Good Debt vs. Bad Debt: Whats The Difference?
- August 12, 2020
- 7 min read
- 1076 reads
Debt is like chocolate, a piece here and there can sweeten life and make your days better. Too much of it can cause a stomach ache and spike your insulin levels, giving you an energy crash. It can make you feel lethargic as your sugar levels drop, and your body begins to feel so heavy that the joy has gone from your everyday tasks.
How much chocolate is too much chocolate? Well, if you’re like my husband, he would consume a full family-sized block before feeling sick. Me, on the other hand, a row, and I’m done.
Debt is a lot like that, some people can handle a lot of debt and continue to sleep well at night without a stomach ache caused by worry and stress. Others tend to be more risk-averse and need a lower debt load to enjoy life.
How much debt you should have really depends on the type of debt and what it’s used for. Debt can propel you into a better future and open doors for you faster than if you had saved and used cash on hand.
Other debt with high-interest rates and fees can limit your disposable cash flow and lock you into a debt cycle.
Types of Debt: GOOD DEBT vs. BAD DEBT
There are two main types of debt ‘Good Debt’ and ‘Bad Debt.’ Knowing the difference between the two will help you make sound financial decisions and save you from many stomach aches.
Let’s take a look at some examples:
Good Debt Examples
What is good debt? Good debt is low-interest debt that will improve your financial future by increasing your income or your net worth.
Good debt creates opportunities. By leveraging your finances now, you can build wealth over time. Good debt can be seen as an investment in your future.
Student loans are considered good debt because they open the door to the opportunity to increase your income once you graduate.
According to u.s bureau of labor statistics, the average income of those with a bachelor’s degree in 2019 was $1173 per week. The weekly average wage for those that hold no higher than a high school diploma is $712 per week. That’s a $461 per week difference or an extra $23,972 per annum.
Everyone needs somewhere to live. Having a mortgage allows you to one day own your home. Mortgages are good debt because they are an investment in your financial future.
A home is an asset that most likely will increase in value over time. It’s important not to extend yourself when borrowing for a mortgage as you will be paying that debt off for the next 20 – 30 years.
Many people get into trouble when they don’t balance their debt to income ratio. Their outgoings become too high to manage. A rule of thumb is to keep your mortgage payments under 36% of your household income. Take into consideration the years your household income may reduce during young family years when looking for a mortgage.
Home equity lines of credit can be good debt, depending on what they are used for. Renovating your home or using a HELOC as a deposit on an investment property can be potentially useful options.
HELOC debt may increase your net worth over time. As long as you do not overcapitalize on your property and, you can also cover repayments on your investment.
Debt Consolidation Loans
Is it a good idea to get a debt consolidation loan? If you have more than one small high-interest loan that you are paying off, getting a debt consolidation loan may be beneficial.
For those of you trying to increase your credit score, debt consolidation loans can help long term.
Debt consolidation loans can merge all your high-interest small loans into one loan. Consolidation loans are only considered good debt if their interest rates and APRs are much lower than your current loans.
You can read more about debt consolidation loans here.
Small Business Loans
Small business loans can be good debt if you have a solid business plan. They can give your business the initial cash injection it needs to begin bringing in sales. Small business loans can speed up your business growth.
When I was in my early 20s, a friend and I started a small cleaning company. We didn’t get a loan for new equipment. We just slowly saved and purchased as the money came in.
We wouldn’t even post out flyers; instead, we would hand-deliver them to mailboxes to save money. It took 3 years for the company to really start making a profit. It finally did, and we had development money to inject into the business.
By year 3, we put money into more marketing and equipment. The company grew more in one year than in the three previous. By year 4, the company had expanded into commercial, residential, and new construction cleaning. We went on to sell the company and move on to other things.
If we had taken a small business loan from year 1 and invested that money into development and marketing, the business would have grown much sooner.
Bad Debt Examples
Bad debt is expensive debt that absorbs your cashflow without any future benefit. Debt that is used to purchase items that go down in value immediately after you buy them is ‘bad debt.’
Bad debt can sometimes be ‘good debt’ get gone wrong.
An example is credit cards. Credit cards can be beneficial and help build your credit score, they can be used for emergencies or certain purchases. But when credit cards are used for discretionary spending because your funds are insufficient, they become bad debt.
Are auto loans bad debt? Most people need a vehicle to get to work and to live. But vehicles depreciate from the day of purchase.
If you can avoid having an auto loan, then do. Unless you’re purchasing a classic car, it is not going to increase in value.
Auto loans usually offer low APRs and fees. Therefore, if you need to finance a vehicle, then you’re paying most principally rather than fees and interest. But be aware auto loans are bad debt. You will be paying off your car for more than it is worth within a year or two.
If you need an auto loan, make sure you purchase within your means and find the lowest lending possible.
Payday loans are useful in the case of an absolute emergency. But they are still considered bad debt. They offer astronomically high APRs and fees and are probably the most expensive way to borrow money.
If you do need money for an emergency, then an online lender or a 0% interest credit card may be a much cheaper alternative.
Debt can leverage your cashflow now for a better financial future. Bad debt is expensive debt on items that will not increase in value.
Do you think there is such a thing as good debt? How have you used debt to improve your financial future? Comment below.