While most of us cannot live entirely debt-free, there are major differences between what is considered “good” debt and “bad” debt. Though some debt falls into a bit of a gray area, good debt is simply defined as money borrowed to pay for items you truly need or that appreciate in value, and bad debt is accrued for items you only want and that generally depreciate in value.
To help you make this distinction, it is important to be able to differentiate between wants and needs. Moreover, before borrowing money, you need to determine whether the money is going toward something that will have a positive or negative effect on your overall financial situation. Ultimately, debt is not always bad – it’s how you use it that counts.
1. Borrowing Money for Education
When you take on student loan debt, you are rarely making a bad decision. Generally, those with college degrees tend to earn more money over their lifetime than those without a degree.
And taking out a student loan to pay for your child’s education sure beats using your retirement money to do so. After all, you cannot borrow to pay for your own retirement. There are many government programs offering low-interest or interest-free student loans, and you can often deduct student loan interest on your taxes.
2. Paying for Medical Care
While unpaid medical bills account for more than 60% of bankruptcies in the United States, there is no amount of money not worth borrowing to help pay to keep a loved one healthy. You can always pay back money you borrow, but you cannot replace a human life. If someone needs expensive treatments or surgery to regain their health, this an acceptable debt to take on, no matter what.
3. Taking out a Mortgage on a Home
Make no mistake, taking out a loan of this size can be daunting, but buying a home builds ownership in something that not only provides a roof over your head, but also is a potential source of retirement money. And while your drive to stay out of debt may feel like encouragement to put any and all available liquid cash down as a down payment (which effectively reduces your monthly payment and interest charges), it may not be the smartest move.
Home mortgage interest is deductible on your taxes, and the interest rate is much lower on your home loan than it is on your credit card, so having cash to pay other expenses instead of using your credit is important.
While buying a house was formerly seen as a solid, future-proof investment, some homeowners are finding themselves upside down on their home mortgage loan, owing more to the banks than their homes are worth. But careful planning, buying only what you can afford, and keeping those interest rates low by having good credit enables you to buy a house that you will one day own outright.
4. Purchasing a Car
If public transportation is not available in your area, or you cannot find anyone with whom to car pool, you are probably going to need to buy a car. An auto loan can fall into that gray area between “good” and “bad,” but the key to keeping an auto loan closer to good debt rather than bad is to make sure you get the lowest possible interest rate on your loan. Also, it’s important to put as much down as possible, while making sure you still have cash on hand should you need it.
Your best bet is to buy a late-model used car rather than a brand new one, potentially saving you thousands on the sticker price and the interest paid over the life of the loan.
5. Business Loans
While this wouldn’t be considered good debt in every single case, borrowing money to start or expand a business is generally seen as a good idea, especially if business is booming. After all, it takes money to make money, right?
Sometimes you have to borrow capital in order to hire new employees, buy new equipment, pay for advertising, or just to manufacture the first run of a new widget you invented. As long as the money is borrowed with a plan in place to generate more business or income, then taking out a business loan counts as good debt.
1. Credit Card Debt
The average U.S. household carries a balance of more than $10,000 on their credit cards each month. Credit card debt often piles up quicker than we realize, and is often used to pay for things we want rather than need. It’s much easier to think we can afford something using a card rather than paying with cash.
By the time credit cards are paid off, interest rates and minimum payments can turn $100 items into $200 items, and many items depreciate in value rapidly, making the loss that much more substantial. Credit card debt is without question a bad debt, and one that millions of Americans find themselves with today. It’s hard to get out of credit card debt and is best to avoid it in the first place – most Americans should not use credit cards.
2. Borrowing From a 401k
When you borrow money from your 401k plan, you have to deal with the IRS, and unless you are using the money to buy a home, you have to pay back the borrowed money within five years. If you don’t pay it back when you should, you could get hit with heavy early withdrawal penalties. Plus, the interest you’ll pay on the loan will effectively get taxed twice – first when you pay it, and again when you withdraw it during retirement.
You cannot borrow money to fund your retirement. Therefore, borrowing money from your retirement fund to pay for anything other than retirement is a bad idea. You put your retirement at risk when borrowing from a 401k, so don’t do it unless absolutely necessary.
3. Vacations, Jewelry, and Expensive Clothes
If you cannot comfortably afford to pay for these luxuries with cash on hand, don’t do it. These are not needs but wants, and thus bad debt. Wait until you have the money to pay for them. Going into debt just to pay for a vacation or a handbag is most definitely a terrible use of borrowed money.
4. Payday Loans
It may be easy to borrow money from payday loan companies, but it’s very difficult to pay them back. These companies loan out money with terrifyingly high interest rates, taking advantage of the fact that many people are desperate for cash. Even a small amount borrowed through a payday loan outlet can end up costing a small fortune when finally paid back.
Payday loans are often considered the worst kind of debt you can take on. If you are in serious need of a short-term loan, you are better off taking a cash advance on a credit card than borrowing money from these companies.
Modern life requires many of us to borrow money at some point or another. But knowing the difference between good debt and bad debt can make a big impact on your financial health and chance of success.
It is best not to incur more debt than you can comfortably afford to pay back, regardless of whether it is good or bad. Also, don’t let debt add up to more than 36% of your total gross income, as credit agencies do not differentiate between good and bad debt when determining your credit score and credit-worthiness. If you find yourself too deep in the red, look for ways to snowflake your debt and get back on track.
Do not be scared of debt as a general concept. Instead, use it as a tool when seeking to improve your life or your financial situation, to increase earnings, or to invest in your future.
What types of debt have helped you improve your finances and your life? What do you believe is the worst type of debt to take on?