Understanding Good Debt vs Bad Debt
Are you wondering, what is good debt? It’s an important question to consider before taking on a new loan or opening a credit card account. Examples of good debt include home mortgage loans and student loans. But when it comes to good debt vs bad debt, it’s as much about how you manage your loans as to the kind of debt you have. Keep reading to learn more about good debts and the not-so-great kinds of debt.
What Is Good Debt?
A debt is considered “good” when it’s tied to an asset, such as a house or car, or when it can actually help you increase your income. For example, you could consider student loan debt an investment in your future. Using a mortgage loan to renovate your home could be an investment in an asset you expect to appreciate.
If your goal is to build your credit score, there are situations in which adding or maintaining additional debt can be a “good” thing. For example, credit bureaus tend to look favorably on accounts that have been open for a long period of time. That’s why, while it may be tempting to close an old credit card account, removing one of your oldest accounts can actually bring your score down.
Of course, the key with good debt, as with any kind of debt, is to borrow no more than you can afford to repay, make your payments on time, and manage it responsibly. If you fail to do this, even debt accumulated with the best of intentions can become a serious problem. For example, defaulting on a car loan leads to your vehicle being repossessed. Falling behind on mortgage payments could send your home into foreclosure. And making only the minimum payments on your credit card balance will accrue interest charges and make it harder to pay off over the long run.
Examples of Good Debt
Low-Interest Personal Loans: Can help you build your credit if managed well. A convenient way to cover a large expense, such as a new laptop.
Home Mortgage Loans: A mortgage gives you access to an asset that you can reasonably expect to appreciate, especially in real estate markets like Bucks County where property values are increasing. The interest paid on a mortgage may be tax-deductible.
Home Equity Loans and HELOCs: Can be used to improve your home’s overall value, which also making it more suitable to your tastes and lifestyle. The interest you pay on a Home Equity Loan or HELOC may also be tax-deductible.
Small Business Loans: Sometimes you need to spend money to make money! Getting a small business off of the ground requires an up-front investment, and sometimes you need additional financing to grow and expand. But if your hard work pays off, then your business debt was worth it.
What about debt refinancing?
Refinancing higher interest debt, such as credit card balances, can help you get out from under onerous interest rates. It may also be advantageous to refinance your student loan debt, car loan, or mortgage if your credit score as improved since you first obtained the loan or average interest rates have fallen.
Refinancing your debt means taking out a new loan to pay off one or more existing debts. You shouldn’t automatically assume this is good debt. Ask yourself if you can make the new loan payments on time and manage your debt responsibly. Have you made changes in your habits so you won’t accumulate credit card debt again? Refinancing can help you pay down debt and save money on interest, but it isn’t a get-out-of-jail-free-card by any stretch of the imagination.
What is Considered Bad Debt?
Generally, speaking bad debt is unsecured by an asset, such as credit cards or personal lines of credit. Bad debt is used to spend on depreciating assets or things of no value at all. Accumulating interest on something that loses value (or disappears altogether) is rarely a winning approach from a financial standpoint.
Examples of Bad Debt
High Interest Loans and Credit Cards
The simple fact is that, if your debt is difficult to afford, compounding interest can become a serious problem for your net worth. Try to avoid high interest loans and pay off credit card balances every month if at all possible.
Of course, there are exceptions and when managed well, vehicle debt can help you build credit. However, it is a well-known fact that a vehicle begins to lose value the moment you take it off of the lot. In recent times, the value of some used cars has actually been increasing due to the effect of inflation on the economy. But this is a major exception, historically speaking, and borrowers shouldn’t expect this condition to last. The bottom line is that you shouldn’t use debt to buy a more expensive vehicle than you really need or can afford.
Debt on anything you consume
It may be tempting to borrow money for vacation and sure, the experience and memories will be something you treasure. But from a financial standpoint, this is a net negative, and you’ll be paying it off for some time. The same applies to many every day necessities, like clothing, food, energy & water bills, etc. Try to pay for these kinds of things in cash. Especially with inflation rising and the value of cash declining, it makes more financial sense to spend your cash on such items rather than to borrow.
Learn more about personal loans and lines of credit from The First!
When it comes to personal finance, there are exceptions to every rule. Sometimes you simply have to do what you have to do, especially if you’re recovering from a financial setback. But, if you want to manage your finances responsibly and set yourself up for long-term success, it’s important to understand how much good and bad debt you’re carrying. If you need help managing your debt, we offer debt consolidation loans as well as financial planning services to help you reach your long-term financial goals. To learn more, contact us or visit your nearest branch location in Bucks County. You can also reach us by phone at (215) 860-9100.