Debt is a part of modern life. As a consumer, it’s important to understand its uses, benefits, and risks. Most people will borrow money during their lifetime, and for many it will be beneficial. For others, however, the debt will become a burden that hinders their financial success rather than helping it.
Why does debt help some people but hurt others? A big factor is the types of debt people are using. Some types of debt are more likely to be “good” and some are more likely to be “bad.” Good debt can be defined as debt that creates long-term value for you. Bad debt, on the other hand, gets in the way of achieving financial success.
Below, we’ll explore the different types of debt and explain how each can affect your financial health and long-term goals.
What is good debt?
In general, borrowing to invest in things that increase your wealth over time or improve your earning power can be considered good debt. However, in order for that to happen, the loan payments can’t be unaffordable or burdensome. When considering a loan, it’s important to review the interest rate, payments, and your ability to take on the payments. It’s also important to evaluate how a change in the economy or in your own household could affect your ability to make the payments.
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Student Loans
Investing in one’s education is generally a good idea. Education tends to increase people’s earning potential and leads to greater financial stability. On the other hand, many Americans enter the workforce saddled with too much student debt, and if their earnings don’t increase commensurately, they struggle to get out from under the debt burden.
There are many student loan programs that offer low interest rates and features such as re-payment deferral or income-based repayments. There are also opportunities to consolidate, re-structure, or refinance student loans. Once a student enters graduate school or undertakes loans in addition to undergraduate borrowing, it is important to consult a financial advisor. Physicians in training, for example, can benefit from the expertise of a financial professional who can help them navigate loan consolidation and payoff options.
Mortgages
Buying a home is one of the most important financial decisions most people will ever make. It’s highly unlikely that most consumers will ever be able to purchase a home without borrowing a large portion of the money required. A mortgage for purchasing a home is generally considered good debt because the home can increase in value over time. As you make payments on a mortgage, you are also increasing equity in your home, which helps your net worth grow.
Unfortunately, a lot of people get into trouble with mortgages. Usually, it’s because they took on too big of a mortgage, or a mortgage with a payment that can increase rapidly. A good rule of thumb is to keep your home related expenses (combination of mortgage, property taxes, insurance, and homeowner association’s fees) well below 28% of your pre-tax income. This keeps your payments affordable, so you are less likely to default on your mortgage during the next economic recession. Those who rode out the 2008 great recession and kept paying their mortgages have been rewarded with an asset that’s appreciated over the long run.
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What is bad debt?
Debt that provides no value over time can be called bad debt. Many Americans are saddled with debt that they used to buy something with no lasting value. An example is a big-screen TV. While technically an asset, the value of the TV declines much faster than the balance of the loan does. When the TV needs to be replaced, it has little value, but the loan used to buy it may be just as large as when you bought the TV in the first place. If whatever you are purchasing will decrease in value, borrowing money to purchase it is considered unwise. Here are some examples of bad debt.
Payday Loans
Payday loans are, for the most part, not only considered bad debt, but downright dangerous. They often come with interest rates as high as 300%. They are short-term, small loans meant to be repaid within weeks, but they often go unmanaged and can completely derail a borrower’s credit. If you find yourself in a situation where you are tempted to borrow from a payday lender, consider contacting a credit union or asking family members for help. Stay away from these lenders if you can.
Credit Cards
Many consumers are unaware of the high level of interest associated with the credit cards they keep in their wallets. If you always pay off your credit cards’ entire monthly balances, it’s fine to continue using credit cards since they are convenient and can help you accumulate reward points. However, it does not serve any consumer well to keep a balance on their credit cards month after month. You will continue to pay high interest payments long after the purchased goods are consumed. Consider paying down any credit card debt you may be carrying.
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Auto Loans
Auto loans aren’t necessarily bad debt. After all, we may need a car to stay employed and take care of our family. An auto loan becomes bad debt if you use it to purchase an expensive vehicle that doesn’t hold its value. Consider purchasing a car that fulfills transportation needs but doesn’t exceed your financial means. Most new cars do not retain their value; in fact, they begin to depreciate the moment you drive them off the lot. If you need to borrow to purchase a car, look for a loan with low or no interest.
Well-Managed Debt
Good debt can help you achieve your goals, but if debt goes unmanaged or is incurred unwisely, it can have a detrimental effect on not only your goals, but your ability to borrow in the future. Managing debt takes diligence and consistency. It might be wise to consider partnering with a financial advisor if you feel like your debt is out of control or overwhelming. Here are some quick tips for managing your debt wisely:
- Don’t take on more debt than you can afford, i.e., don’t borrow money for a house or car outside of your budget.
- Make payments on time and consider paying more than the minimum if you can, even if it’s just every other payment.
- Keep an eye on interest rates and refinance when rates are low.
- If you use credit cards, pay them off completely every month.
