Good Debt vs. Bad Debt in Real Life

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The subject of debt often instills tension among Americans. That tension may be warranted, considering the national consumer debt surpasses $14 trillion dollars. Contrary to popular belief, however, debt is neutral and is often required to make major purchases. While debt in itself is neither good nor bad, experts often categorize the deficits in two categories: good debt and bad debt.

Installment debt, which is typically how good debt is categorized, is borrowed in lump sums as a single fixed amount. Bad debt is often revolving, meaning the loan is available up to an established credit limit, like with credit cards. It’s worth noting that there are installment debts that experts would group as bad debt, such as a loan for a sports car. In short, any debt that improves your financial future is typically considered good.

What’s the importance of managing good debt vs. bad debt? Lenders look at things like outstanding debts and verified income when deciding whether or not to loan out money. Additionally, too much bad debt may have a negative effect on your credit score. Using resources such as the debt-to-income ratio and checking your credit score can often help determine if your personal deficit is too high for your income.

What Is Good Debt? 

Good debt, also called installment debt or non-revolving debt, is characterized as borrowed money that has the potential to generate income after it’s paid off in the long-term. Each decision to acquire this kind of debt is a strategic move to increase future net worth.

Consider the terms when deciding whether or not to accrue this kind of loan. Scrutinize the interest rate to make sure it’s fair and affordable given your monthly income. Good loans should come with the stipulation of an expected lasting benefit from the purchase.

Examples of good debt are:

  • College Educations: Debts that help finance higher education, such as student loans, are considered future investments. In exchange for this debt, you hope to gain a career that nets positive against the loan in the long run.
  • Small Business Loans: Debts used to finance personal business ventures, such as a small business loan, have the potential to generate future cash flow. With proper management, these investments have the potential to yield positive gains.
  • Mortgages: Debts used to finance owned real estate, such as home loans, are for an appreciating asset in most cases. These are often considered the best form of debt because there is equity built within the asset.

Although lenders and creditors will classify most of the above as good debts for a positive financial future, it is possible for any loan to become a bad debt. Any amount of borrowed money that’s defaulted, or that you’re no longer able to make a payment on, may be considered a bad deficit.

What Is Bad Debt?

Any debt you’re unable to repay should be considered bad debt. Revolving debt is the most common form, particularly with credit cards that have a high-interest rate. Beyond a defaulted credit card, loans with high-interest rates typically won’t provide any kind of return, therefore warranting a negative effect on your financial future.

Depreciating assets lose their initial value quickly without generating income so experts broadly consider these bad debts. Simply, anything that is high-cost and won’t bring future income or a tax deduction is routinely treated as bad debt. Consider the return on your investment before taking on these types of loans.

Examples of bad debt are:

  • Credit Cards: These loans are a revolving debt used to finance purchases under a certain credit limit. Unless the balance is paid in full each month, high-interest rates (over 20%) on credit cards are detrimental to a healthy financial life.
  • Payday Loans: Debts used for the sole purpose of cash advances are some of the most expensive types of loans in the country, offering a relatively small amount of cash for exorbitant fees.
  • Depreciating Assets: Debts used to finance assets such as cars, boats, and motorcycles depreciate in value immediately after purchase, offering little to no future monetary return. Well-maintained collectibles are the common exception, often accruing future value.

While the above are loosely classified as bad debts in the general sense, there are always exceptions. A credit card that’s being paid off in full each month is an example of a debt that isn’t having a negative impact. Another example is a collectible handbag or figurine, which, with proper care can be an appreciating asset.

To conclude, debt that’s used to better your financial future is usually considered good debt to have, including loans where interest is tax-deductible. It’s advantageous to get rid of any bad debt as quickly as possible, as there is no potential for long-term earning, and the likelihood of negative effects on your credit score is higher. When considering whether or not to take on a loan, weigh your monthly income and existing debt-to-income ratio first for the best potential outcome.

Sources: Federal Reserve 1, 2 | Federal Reserve Bank of New York | Forbes 1, 2 | Consumer Finance Protection Bureau

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