Managing finances can be challenging, especially when you factor in debt. But the fact is, very few people can maintain a completely debt-free lifestyle over the long haul. If you’re like most people, you frequently find yourself having to decide whether or not to take on debt.
Good debt can help you achieve larger goals such as an education or home ownership. Bad debt, on the other hand, often only satisfies momentary desires while leaving you with high-interest payments that can be hard to get rid of.
What is good debt?
As we mentioned, good debt is debt that helps you achieve life goals. It has the potential to help you acquire wealth and financial security over time. Some examples of good debt include:
Student loans: A student loan can help you pay for your college or trade school education and, in the process, help increase your future earnings potential. People with a bachelor’s degree, for example, earn 55% more* in their lifetime, on average. And people with a trade school training certificate often have an easier time finding work than their uncertified counterparts.
Mortgages: Home ownership is one of the cornerstones of the American Dream. A mortgage can help stabilize your living expenses and, depending on where you buy and the amount you’re able to use as a down payment, mortgage payments can actually be less than rental payments for similar properties. In addition, home values tend to appreciate over time and can help you accumulate generational wealth.
Small-business loans: Entrepreneurs can use small-business loans to turn their dreams of opening and operating a profitable business into a reality. Of course, not all small businesses succeed but, with careful planning and a little luck, a small business can return big profits.
What is bad debt?
While good debt can be thought of as an investment in your future, bad debt is best thought of as borrowing against your future earnings. Bad debt often carries a higher interest rate (one possible exception: auto loans) than good debt and can lead to a cycle of repayment that can be hard to extract yourself from. Some examples of bad debt include:
Payday loans: There are few types of borrowing more expensive than payday loans. With few exceptions, they carry some of the highest interest rates you’ll find (up to 400% and more!) in addition to other fees often buried in the fine print. Payday loans are so expensive that some states have gone so far as to prohibit them.
Credit cards: Credit cards are frequently used to make non-essential purchases and, while they aren’t as expensive as payday loans, they can still carry interest rates as high as 30% or more. For example, let’s say you charge $500 on a credit card with a 22% APR. Making only the minimum payments would take over four years to repay and end up costing you almost $280 in interest charges.
NOTE: It is possible to use credit cards effectively, with little or no harm to your finances, if you are disciplined enough to only charge what you can pay off completely every month. You will save yourself from paying interest charges and still benefit from any cash back or other rewards the card offers.
Auto loans: While cars offer you a reliable way to get to work, auto loans can be a costly way to pay for an asset that depreciates in value. In fact, new cars lose a significant amount of value as soon as they are driven off the lot. If you can’t pay cash for a car, vehicles sold as “certified pre-owned” offer a better option than new ones. They are usually from one to five model years old, have been well maintained, and are often backed by a dealer’s warranty.
If your heart is set on a new car, choose a model with a reputation for maintaining its value. Then, save to make as large a down payment as you can and wait for end-of-model-year sales, which usually include discounted financing offers.
Choose your debt carefully
When it comes to taking on debt, make your choices consciously, making sure you evaluate and understand its impact on your finances. Choosing good debt over bad debt can help you save for the future and responsibly afford the things you want.
* https://nces.ed.gov/programs/coe/indicator/cba/annual-earnings