For most people, debt is a part of life. None of us like making those interest payments, but saving enough cash for really big purchases – say, a home or college education – isn’t always possible. And in some cases, it isn’t financially smart.
So, if you’ll probably have to take on debt at some point in your life, how can you tell when it’s worth it? How do you know when the cost of interest is worth the benefits? Well, good debt benefits your financial future, while bad debt harms it. And luckily, what you’re buying often makes that distinction clear.
Is There Such A Thing As Good Debt?
There’s an argument to be made that no debt is good debt. But there are cases where taking on debt pays dividends in the future.
Student loans: Student loans allow you to get an education and increase your long-term earnings potential. People with a bachelor’s degree earn 66% more in their lifetime, on average, than those without a degree. And those who take on a small amount of debt to complete trade school also significantly increase their earnings potential, especially with today’s current shortage of tradespeople.
Mortgages: Mortgages are also generally viewed as a source of good debt. You have to live somewhere, and by taking on a mortgage, your living expenses build equity in an asset, instead of just going to a landlord. Also, it gives you the security and stability of owning your own home.
Small business loans: A small business loan can allow you to start or grow a profitable company to increase your future cash flow. And while not all new businesses are thriving, Small Business Association (SBA) loans do require you to create a comprehensive business plan – forcing business owners to consider both their goals and risks.
Good debt can also be about long-term arbitrage. The long-term returns of the stock market have historically outpaced today’s low mortgage interest rates. So, even if you could pay cash for a home, your financial future might be brighter if you left that money invested.
Student loans, mortgages, and small business loans are the most common forms of good debt. But even good debt has its risks.
The Risks of Good Debt
When we take on good debt, we’re making assumptions about the future based on our own goals and typical results in the past. But there are no guarantees. A college degree doesn’t guarantee a great job after graduation; taking on more mortgage than you can afford can make it difficult to save for the future; and yes, new businesses can fail.
Before taking on any debt, it is always smart to carefully consider what return you expect to get. How do you expect life to look after taking on this good debt? And where could things go wrong?
For example, understanding what your student loan payments would be upon graduation allows you to determine whether entry-level jobs in your chosen field could comfortably cover those payments, or if you would be better off in a different major or pursuing a lower-cost education. A good rule of thumb is to limit your borrowing to 1.5 times your expected first year salary.
Similarly, nearly 40 million households in the U.S. are “house poor”– meaning they own a home they can’t easily afford. Their high mortgage and property tax payments make it hard to cover other expenses, save for emergencies, or invest for the future.
Too much of a good thing is bad. And that is indeed the case with debt. Just because it can be good, doesn’t mean it is for you. Whenever taking on debt, be sure to think through how it will impact your life and how you can pay it off.
Avoiding Bad Debt
We’ve covered good debt, but what is bad debt? Bad debt is anything where you are taking money from your future self to spend more today. As an example, pulling out your credit card to afford football tickets is bad debt.
If the debt won’t bring you future income or wealth, but rather funds your current lifestyle, it’s bad debt.
Payday loans: The most prominent example of bad debt is payday loans. These are usually small-dollar loans, under $500, that are due at your next payday. Fees are significant, typically ranging to $10 to $30 for every $100 borrowed. That can mean an annual percentage rate of just under 400%. This is some of the most expensive debt in the U.S., which is why some states regulate or prohibit these loans.
Credit cards: While the APR for credit cards pales in comparison to payday loans, the 12% to 30% rates are nothing to scoff at. Credit card debt, especially when taken on for nonessential purchases, is undoubtedly bad debt. Making only minimum payments with a 22% APR credit card, $500 in credit card debt would take over four years and almost $280 in interest to pay off.
Auto loans: You may need a car to get to work, but the type of car you choose to buy can make an auto loan a grey area for debt –- or straight up bad debt. New cars depreciate as soon as you drive them off the lot, which could result in being underwater on your loan. And paying interest for years on an asset that is continually falling in value is harmful for your financial future. If you can’t afford to pay cash for your car, choose well maintained used vehicles that won’t see the same decline in value as their new counterparts.
In general, bad debt is any debt that is looking to exploit our desire for instant gratification. You should always try to avoid debt for consumer goods and entertainment or with high-interest rates.
Choosing the Right Debt
By always being conscious of the type and purpose of the debt you’re taking on, you’re protecting your future self. The right amount of good debt can increase your ability to save for the future, build wealth, and responsibly afford the things you want in life, without bad debt.
