Good debt vs. Bad Debt – Forbes Advisor
Editorial Note: Forbes Advisor may earn a commission on sales made from partner links on this page, but this does not affect the opinions or ratings of our editors.
For most people, debt is a part of life. None of us like to make these interest payments, but saving enough money for very large purchases – for example, a house or a college education – is not always possible. And in some cases, it’s not financially smart.
So if you are likely to have to go into debt at some point in your life, how can you know when it’s worth it? How do you know when the cost of interest is worth the benefits? Well, good debt benefits your financial future, while bad debt hurts it. And luckily, what you buy often makes this distinction clear.
Is there good debt?
There is an argument to be made that no debt is good debt. But there are cases where going into debt pays dividends in the future.
Student loans: Student loans allow you to get an education and increase your long-term income potential. Those with a bachelor’s degree earn on average 66% more over their lifetime than those without. And those who incur small debt to complete trades school also dramatically increase their earning potential, especially with the current shortage of tradespeople.
Mortgages : Mortgages are also generally regarded as a source of good debt. You have to live somewhere, and by taking out a mortgage your living expenses are an asset, instead of just going to a homeowner. Plus, it gives you the security and stability of owning your own home.
Small Business Loans: A small business loan can allow you to start or grow a profitable business to increase your future cash flow. And while not all new businesses are successful, Small Business Association (SBA) loans require you to create a comprehensive business plan, forcing business owners to consider both their goals and their goals. risks.
Good debt can also be a matter of long-term arbitrage. Long-term stock market returns have historically exceeded current low mortgage interest rates. So even if you could pay cash for a house, your financial future could be better if you left that money invested.
Student loans, mortgages and small business loans are the most common forms of good debt. But even good debt has its risks.
The risks of good debt
When we take on good debt, we make assumptions about the future based on our own goals and typical past results. But there is no guarantee. A college degree does not guarantee a great job after graduation; taking out more mortgages than you can afford can make it difficult to save for the future; and yes, new businesses can fail.
Before incurring debt, it is always a good idea to take a close look at the return you expect to earn. How do you expect life to get away with taking on this good debt? And where could things go wrong?
For example, understanding what your student loan payments would be after graduation allows you to determine whether entry-level jobs in the field of your choice could comfortably cover those payments, or whether you would be better off in another. major or pursuing studies at a lower cost. . A good rule of thumb is to limit your borrowing to 1.5 times your expected salary for the first year.
Likewise, nearly 40 million households in the United States are “housing poor,” which means they own a home they cannot easily afford. Their high mortgage and property tax payments make it difficult to cover other expenses, save for emergencies, or invest for the future.
Too much of a good thing is bad. And this is indeed the case with debt. Just because it can be good doesn’t mean it is for you. Whenever you incur debt, think about how it affects your life and how you can pay it off.
Avoid bad debts
We’ve covered the good debt, but what is the bad debt? Bad debt is whatever money you take from your future self to spend more today. For example, withdrawing your credit card to buy football tickets is bad debt.
If debt will not bring you future income or wealth, but rather finances your current lifestyle, it is bad debt.
Payday loans: The most striking example of bad debt is that of payday loans. These are usually small loans, less than $ 500, that are due on your next payday. The fees are significant, typically ranging from $ 10 to $ 30 for every $ 100 borrowed. This can mean an annual percentage rate of just under 400%. It is one of the most expensive debts in the United States, which is why some states regulate or prohibit these loans.
Credit card: While the APR on credit cards is paltry compared to payday loans, the rates of 12% to 30% are nothing to laugh at. Credit card debt, especially when incurred for non-essential purchases, is definitely bad debt. Making only minimum payments with a 22% APR credit card, $ 500 in credit card debt would take over four years, and almost $ 280 in interest to pay off.
Auto loans: You might need a car to get to work, but the type of car you choose to buy can make a car loan a gray area for debt – or just bad debt. New cars depreciate as soon as you leave them, which could lead to a dip in your loan. And paying interest for years on an asset that keeps falling in value is detrimental to your financial future. If you can’t afford to pay cash for your car, choose well-maintained used vehicles that won’t see the same drop in value as their new counterparts.
In general, a bad debt is any debt that seeks to exploit our desire for instant gratification. You should always try to avoid debt for consumer goods and entertainment or with high interest rates.
Choosing the right debt
By always being aware of the type and purpose of the debt you are taking on, you are protecting your future self. The right amount of good debt can increase your ability to save for the future, build wealth, and responsibly afford the things you want in life without bad debt.