Did you know that not all debt is the same? Just like there are “good fats” and “bad fats”, there are also good and bad forms of debt. And knowing the difference between the two can make a big impact on which ones you try to avoid or pay off first.
Generally speaking, good debt is anything you buy that has the potential to increase your net worth or livelihood. For instance, a business loan might seem like a bad thing because you’ll owe money to the bank. But if your new business takes off, you’re able to repay the loan in a few short years, and the revenues continue to grow, then this loan could be more like an investment than a debt.
Bad debt, on the other hand, is when you take out a loan to buy something that will lose value or become consumed. For example, if you took out a personal loan because you neglected to budget your finances for the month and weren’t going to be able to pay your rent or buy groceries, then this would be classified as bad debt.
In this post, I’d like to explore some common forms of debt and explore just how “good” or “bad” they really are.
Many people consider the loan you take out to buy your house to be good debt. This is for several reasons:
- Even though you live in your house, it’s still an asset. When you go to move someday, you’ll most likely be able to sell it for the same or more than what you paid for it. That’s especially true if the home is well maintained or in a desirable neighborhood.
- As you make mortgage payments, a percentage of that check goes towards building equity in the property. Therefore, in a way, you could think of it as paying yourself.
- Nowadays, mortgages come with interest rates that are very low. With 15 year mortgages in the 2-3 percent range, this makes them extremely cheap.
- If you itemize your federal tax deductions, then you can deduct mortgage interest against your adjusted gross income (AGI).
However, not all mortgages are necessarily such great deals. One prime example of this is an ARM. ARM stands for “adjustable-rate mortgage”. This is when the interest rate of the mortgage adjusts from a low introductory rate to whatever the current market rate is after a certain amount of time (usually 3-7 years).
As harmless as that may sound, it brought havoc upon many homeowners during the Great Recession in 2008. When the economy took a downturn and many people became unemployed, the interest rate on their houses jumped and caused their mortgage payments to effectively double overnight. That caused a lot of people to walk away from their homes and mortgages altogether. That’s why whenever possible, most financial experts recommend you go with a 30 or 15-year fixed-rate mortgage.
As much of a necessity as a vehicle can be, auto loans are typically regarded as bad debt. This is because every year that you own your vehicle, it depreciates in value until its worth virtually nothing more than scrap metal.
It doesn’t matter how nice your vehicle is or who the manufacturer is. Nearly all of them lose 20 percent in the first year and 60 percent by the fifth year.
Depending on the loan you get, this can put you in a very difficult spot. For decades, most auto loans were roughly 60 months (5 years) because that’s approximately how long consumers held onto their vehicles. But in an effort to make the payments appear smaller, lenders started offering 66-month, 72-month, and now even 84-month loans.
If you were to take out one of these 84-month loans, you might make payments for 3 to 4 years and still owe significantly more on the loan than what the vehicle is worth (thanks to depreciation). Not to mention the total interest would be a lot more too!
The perspective of whether student loan debt is good or bad is debatable. The idea behind one, of course, is that you can afford to go to college, get a 4-year degree, and then qualify for a high-paying job.
While this has been the rationale for decades, college tuition has unfortunately become ridiculously expensive. This combined with increased opportunities in the gig economy has got many young people wondering “Is college even really worth it?”
For example, according to the site EducationData.org, the average student borrows over $30,000 to pursue a bachelor’s degree. However, 20 years after entering school, half of those students still owe $20,000. That means they’ve barely put a dent in their balance!
One silver lining to student loans is that the interest on the loans is tax-deductible, whether you itemize your federal tax return or not. Plus, while you’re actually in school, you can apply for some pretty lucrative tax credits (like the American opportunity tax credit) which can significantly reduce how much you owe the IRS that year.
Credit Card Debt
It’s pretty safe to say that if credit card debt was a character in a movie, it would be one of the main villains. Credit card debt is one of the worst kinds of debt you can get into because once they’ve got you, it’s hard to get out.
This is thanks to the way they’re designed to work. When you make $1,000 worth of purchases on a credit card, the issuing company only requires that you make a “minimum” payment of approximately 2-3 percent (about $25).
If you do pay only the minimum, you’ll accrue interest on the remaining balance. When left unpaid, next month you’ll pay interest upon that interest, and your outstanding will balance will escalate this cycle continues. This has caused millions of people to go into downward spirals that eventually lead to job loss, alcohol abuse, divorce, or even suicide.
The trick to credit cards is to use them responsibly and never carry a balance. You might think “what’s the point of having a credit card” then, but remember that one of the main reasons to get one in the first place is to build your credit score. The more you can demonstrate responsible usage and timely payments, the higher your FICO score will be, and the better your opportunities will be for other loans and lower interest rates.
An easy way to manage your credit card purchases is to use an app like Buxfer to keep track of them. Buxfer can connect to your credit cards (as well as your banks), automatically track your transactions, and show you in real-time how much you’ve spent. Click here to learn more about how Buxfer can help you monitor your spending habits.
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