loan will be the first time they borrow a significant amount of money, and it can help build credit history.
Improve Bad Debt and Maintain Good Debt
- Credit Card Debt: The most common type of bad debt is credit card debt. While minimal credit card debt is okay and can be helpful to your credit score, high credit card balances can lead to financial problems. Interest charged on credit card balances tends to be very high, often above 20%, which means that in the end you will likely be paying a lot more for the things you buy with a credit card, if you don't pay your card balance in full each month.
- High-Interest Personal Loans: Another example of bad debt is a personal loan used to purchase consumer goods, take a vacation, or pay for other things you can’t really afford. Like credit cards, personal loans can have high interest rates since they are “unsecured”. Those high interest rates can make a personal loan difficult to pay back, and missing payments or making payments late can wreak havoc on your credit score. When used correctly however, it is possible for a personal loan to have a positive impact on your credit. Just be sure to only borrow what you can afford to pay back, and shop around for the best interest rate available to you. You may also want to consider a co-signer as it could potentially help you to get a lower interest rate.
- Payday Loans: Payday loans, also referred to as a cash advance, are considered bad debt and can result in a toxic debt cycle. While these loans can be tempting because they offer quick cash even if you have poor or unestablished credit, their extremely high interest rates can make them almost impossible to get out of. Sixteen states, including Massachusetts, have outlawed payday loans completely for this reason.
If you find yourself with a lot of bad debt
, there are ways to help get it under control. The first step is to stop purchasing things unless you really need them. Living above your means is a surefire way to continue piling up debt.
You should also create a plan to help pay off your debt as quickly as possible. This often involves attacking the debt that has the highest interest rate first
. Stick to a budget
and refrain from adding to your debt. After you have paid down most of your debt, aim to keep your credit utilization between 11% and 30%
of your overall available credit.
If you currently have loans that are considered “good debt”, it is essential to make your loan payments on time, every time. Failing to do so will have a negative impact on your credit score, and could prevent you from being approved for loans or credit cards in the future, or could result in high interest rates if you are not denied outright.
Don’t Avoid Debt, Just Manage it Carefully
Most people will accrue at least some debt during their lifetimes, and that’s okay. Rather than try to avoid debt altogether, just be aware of the kinds of debt you’re adding to your plate and what they could potentially mean for your financial future. Use “good debt” to your advantage, to help build your wealth and credit history and limit “bad debt” whenever possible. If you do have to take on some bad debt, just be sure to manage it responsibly so it won’t put you in a dire financial situation.