Articles consistently flood the internet on ways to get out of debt, including right here on SavingAdvice.com, so how could any of it be good if we are always trying to get rid of it? Alternatively, many try to avoid it completely in the hopes of never having to worry about looming financial obligations. The fact of the matter is we need debt sometimes in order to build ourselves financially. Familiarizing yourself with the difference between good and bad debt is a better route than trying to hide from it entirely.
So, how do we tell the difference?
What is Bad Debt
Let’s start with the bad news.
To simplify the term, bad debt is essentially items you purchase with a loan or borrowed money that accrues interest that depreciate in value. Basically, if you go into debt for an item that won’t create income or does not go up in value, that is bad debt. It may be advised to avoid this debt at all costs, but we all know that may not be feasible.
Examples of bad debt include:
- Credit cards. Credit cards tend to have significantly higher interest rates than consumer loans. By not paying off your monthly balance on your credit card, you end up paying more than the cost of the original item. This is especially true if you use credit cards to pay for things such as vacations, clothes and food.
- Cars. The minute you drive a vehicle off the lot, it loses value. Even as you maintain it throughout the next few years following the purchase, it depreciates in value, developing a lower value than what you originally paid for it (plus interest). The cost of your car ends up being a loss by the end of it, which is why this falls under the category of bad debt. If you have a strong credit and are able to pay for a car out of pocket with cash, it is recommended to do so to get a bigger bang for your buck.
What is Good Debt?
Now, let’s move forward to what makes up or defines good debt. This positive side of financial obligations should help you build wealth, not take away from it as bad debt tends to do. With good debt, you are using money to make money, which helps to improve your overall net worth.
Examples of good debt include:
- College or higher education loans. Those with a higher education or more likely to obtain employment, whether it be a four-year college program or training at a technical school. More opportunities exist with such an investment, even if it is not within your field of study. The money put into advanced knowledge like this is more likely to provide you with an ongoing source of income to tackle the debt accumulated.
- Real estate. While homes and properties do still tend to depreciate in value over the years, the investments placed in real estate are more likely to turn over a profit than that of say a car. Circumstances exist that allow you to collect money on properties as well such as renting out space. Because of this, real estate falls more under good debt than bad.
- Investments. Whether choosing to invest in stocks, bonds or the like, investing does take some initial funds in order to get started. Despite the risk and lack of guarantees, you do have a greater chance of achieving a return on investment. A variety of options exist for beginners to the more advanced investor as well. Consulting with a financial adviser will help to lead you in the right direction.
Some may argue that all debt is bad, but as you can see, some is needed to build credibility as well as get by daily in our lives. Being choosy and wiser about which debt you take under your belt will help keep you out of trouble longer. Learning how to differentiate between good and bad debt creates more stability for your bank account. Having bad debt won’t put you so far under necessarily, but it easily can. It’s as the old saying goes, “everything in moderation.”
Do you think you hold more good debt or bad debt? What steps are you taking to get out of debt?
Photo: Flickr: Christian Schnettelker