Good vs. Bad Debt: What's the Difference?
While understanding different types of debt isn't always easy, making an effort might help you achieve your financial goals sooner. Labeling debt as "good" or "bad" can help clarify which type of debt you could pay off over time without negatively affecting your finances.
Hint: The purpose of the specific debt you have plays a role in whether it can be classified as good or bad.
Examples of Good Debt
Some debts can open the doors to opportunities and experiences out of reach for many consumers. For example, mortgage loans help homebuyers live the life they want today instead of waiting years, and sometimes decades, to achieve the American dream.
Good debt is usually debt incurred for a specific investment that has the potential to increase in value, generate income, or both. Here are several examples of good debt:
- Home loans or other real estate investments rising in value or providing other financial benefits that outweigh or offset the financial costs.
- Low-interest rate home equity loans or home equity lines of credit used to:
- Maintain or make improvements that increase the value of your home;
- Pay off high interest rate debts, such as credit cards; or
- Cover college expenses when low-interest student loans aren't an option
- Student loans. College graduates have a higher lifetime earning potential than high school graduates. Recent data from the Association of Public & Land-Grant Universities confirms that bachelor's degree holders continually earn about $32,000 more annually than high school graduates.
- Lower interest rate debt, such as auto loans and credit cards, that are repaid in a reasonable time frame. An auto loan might be necessary for reliable transportation to your job. Wise credit card use can help you earn cash back rewards or pay down other higher interest rate debts.
- Good debt has the potential to leave you in a better financial position than when you first borrowed the money. Sometimes it means possession of a tangible item, such as a house or car. Other times, it might mean an improved credit score that resulted from repaying the loan as agreed.
Examples of Bad Debt
Bad debt can interfere with your ability to achieve your financial goals. Borrowed money used to buy items that decrease in value or fail to generate income is a telltale sign of bad debt. But even debt initially considered good can turn bad. Here are examples of bad debt that might surprise you:
- Low-interest rate home equity loans or home equity lines of credit used to pay for vacations or experiences you can't repay in a short timeframe.
- Cash advances or payday loans since high-interest rates are built into the repayment schedule. According to the Federal Trade Commission, the average payday loan charges nearly 400% interest.
- Purchases made with a high-interest rate credit card that can't be repaid by the due date. These include items that seemed like a good deal, like discounted clothing. Even when buying necessities, paying high interest on these items makes them cost more than the initial savings.
If you're using loan proceeds to buy items expected to decrease in value, it's generally considered bad debt. Before you label a debt as "good" or "bad", consider the reason for borrowing and your long-term financial goals.
Reduce the effect bad debt has on your finances by transferring high-interest rate debts to a Credit Union of Colorado low- interest rate credit card. Apply now, and let us help you achieve your financial goals!