Are you making your 2021 financial goals? Is debt reduction on there? Probably this is a goal of most Americans, and it’s a good one. However, all debt is not bad, as long as you can make the payments. What’s the difference between good debt and bad debt?
Simply put, good debt is money invested in you. Bad debt is money invested in creditors. But it’s not so black and white. And without good financial habits, even “good debt” can turn into “bad debt.”
Taking out a loan to cover the cost of something that increases in value over time and improves your life is considered good debt. Student loans, mortgages, and business loans fall into this category. An auto loan might also be good debt if it’s going to get you to a better paying job or helps you join the gig economy.
Debt can be good if you’ve done your homework and have answered the most critical questions. Why do I need it? Can I afford it? What is my plan for paying it back?
Buying a home has always been one of the safest investments to make. Over time, you build equity in your home, and if you decide to sell, you’ll get a return on your initial investment and even make money.
Home Equity Line of Credit
A home equity line of credit can be good debt, assuming you have the cash flow to pay it back. Making repairs or improvements can add to the value of your home, ultimately netting you a higher return when you decide to sell.
Probably the hottest topic today is student loan debt. Few people can finance their education without borrowing money. Obtaining a college or other post-high school degree can improve your job prospects and long-term income potential. However, if you borrow more than your expected salary, you could find yourself in debt for decades. The Charles Schwab Foundation suggests that you not borrow more than what you think your first-year annual wage will be.
Taking out a loan to begin your own business can be good debt if you have defined your business goals and objectives and have researched the market. You’ll need a good business plan and realistic financial projections for the first few years. Once your business is thriving and growing, it will return more than the loan you took out to launch it.
Going into debt to pay for things that will not increase in value, that you don’t need or can’t afford is bad debt. But the difference between good debt and bad debt can be blurred by how you handle the debt.
Credit cards usually top the list of bad debt. Irresponsible use of credit cards can trap you in debt for many years. Most purchases do not increase in value. Therefore, your credit card purchases are typically not an investment in you.
If you use credit cards sparingly and commit to paying the balance in full every month, credit card debt can be good debt. Today, almost all retail transactions are through e-commerce platforms. You need a credit card. If you establish an excellent track record with credit card use, it can result in a good credit score.
Outside of the exceptions noted above, auto loans can be bad debt, especially if you don’t need the car and can’t afford the loan terms. Many consumers find themselves stuck with car payments they can’t afford because the vehicle was much more than needed.
What’s the difference between good debt and bad debt? In truth, debt can be good or bad. It depends on how you use it. Balance transfer cards can be good debt if you pay off the balance within the introductory period. It will save you money, which is a good thing. The bottom line is to be strategic, consumer conscious, and consider alternatives to financing.