Taking on debt is a big decision that can potentially improve your future financial decision but can also cripple it. Good debts are often considered to be investments for your future that provide some return or future opportunity. A bad debt, however, could hurt your finances in the short- and long term. This article covers the differences and shares examples of each type of debt.
Good Debt vs. Bad Debt
Many people consider all debt “bad” and try to avoid it at all costs. However, navigating life without taking on some debt is challenging. That’s why it’s important to determine whether the debt is good or bad for your situation before moving forward. Some debts that others consider to be good might actually be bad for you.
A bad debt is money you borrow that can lead to financial problems or obstacles for you in the future. Bad debts often lead to financial struggles as you borrow money for things you can’t afford and end up struggling to make payments on that debt. This can lead to a cycle of paying large amounts of interest on your purchases, making things much more expensive than they should be.
Good debt is still debt. It is money you’re borrowing for a purpose that makes it valuable. That means that good debt is typically money you borrow for something that will increase your total net worth, help you build wealth, or increase your financial opportunities for the future. Good debt is typically an investment into something that can create a better return for you.
Examples of Bad Debt
High-interest consumer debt is considered bad because you’re not borrowing to buy anything that will benefit you financially. Bad debt also typically funds depreciating assets and isn’t considered a strong investment. Here are some examples of what many people consider to be bad debt:
- Consumer debt (such as buying clothes or gifts)
- Buying something you can’t afford
- Auto loans
- Borrowing more than you can afford to make payments on
- Student loans for a degree that won’t help you earn more money
It’s important to note that the type of purchases you make when borrowing money is only one consideration of whether it is a good or bad debt. If you can’t afford to make the payments on what you’re borrowing, it’s a bad debt because it will hurt your finances. This is why it’s essential to ensure that any amount of money you’re borrowing still leaves you with a low debt-to-income ratio. You also need to make sure that any debt is right for your situation, regardless of what others say.
Examples of Good Debt
A good debt generally provides a positive return on investment for your situation. If you’re trying to determine whether what you are borrowing is a good debt, consider calculating the potential return for your investment. For example, if you are borrowing money to go to school, it might be a good debt if it improves your ability to make more money for the rest of your life. You can calculate the potential versus what you would make without the degree and see if that education’s cost is worth it.
Good debts could come from a variety of sources. Here are some examples of the most popular types of debt that many consider being good debt:
- Borrowing to buy a house
- Education debt
- Business debt
- Loans to buy a business
- Loan to invest in real estate
This isn’t an all-inclusive list, but these are all investments that create a higher potential payout when you sell that asset or help you make more money in your career. Some consider an auto loan to be good debt because many people need a car to get to work. Still, it is considered a bad debt because cars depreciate almost immediately.
Considerations Before Taking on Any Debt
Before you decide to take on any debt, there are certain steps you should take to help you determine if it’s a good or bad debt opportunity for your finances. Remember, good and bad debts aren’t going to be the same for everyone. Each one will help you get your hands around your finances better and improve your overall decision-making so that your money doesn’t come back to hurt you in the future.
Here are the things you may want to consider before taking on debt:
- Can You Find Money Somewhere Else: Is there any other way to pay for what you’re purchasing? For example, what can you do to lower the total amount of debt you must take out if you’re borrowing money for school?
- Potential Return: What is the return on your investment going to be? For example, when you buy real estate, the chances of the return being higher than what you pay is pretty good.
- Whether You Can Afford It: Can you afford to make the payments in a way that will actually pay the debt off instead of just making interest payments?
- Whether You Need to Make the Purchase: Do you need what you are purchasing to put yourself in a better financial position?
- How Long it Will Take to Pay Off: Before taking on debt, you should know how long it will take you to pay off that debt.
Overall, no decision to take on debt should be made lightly. Make sure you exhaust all avenues of finding money before taking on debt and then do what you can to limit the amount you’ll need to borrow.
The Bottom Line
When considering whether a debt is “good” or “bad,” you should first analyze what you’re buying. Nothing is a good debt if you can’t afford to pay it off in a timely manner for what you’re borrowing. For example, you won’t be paying off a house in a year or two, but you can pay it off by the end of your mortgage term. Overall, choosing to only borrow money for strong investments will improve your financial health and help you make better decisions.