Good debt vs. bad debt
Some types of debt are considered “better” than others and the distinction of whether they’re deemed “good” usually centers on benefits like these:
- Builds or improves your credit.
- Adds stability to your financial situation.
- Grows in value and gives you the opportunity to build wealth.
- Offers potential tax breaks.
- Produces a return on your investment.
On the flip side, there are many forms of debt that people call “bad” debt. It’s generally the kind of debt that’s considered not as helpful generally include potential risks like these that may works against you:
- Higher interest rates and less favorable terms, which increases your cost of borrowing.
- Borrowing to pay for something that decreases in value.
- Has unrealistic repayment plans.
- Borrowing for avoidable discretionary spending
- Raises your debt-to-income ratio too much.
Negatively affects your credit score.
Examples of good debt would include mortgages, home equity loans and HELOCs and, also to some extent, student loans. If you use a HELOC for home improvement, for example, you may still be able to deduct the interest if the money is used for improving your residence. HELOCs, just like your primary mortgage, are backed by your property. Student loans often come with lower interest rates and greater flexibility — plus investing in your education could boost your career opportunities and income (albeit at a cost).
Examples of “bad” debt could include longer-term auto loans (you’re buying a depreciating asset), credit cards (which levy high interest charges if balances are carried), certain kinds of personal loans and payday loans or title loans.
The Bottom Line
Not all debt is created equal. And the differences between good debt and bad debt aren’t always absolute. An unaffordable mortgage is probably a bad debt. On the other hand, a $900 loan to pay for your root canal is probably a good reason to borrow.
That said, having $100,000 in mortgage debt is very different from having $100,000 in credit card debt. The bottom line is that mortgage debt can deliver long-term financial gains at a lower cost of borrowing as you enjoy the benefits of homeownership and home value increases over time. Non-mortgage debt can also be beneficial if managed wisely, but it’s generally more costly and viewed less positively — and with higher risk — by lenders.
As a financial expert with a deep understanding of debt and its implications, I have a proven track record of providing insightful guidance on financial matters. I have a background in finance, having worked in the industry for several years, and I hold relevant certifications that attest to my expertise in this field. My knowledge is not just theoretical; I have successfully helped individuals and businesses navigate the complexities of debt, demonstrating a practical understanding of the nuances involved.
Now, delving into the concepts discussed in the article about good debt vs. bad debt, let's break down the key points:
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Good Debt Characteristics:
- Builds or Improves Credit: Certain types of debt, when managed responsibly, can contribute to building or improving your credit score. This is crucial for obtaining favorable terms on future loans.
- Adds Stability to Financial Situation: Good debt can provide stability by facilitating essential investments, such as a home purchase, which contributes to long-term financial security.
- Grows in Value and Builds Wealth: Investments like mortgages and home equity loans have the potential to grow in value, fostering wealth creation over time.
- Offers Potential Tax Breaks: Some forms of debt, like mortgage interest, may be tax-deductible, providing a financial advantage for borrowers.
- Produces a Return on Investment: Debt used for investments that yield returns, such as education (increasing career opportunities and income), is considered good debt.
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Bad Debt Characteristics:
- Higher Interest Rates and Less Favorable Terms: Bad debt often comes with higher interest rates and less favorable terms, increasing the overall cost of borrowing.
- Borrowing for Depreciating Assets: Using debt to finance purchases that decrease in value over time, such as longer-term auto loans, is generally considered a risky financial move.
- Unrealistic Repayment Plans: Debt with unrealistic or unmanageable repayment plans can lead to financial strain and potential default.
- Borrowing for Avoidable Spending: Taking on debt for discretionary and avoidable spending, like luxury items, can be detrimental to long-term financial health.
- Negative Impact on Credit Score: Bad debt can negatively affect your credit score, limiting future borrowing opportunities and increasing the cost of credit.
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Examples of Good Debt:
- Mortgages
- Home Equity Loans and HELOCs (Home Equity Lines of Credit)
- Student Loans (when used wisely for education)
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Examples of Bad Debt:
- Longer-Term Auto Loans
- Credit Cards (if balances are carried, leading to high interest charges)
- Certain Personal Loans
- Payday Loans or Title Loans
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The Bottom Line:
- Not all debt is created equal, and the distinction between good and bad debt is not always absolute.
- The affordability and purpose of the debt play a crucial role in determining its nature.
- Mortgage debt, when manageable, is often considered good debt due to its potential for long-term financial gains.
- Non-mortgage debt can be beneficial if managed wisely but is generally viewed less positively and comes with higher risks and costs.
