Good Versus Bad Debt

Good Versus Bad Debt

Not all debt is created equal. Good debt is often used as a tool for building or growing personal wealth. Taking on good debt is generally considered a worthwhile investment as long as interest rates are low and there is long-term income potential. But, you need to be sure you can afford the payments and that what you’re purchasing with the debt will likely increase in value over time.

Here are several examples of Good Types of Debt:

  • Real estate – As Liz Davidson explains in her book, What Your Financial Advisor isn’t telling you (https://www.amazon.com/What-Your-Financial-Advisor-Telling/dp/0544602307), real estate is usually considered a good type of debt to acquire for several reasons. First, mortgage interest rates are generally lower than credit card interest rates. Second, real estate values have been less unpredictable than the stock market. Third, because of the tax benefits associated with paying down mortgage interest, you’re likely to receive a higher annual tax refund. Fourth, instead of spending money on rent, paying down your mortgage loan will result in more money for you when you sell the house, provided there is enough equity to cover the amount you owe.
  • Small business loans – These are also considered good types of debt as long as interest rates are reasonable and are not secured by personal assets. They can get your business started, which is likely to generate future revenues. Consult the Small Business Administration (https://www.sba.gov) to determine what’s considered reasonable in terms of interest rates.
  • Student loansStudent loans are generally considered good debt if the increased earnings you are likely to receive as a result of securing your degree is higher than the loan itself.
  • Car loans – Similar to student loans, car loans can be good debt, but only under certain conditions. For example, if your life clearly won’t work without a car and you don’t have the money to purchase the car outright, then securing a low-to-zero interest car loan is your best option. As long as you make regular loan payments on-time and interest rates are close to 0%, then you’ll be able to pay off the debt relatively quickly.

Bad Debt

Unlike good debt, bad debt generally decreases personal wealth by trapping people in an endless circle of payments without significantly reducing the actual debt. This is because of higher interest rates and limited, if any, long-term income growth.

 

Here are some examples of Bad Types of Debt:

  • Car loans – Car loans can become bad debts when you purchase a car you can’t afford, resulting in reducing your cash flow and increasing your credit card debt. Or when you purchase a second (or third) car you can’t afford and don’t need.
  • Credit cards – When you use high-interest credit cards, your ability to invest in your future is limited unless you pay them off in full and on-time every month. If not, you’re likely paying double-digit interest rates that eat up your available income for no long-term benefit.

 

If you’d like help in determining how to use debt to your advantage and/or eliminate certain types of debt, please contact me to schedule an appointment.