What Makes Good or Bad Debt?
We’re constantly bombarded with messages about how important it is to get out of debt, yet you’ll probably also hear people talk about having “good debt.” And while you’ve probably heard about the benefits of saving up for large purchases, it’s almost impossible to save up for something as large as a house or a car.
When is it a smart idea to borrow money? We’ll help you decide how to make the right choices for your family.
What Does Debt Bring You?
The most important thing to think about is what debt will bring you long-term. Good debt is something that’s more of an investment. You take out student loans because the college degree will help you get a better job with a higher salary. Taking out a mortgage will also give you a lot of debt, but property values can increase, and you’re building equity every time you make a payment. These are examples of good debt.
Bad debt, on the other hand, only offers short-term benefits. Putting a vacation on a credit card, for instance, offers you a burst of pleasure, but you might be paying off that debt for a long time.
Even debt that seems good might not be the best choice. For instance, taking on a lot of students loans in a highly specialized field where there aren’t a lot of jobs can turn out to be a bad idea.
Ability to Pay
Whether a debt is good or bad, you still have to factor in your ability to pay. Good debt quickly becomes bad debt if you’re struggling to make payments.
This means that you have to make smart choices about what debt you’re taking on. Could you get the same education for less money at a different school? Would your home be more affordable if you chose something smaller or in a different neighbourhood? Seemingly small choices can make a big difference overall.
Interest rates play a big role in affordability and in determining whether or not a debt is good or bad. If your debt has a high-interest rate, then more of any payment you make is going toward the interest instead of the principal balance. This usually means that it takes longer to pay off the loan, and you end up paying a lot more overall. In some cases of high-interest debt, the item costs you twice as much as the original payment once you factor in these interest charges.
In general, the types of things that people consider good debt – houses, cars, and student loans – tend to have relatively low-interest rates: most under seven percent. Bad debt through credit cards tends to have much higher interest rates: as much as 20 percent or more.
Learning the Nuances
It’s almost impossible to say that any one type of debt is good or bad. It really depends on the situation and on you making decisions that are right for you. Essentially, you have to ask yourself:
- Does this debt move me closer to reaching my goals?
- Can I afford to take on this debt?
- Is there a way that I could take on less debt?
We’ll illustrate this with an example. Let’s say you’re thinking about a car loan. Is it good or bad? If you live in an area with good public transportation, you may not need a car. In this case, the debt might be bad debt for you. However, if you need that car to get to work, you could consider it a good debt. You can then break it down further, though. If you can easily afford a car loan for a BMW, then maybe you’d want to choose to take on that debt. But if you’d struggle to take on that payment, you’d be better off taking out a loan to pay for a used Toyota. In both cases, the debt allows you to get something that you need, but one is far more affordable than the other.
The same is true when it comes to buying a home. In general, mortgages count as good debt. However, you still need to make smart decisions about the home you buy. Don’t go for a lot of extras and upgrades if you’ll struggle to make your payments.
Being financially responsible is always a balancing act, but it’s worth the effort you put into it. Shop smart when it comes to purchases made with good debt, but save up for things that are more frivolous. This helps you build a more stable lifestyle.