Financial Literacy
Money Management 101 - Managing Good And Bad Debt
You probably know there are different kinds of debt, but do you which ones are considered good or bad debt? While it might seem strange that any debt at all can ever be considered a “good” thing, there are some types of debt that can your financial outlook a boost, as long as you can responsibly pay it back. Here in this article, we will cover what are good bad debts and how to identify which types of debt can be considered good and bad.
What's the Difference Between Good and Bad Debt?
There certainly is an argument to be made that no debt is good debt, but borrowing money and taking on debt is the only way for many people to purchase expensive commodities, such as homes and cars. What typically separates good debt from bad debt is the reason an individual took on the debt and how it impacts the financial net worth of the individual. Generally, good debt is a loan that you’ve taken on that has the potential to increase your net worth — like taking out a mortgage to purchase a home — while bad debt is debt you’ve incurred to purchase items that don’t generally increase your net worth; in fact, they often depreciate in value! Bad debt includes credit card debt for your monthly Netflix subscription and car loans. In the section below, we shall cover some examples of good and bad debt by most financial experts and lender’s point of view.
Good Debt
As the saying go, “it takes money to make money.” If the debt you take on can help you generate income and increase your financial net worth, then it is generally considered good debt. Here are a few notable things worth going into debt for:
- Higher Education. In general, the more education an individual has, the greater that person’s earning potential could be. Education also has a positive relationship with an individual’s ability to find employment. Typically, graduates are likely to pay the debt off within a few years of entering the workforce. In addition, like a mortgage, student loans typically have much lower interest rates than bad debts. From a financial perspective, if the degree that you are pursuing has a low income earning potential, your student loans can quickly turn into bad debt. As such, it’s important to maximize the value of taking on debt for an education as well as the field of study must be chosen carefully.
- Business ownership. Being in control of your own financial wealth plays a significant role in individuals who choose to become an entrepreneur. With a bit of luck and effort, you can turn your small business into a major source of wealth. Similar to higher education, entrepreneurship does come with its own risks. Many businesses do fail, but your chances for success are greater in a field that you are passionate and knowledgeable about.
- Real estate. There is a variety of ways to make money in real estate, which you can find out here. One of the simplest real estate investment strategy often involves buying a residential property with a mortgage and living/renting it out for a few decades before selling it at a profit. In general, real estate property tend to appreciate in value over time. In addition, mortgages are usually long-term loans that can last up to 30 years and have very low interest rates. This allows you to build your net worth in the form of home equity.
Bad Debt
While good debt has the potential to increase a person’s net worth, it’s generally considered to be bad debt if you are borrowing money to purchase depreciating assets. In other words, if it won’t go up in value or generate income, you shouldn’t go into debt to buy it. Here are some general examples of bad debt:
- Car Loans. Although it’s generally considered to be bad debt, most people consider car ownership a necessity. New cars, in particular, cost a lot of money and they lose their value as soon as you drive it off the lot. While you may need a vehicle to get yourself to work and to run the errands that make up everyday life, paying interest on a car purchase is simply a waste of money. In addition, many individuals take out high interest loans to drive the car of their dreams that will continue to depreciate over time.
- Credit cards. These are one of the worst forms of bad debt because they’re often used to make purchases on depreciating goods and services, such as clothes and consumables. Generally, these products are worth less than what consumers originally paid for over time. Furthermore, credit cards interest rates charged are often significantly higher than the rates on consumer loans, and the payment schedules are arranged to maximize costs for the consumer.
- Pay Day Loans. A payday loan is a short-term loan with high fees that make it a very expensive way to borrow money. Generally, you can borrow up to $1,500 and you must pay the loan back from your next pay day. Nearly 2 million Canadians use these types of loans each year, while 50% have taken out more than one payday loan in the last three years. What makes these debt truly bad is the outrageous interest rates associated with them as they can be as high as 650% depending on the province you live in.
Special Considerations - Debt Grey Zone
Sometimes, it’s not so easy to classify good or bad debt as it depends on your own financial situation as well as other factors. A few types of debt may be good for some people but bad for others:
- Consolidation loans. For consumers who are already in debt, consolidating higher-interest debt by taking out a loan at a lower rate of interest can be beneficial. It’s important to use the cash that has been freed up from lower payments to keep paying down the consolidated debt.
- Borrowing to invest. Leveraging or borrowing money at a low-interest rate and investing at a higher rate of return, such as margin trading, may appear to investors as a good way to increase expected returns. Unfortunately, it also comes with numerous risks and you are required to compensate your lender for the borrowed funds. This is an option that should be pursued only by knowledgeable investors who can afford to absorb such potential losses.
- Credit card reward programs. In certain situations, you’re going to have to spend money on necessity, such as food. As such, there are some great credit card reward programs available for consumers that can help buyers earn free airline tickets, free cruises, cashback, and a host of other rewards. If you have the discipline to pay off your balance every month, credit card reward programs can be worthwhile. Otherwise, the interest on credit card debt greatly outweighs the value of the rewards.
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