What's the difference?
While taking on too much debt is never wise, borrowing money is not, categorically, a bad idea. Most financial experts agree that there is good debt and there is bad debt. But what is the difference? What kinds of purchases and investments are worth borrowing for, and which are not? Keep reading to find out.
Distinguishing Between Bad Debt and Good Debt
To determine whether a debt will be "good" or "bad," ask whether taking on the debt will earn you more money in the future, or whether it will cost you more money than you put in. This may sound confusing at first but consider an example.
Say you borrow $1,000 to pay for a class, which enables you to get a better job and earn an extra $10,000 a year. That $1,000 loan is considered good debt. Even after paying interest on the loan, borrowing the money earned you additional money in the long run.
As another example, imagine you put $500 on your credit card for a new pair of shoes. You pay the minimum balance off each month, and after interest, you end up paying $900 total. This debt cost you even more than the shoes were even worth; it's bad debt.
Good Types of Debt
These types of debt are not always good, but more often than not, they do tend to earn you money in the long run:
- Student Loans
Typically, student loans allow you to afford an education that increases your earning potential in the future. Of course, there are limits. Borrowing more than you need is never wise. It's also important to consider the degree program you enroll in. Make sure you are enrolled in a program that will make you competitive in the job market and increase your income earning potential. Financial experts often recommend that students borrow no more than one year's expected earnings after graduation.
Mortgages are usually considered good debt because they enable you to build equity in a home over time. If you borrow $100,000 to buy a home in 2021, and the home's value increases to $300,000 by 2051 when your 30-year mortgage is paid off, you will have built significantly more equity than you've paid in interest over the years.
Even mortgages, though, are not always good debt. You still have to borrow responsibly. Look for a low-interest rate, and, in general, stick to fixed-rate mortgages. Adjustable-rate mortgages have their place, but do tend to be riskier.
Bad Types of Debt
Any type of debt can be bad debt if it costs you more than it earns you. However, the following types of debt tend to be bad debt more often than not:
- Credit Card Debt
If you pay your credit card off each month, it can be a helpful tool. However, buying things you don't need with a credit card tends to generate bad debt. Credit cards usually have high interest rates, and making the minimum payments will cost you a small fortune over time.
- Car Loans
If you need a car, then taking on a reasonable car loan is not a terrible idea. However, car loans are typically considered "bad debt" because cars depreciate in value as you own them. By the time your loan is paid off, your car will be worth significantly less than you paid.
To improve your financial position, it's a good idea to take on more good debt and less bad debt. Overall, you simply need to ask yourself whether taking on a loan will cost you money or earn you money over time. Read the fine print, consider the interest rates, and borrow wisely.