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The U.S. national debt is greater than $31 trillion for the first time, according to a Treasury Department report. These figures seem bleak until you realize that there are both positive and negative consequences of having debt. In this post, we will be looking at good debt versus bad debt.
Types of Good Debt
Good debt is debt that is used for positive and productive purposes. Good debt can help you accumulate wealth, increase your income, and generate revenue over time. If you're punctual and consistent with your repayment plan, good debt can improve your credit rating. Good debt can be easier to repay as it typically comes with lower interest rates and longer repayment periods.
Read on for types of good debt versus bad debt.
Education
A loan for educational purposes is typically one of the types of good debt. Borrowing money to get an academic degree typically results in the ability to earn a higher salary upon graduation. Studies show that median earnings for bachelor’s degree graduates are $36,000 (or 84 percent) higher than that of high school graduates.
Student loans are considered good debt, but even good debt can turn bad if you're unable to make your monthly payments. The key to making your student loan good debt versus bad debt is to ensure that the total loan amount is within the range of your expected starting salary upon graduation. There are many student loan estimator tools like this one from Salle Mae to help you calculate your monthly loan payment.
Business
Borrowing money to start or grow a business is typically considered good debt. Running and operating a business comes with rigorous challenges but having sufficient capital can help you grow your organization at a faster pace. Working capital allows you to leverage growth opportunities that can take your business further, and faster. That said, you must ensure that your resulting revenue can cover the loan promptly and without turmoil.
When taking out a loan to fund your business, ensure you have established a solid repayment plan. Opt for a loan with a low-interest rate and long repayment period so that monthly payments won’t take a toll on your finances. Also, do business in an industry you're familiar with to increase your chances for success.
Home and Other Real Estate
A mortgage is considered one of the safest types of good debt, as real estate generally increases in value over time. Owning a home is a smart decision, even with a loan. You need a place to live, and it's wise to spend money on your own mortgage payment. vs. paying rent to cover someone else's property investment.
You instead own an asset that appreciates, which delivers some measure of financial security and qualifies it as good debt versus bad debt.
What is Bad Debt?
Bad debts are those incurred for purposes that do not improve your finances, e.g., acquiring material goods. Check out some examples of bad debt.
Auto Loans
An automotive loan can be a type of good debt or bad, depending on the terms. It's conventional wisdom that a car’s value decreases the moment you drive it off the dealership lot. However, that car loan can still be "good debt" if it puts you in a position to get (or keep) a better job, which improves your earning potential. A "bad debt" auto loan might have a high-interest rate or a total amount that does not relate to your financial reality.
Consumables
Consumables like clothes, shoes, and vacations are considered bad debt. When the debt for these items becomes harmful to the debtor, it is likely the consumer hasn't delineated between their wants and their needs. Having no repayment plan and relying on credit cards with high interest rates to acquire wants or needs is a sign that there is a problem.
How to Avoid Bad Debt
Bad debt will set you back on your goals and prevent you from growing financially.
Here are a few tips to avoid bad debt:
Keep your Debt-to-Income Ratio Low
Your debt-to-income ratio (DTI) compares the amount you owe every month to the amount you earn. To get a qualified mortgage, your DTI needs to be below 43%, or, for many lenders, below 36%.
One way to keep your debt-to-income ratio low is to take out loans for only the amount you need.
Start an Emergency Fund
Starting an emergency fund is another way to avoid bad debt. An emergency fund helps you cover unexpected bills without taking on more debt. Your emergency fund should be easily accessible, e.g., a high-yield savings account, which offers easy access and a competitive yield.
Avoid Using High Interest Credit Cards
While responsible use and payment on a credit card can help you build credit when you're just starting out, non-payment of monthly charges can quickly become bad debt. If you fail to pay your monthly balance, you risk having a low credit score and high interest rates. Instead of using a credit card, try healthier options like debit cards, or save up to buy luxury items.
Conclusion
The definitions of good debt versus bad debt rely on several circumstances, many of which are in your control. For example, a car loan that lets you drive to a better-paying job can be a type of good debt. Going into debt to fund a high-risk business you know nothing about can result in bad debt. Before getting into debt, consider factors like the interest rate, repayment period, and the urgency of the purchase. You should also consider alternative ways to finance the purchase.
Devidot Credit Union is Here to Help
Our purpose is to help guide our members to better financial lives today and for generations to come. Our blog has topics like raising financially responsible children and tips on becoming a homeowner to keep you informed on financial topics. Want to talk to us about your financial goals? Contact us today to learn more about our solutions.
The U.S. national debt is greater than $31 trillion for the first time, according to a Treasury Department report. These figures seem bleak until you realize that there are both positive and negative consequences of having debt. In this post, we will be looking at good debt versus bad debt.
Types of Good Debt
Good debt is debt that is used for positive and productive purposes. Good debt can help you accumulate wealth, increase your income, and generate revenue over time. If you're punctual and consistent with your repayment plan, good debt can improve your credit rating. Good debt can be easier to repay as it typically comes with lower interest rates and longer repayment periods.
Read on for types of good debt versus bad debt.
Education
A loan for educational purposes is typically one of the types of good debt. Borrowing money to get an academic degree typically results in the ability to earn a higher salary upon graduation. Studies show that median earnings for bachelor’s degree graduates are $36,000 (or 84 percent) higher than that of high school graduates.
Student loans are considered good debt, but even good debt can turn bad if you're unable to make your monthly payments. The key to making your student loan good debt versus bad debt is to ensure that the total loan amount is within the range of your expected starting salary upon graduation. There are many student loan estimator tools like this one from Salle Mae to help you calculate your monthly loan payment.
Business
Borrowing money to start or grow a business is typically considered good debt. Running and operating a business comes with rigorous challenges but having sufficient capital can help you grow your organization at a faster pace. Working capital allows you to leverage growth opportunities that can take your business further, and faster. That said, you must ensure that your resulting revenue can cover the loan promptly and without turmoil.
When taking out a loan to fund your business, ensure you have established a solid repayment plan. Opt for a loan with a low-interest rate and long repayment period so that monthly payments won’t take a toll on your finances. Also, do business in an industry you're familiar with to increase your chances for success.
Home and Other Real Estate
A mortgage is considered one of the safest types of good debt, as real estate generally increases in value over time. Owning a home is a smart decision, even with a loan. You need a place to live, and it's wise to spend money on your own mortgage payment. vs. paying rent to cover someone else's property investment.
You instead own an asset that appreciates, which delivers some measure of financial security and qualifies it as good debt versus bad debt.
What is Bad Debt?
Bad debts are those incurred for purposes that do not improve your finances, e.g., acquiring material goods. Check out some examples of bad debt.
Auto Loans
An automotive loan can be a type of good debt or bad, depending on the terms. It's conventional wisdom that a car’s value decreases the moment you drive it off the dealership lot. However, that car loan can still be "good debt" if it puts you in a position to get (or keep) a better job, which improves your earning potential. A "bad debt" auto loan might have a high-interest rate or a total amount that does not relate to your financial reality.
Consumables
Consumables like clothes, shoes, and vacations are considered bad debt. When the debt for these items becomes harmful to the debtor, it is likely the consumer hasn't delineated between their wants and their needs. Having no repayment plan and relying on credit cards with high interest rates to acquire wants or needs is a sign that there is a problem.
How to Avoid Bad Debt
Bad debt will set you back on your goals and prevent you from growing financially.
Here are a few tips to avoid bad debt:
Keep your Debt-to-Income Ratio Low
Your debt-to-income ratio (DTI) compares the amount you owe every month to the amount you earn. To get a qualified mortgage, your DTI needs to be below 43%, or, for many lenders, below 36%.
One way to keep your debt-to-income ratio low is to take out loans for only the amount you need.
Start an Emergency Fund
Starting an emergency fund is another way to avoid bad debt. An emergency fund helps you cover unexpected bills without taking on more debt. Your emergency fund should be easily accessible, e.g., a high-yield savings account, which offers easy access and a competitive yield.
Avoid Using High Interest Credit Cards
While responsible use and payment on a credit card can help you build credit when you're just starting out, non-payment of monthly charges can quickly become bad debt. If you fail to pay your monthly balance, you risk having a low credit score and high interest rates. Instead of using a credit card, try healthier options like debit cards, or save up to buy luxury items.
Conclusion
The definitions of good debt versus bad debt rely on several circumstances, many of which are in your control. For example, a car loan that lets you drive to a better-paying job can be a type of good debt. Going into debt to fund a high-risk business you know nothing about can result in bad debt. Before getting into debt, consider factors like the interest rate, repayment period, and the urgency of the purchase. You should also consider alternative ways to finance the purchase.
Devidot Credit Union is Here to Help
Our purpose is to help guide our members to better financial lives today and for generations to come. Our blog has topics like raising financially responsible children and tips on becoming a homeowner to keep you informed on financial topics. Want to talk to us about your financial goals? Contact us today to learn more about our solutions.