When most people think of debt, they automatically assume that it is bad for your finances. While this is often true, it is not always the case. A person can carry both good and bad debt for a variety of reasons.
Good debt is taken on for a sound reason and there is an expected payoff later. Examples of good debt include student loans and mortgage loans. With bad debt, there is no upside to paying interest on the borrowed money. Types of bad debt include credit card debt as well as payday advance loans.
There are also types of debt like auto loans that can be good or bad depending on your situation. Figuring out which debt to carry can help you maneuver your personal finances into positive territory. To help you do this, we are going to take a look at good debt vs. bad debt.
Credit card debt
Bad debtCredit card debt is the worst kind of debt to carry. Sure, credit cards are easy to use; just swipe the card and off you go. However, this convenience comes at a cost: high interest rates that can reach 15% to 20%.
Carrying a balance on a credit card is the exact opposite of saving money in a savings account. Instead of you saving the money, the bank is earning interest on money it lent to you.
Auto Loan
Most often bad debtFinancing a vehicle is the option most people choose when buying a car. Financing a car isn’t as much of a choice as it is a necessity, since a car is a large purchase. When weighing good debt vs. bad debt, it's important to consider the practical value of your purchases. Paying interest on a car loan is considered bad debt, but paying cash usually isn’t an option for most people. Your car gets you to work, school and other places on time, which makes financing a car worthwhile for a lot of people.
Buying an appreciating asset and leasing a depreciating asset is always a good idea. This means that buying a used car with low miles is a sensible choice for many. Therefore, having the auto loan can be considered good debt under certain circumstances. Either way, paying cash for a car is usually the better choice if you can afford it.
Mortgage loan
Good debtBuying a house is the dream of many families around the world, as having a home to call your own is often considered a symbol of having made it.
Hardly anyone would pay cash for a house -- even if they had the money. There are two reasons for this: First, it is better to use leverage and take advantage of the bank’s money to buy the home. This will free up your money for daily living expenses and retirement investing. Second, depending on where you live, there is a tax deduction on mortgage interest.
Payday advance
Bad debtAside from credit card debt, payday advance debt is about the worst type of debt out there. Payday-advance business operate in small retail locations and simply require patrons to have a checking account and proof of employment to borrow up to $300. This is a very easy and convenient way to borrow money, but if you read the contract, you’ll find that there can be interest charges of up to 17% per week, which can add up to a huge yearly sum.
This type of debt should be only considered if you have no place else to turn. Most often, you've already made several credit mistakes if you don’t have a credit card or access to a short-term bank loan.
Student loan debt
Good debtIt comes as no surprise that student loan debt is good debt -- and there is a good reason to incur this debt, which is a college education. After you earn your degree, the expected income stream is high and the debt can be paid off.
There are some circumstances in which student debt can be bad, such as when the earned degree (from an expensive school) yields a job in a low-paying industry. Some former students struggle for years in this situation while they spin their wheels in a low-paying job trying to catch a big break.
Borrowing from your 401(k)
Bad debtAny financial planner will tell you not to borrow from your 401(k) plan or IRA. In fact, these plans should be one of the last places to get money. Borrowing from your retirement plan involves jumping through hoops with your employer as well as dealing with IRS regulations. Not to mention the high penalties you’ll pay.
Using your retirement plan for a quick infusion of cash should be a last resort because this is your retirement money, not short-term savings money. Tapping family and friends could be a wiser move if you plan to pay them back on time and with interest. Having an emergency fund will enable you to avoid this situation altogether.
the good, the bad and the debt
Any time is a good time to take a look at your debt load, but it’s especially important when the economy is unstable. A good place to start is to make a list of your good debt and bad debt.If you find that you only have good debt, you should figure out how to keep it that way. If you have bad debt, you need to figure out how and why it happened and what you plan to do about it. Having no debt at all says something as well. Perhaps you are great at paying off credit cards, but still rent an apartment or don’t have a college degree.
Overall, ridding our financial lives of bad debt is always a good thing. Adding some good debt might not be so bad, either -- it could even be great for your future.
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