Good debt vs. Bad debt - How to know which one is good or bad for you

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Ask Phil Bradford

Debt has become a part of life for many individuals. They eat, sleep and breathe in debt. It’s invariably considered as the devil for your finances. However, debt doesn’t have to be bad always. There are good debts also.

Keep reading to know more about good debt and bad debt.

Is there anything called GOOD DEBT?

Good debt is seen as an investment. It means you need money to make money. It helps you to generate more money in the long run. Some examples of good debt are as follows:

1 Mortgage

Home loan or mortgage is considered as a good debt since home values increase gradually. Your residential property is a huge source of income once you pay off the mortgage.

For instance, you can sell off your home at a much higher price, or you can rent your property for extra income whenever you wish. Whereas, commercial real estates are excellent revenue sources for investors.

When is it bad? A mortgage debt is bad when you go delinquent on the loan and if the value of the property depreciates at the time of selling it.

2 Education loan

Education has always been equivalent to success. Generally, if you’re better educated, your earning potential will be more. Hence, you’ll be placed in good-paying jobs and find good job opportunities easily. But, for that, you need to have a good education.

So, loans taken out for education purpose are good debts, since it helps you to earn thousands of dollars in the future.

When is it bad? Your education loan can put you in debt if you don’t get a job to repay the loan.

3 Business loan

Money making is the core idea behind starting a business. If you have a realistic and sensible business plan, you can earn more than the loan you had originally taken out.

When is it bad? A business loan can be a good debt as long as your business is doing well. If you can’t repay the loan on time maybe due to loss in business, it’ll push you in a debt pool.

4 Investments

Investing money in stocks and bonds gives you the opportunity to generate huge wealth eventually. Since you have the chance to earn money, investments are considered as good debt.

When is it bad? Unless your investments backfire, or the investment market crashes, they are good for your financial health.

DEBT is Bad, as usual!

A debt which doesn’t generate income, can’t be recovered or goes down in value is known as a bad debt. It makes your financial position shaky. Some notable examples of bad debt are given below:

1 Credit card

Credit cards are the worst debts ever. It’s because when you’re unable to pay the balance within the given billing cycle, it starts acquiring interest rates, which maximizes your overall payment amount. Even if you’re clearing your credit card bills at each billing cycle try to keep a low credit utilization ratio on your credit cards and play safe financially.

When is it good? A credit card can do wonders to your finances and increase your credit score if you make timely bill payments and keep a low credit utilization ratio.

2 Auto loan

Though vehicles are costly, they make everyday life effortless.

An auto loan is a bad debt since a car depreciates in value with time.

By the time you decide to sell your car, it’ll be of less worth than it was originally when you bought it. So, think twice before buying a car as you won’t make enough money after selling it.

When is it good? The value of a car decreases with time, but you can free yourself from the loan if you pay it within the given time. Or else, you’ll be in debt.

3 401k loan

When you’re borrowing from your 401k retirement fund, you’re putting your retirement at risk. Since you’re not sure whether or not you’ll be able to pay back the borrowed amount.

Moreover, if you can’t repay the loan, you’ll be charged with heavy withdrawal penalties.

Plus, on a 401k loan, you have to pay taxes twice - first when you’re repaying the loan with the after-tax money and later when you pull out the amount after retirement.

For these reasons, borrowing money from a 401k is considered a bad debt.

When is it good? Actually, it is not good. It won’t make much difference even if you pay back the full loan amount on time, that is, before retirement.

4 Payday loans

Whenever you’re taking out a payday loan (pdl), your finances are at risk. Because payday loan companies charge high interest rates for even a small amount of money borrowed.

Thus, payday loans are recognized as the worst form of debt.

When is it good? It won’t hit your finances hard when you’re sure you can pay off the loan with your next paycheck.

5 Consumable goods and services

Going for vacations or buying expensive clothes and jewelry are wants and not needs and hence, considered as bad debt.

If you can’t afford to pay for your luxuries, don’t do it.

Wait till you have the cash flow to manage your indulgence. Jumping into debt to pay for luxuries is a dangerous and foolish use of borrowed money.

Consumable goods and services are good only when you splurge occasionally within your limit. It can help you keep yourself motivated to achieve your financial goals. So, don’t restrict yourself too much.

When is it smart to be in debt?

No one will advice you to live recklessly and fall into debt, but there are situations when it becomes necessary to stop paying off your debts. These are the few circumstances where incurring debts could be a wise decision.

1. Transferring balances to a 0% APR credit cards

If you are a part of the credit card industry, you might have seen that several 0% APR credit cards have been launched in the market. The credit card companies attract the consumers with a low-interest rate as an introductory offer. Many 0% credit card offers will last for 12 months or more with an interest-free financing. You must remember to tap the available full amount. You'll need to pay a 3% fee on the total amount. If you're fortunate enough, you’ll hit a $10,000 investment line with a 10% return. Liquidate the return after a year, you'll have $1,000 in hand from which you can easily pay the $300 transfer fees, and you can still pay off your credit card debts.

You have to pay minimum payments every month so you don't lose the 0% APR opportunity. When the promotional offer ends, stop using the card and go for another offer.

2. Holding on to mortgage

Try to convert your 30-year mortgage into a 15-year mortgage! Your monthly mortgage payments may be higher, but you'll save a lot from interest charges, and you'll get back the ownership in half of the time given by the bank.

If you are now living in an area where home prices are rising quickly, implementing the opposite strategy will be a wise decision. The upward price in local housing areas will create new equity, and low monthly payments may give you space to enjoy your home instead of being a slave. Apart from that, you can also refinance your current mortgage at a lower interest rate, it can save a lot for your wallet.

3. Borrowing from parents

Borrowing from your parents will be difficult. Taking money from your parents may create a problem for them. Your parents may break their nest egg and provide financial help to you.

If you owe $10,000 on a high-interest card, you must act smart. Meet your parents with proper documentation of how you incurred the debt. Convince them that you’ll use the $10,000 loan to pay off the high-interest card, not in any amusement thing. Ask them to form a repayment option so that you can also pay the money back slowly.

4. Letting your debts as it is

Some creditors will go after you again and again until you pay them off. But at a point of time, they will also lose hope and become silent. This strategy is not so popular to start afresh. As per the federal law, credit reporting agencies will remove most debts from the credit report after seven years. Since your credit score already got a blow by the debt, so you have nothing to lose. Once you make a payment, you can accept the debt again and give the debt collector more time.

5. Having a student loan

Federal laws make it difficult for a teenager to obtain credit cards. Consequently, it also gets difficult for those teenagers to build a positive credit history. As a form of debt, you can take out student loans to build credit. But make sure you take out a loan of proper amount that you can repay after getting a decent job. If you can’t afford the monthly payments (which eventually starts as soon as you get a job or after finishing your studies), it’ll be a very big problem for you.

The standard repayment plan comes with 10 years of the time limit with a federal student loan for a bachelor's degree. Borrowers of these loans are eligible for repayment options that could postpone their payments, lower a number of their monthly payments or even erase their debt altogether.

6. Getting a business debt

Many people opt for a business loan to initiate their personal, small business after completing their graduation. But, it isn’t right to consider these debts as bad debts since the loan is utilized to increase your net assets and to earn a good income.

To conclude...

Good debt and bad debt is just a matter of classification. It all depends on how you manage your loans.

So, as you can see, good debt can become a bad debt if managed inappropriately; whereas bad debt can turn into good debt if handled properly.

Last Updated on: Mon, 27 Feb 2017

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