Debt is often viewed as a bad thing – and it definitely can be if you have too much of it or if you have the wrong kind.
But not all debt is inherently bad. In fact, some debt can actually help you to grow your wealth and improve your financial situation if you know the right time and place to take on debt.
I’ve struggled with the concept of investing back into my blog or going into debt for various business ventures before. Even deciding to attend college and working out how to pay for my tuition was an anxiety causing experience, and it definitely didn’t seem worth the trouble at times.
However, as I’m getting used to the idea of reinvesting back into my online businesses and preparing to buy my first ever condo, I’m warming up to the idea that debt can serve as a valuable tool if harnessed correctly.
Thankfully, we’re lucky to have Nate Matherson here from LendEDU to help break down some of the key differences between good and bad debt! Stick around for this one if you’ve ever grappled with the concept of debt and how to manage your finances.
Take it away Nate!
What Is Good Debt?
Good debt is debt that you take on because it has the potential to improve your net worth, either by growing income, investing in assets, or making overall debt payoff easier. Some common examples of good debt include:
Mortgage loan debt: Mortgage loan debt helps you to buy an asset – land or real estate — that traditionally goes up in value over time. Interest rates on mortgages are usually very affordable and are below the rate-of-return you could get by investing, so it often makes sense to take out a mortgage even if you could pay cash for a house. And, if you itemize on your taxes, interest on mortgage loan debt can be tax deductible!
Student loan debt: Student loan debt helps you to improve your income because earning a degree can open up doors for you in terms of employment. Depending on the type of loans, interest rates are also usually relatively low. And, as long as your income is not too high, up to $2,500 of the interest you pay on your student loans is also tax deductible.
This is not to say that every single time you take out a mortgage or a student loan, you are doing something smart. You still need to consider the potential return on your investment and how much debt your income can handle.
Taking out tons of student loans to attend a for-profit college, for example, is likely a very bad idea because you probably won’t increase your earning power and will just end up owing a lot of money. Additionally, if you work towards a degree that doesn’t present many job prospects, you might find it difficult to actually see a return on your investment into education.
You also need to make certain your debt is affordable and that you understand its terms fully. It does little good to take out a mortgage you can’t afford to pay and to get your home foreclosed on, whereas buying a home you can actually afford is a great way to build equity in an asset.
A classic example of people overstepping their housing budgets can be seen from the many people who got into trouble during the 2008 financial crisis, due to adjustable rate mortgages they didn’t understand that became far too costly for them to pay.
What Is Bad Debt?
Bad debt, on the other hand, is debt that is really expensive and/or that you take on to buy assets that depreciate. You don’t want to borrow for items that won’t be worth as much as you paid for them since you’ll be paying interest on items that are immediately worth less than you purchased them for.
Common examples of bad debt include:
Payday loans: Payday loans are extremely expensive, with an effective APR that’s usually around 400%. When you take out these short-term loans, paying them back becomes so difficult that you effectively become trapped in a cycle of debt that it’s really hard to get out of. Many people end up borrowing again and again, paying a fortune each time in interest.
Credit card debt: Credit cards can also be extremely expensive if used irresponsibly. In fact, Financial Times recently reported the average interest rate on a credit card now tops 17% and is at a 25-year high. If you carry a balance, you are making every purchase more expensive. Additionally, if you only pay minimum payments on credit card debt, it can take decades to repay your balance and you could pay thousands of dollars in interest!
These sorts of debt should be avoided at all costs. You don’t want to take out payday loans or carry a balance on your credit cards unless there is a dire emergency and you have absolutely no choice.
To avoid this type of bad debt, aim to save up an emergency fund to cover unexpected expenses and make sure to live on a budget so you spend within your means.
Additionally, budget for unforeseeable expenses every single month, not just when you think one might be approaching. Car repairs, health bills, and other life events can cause sudden spikes in your monthly spending, so putting money away every month into your savings can help provide a cushion in case these costs arise. Even budgeting every month of the year for expensive holidays like Christmas or for birthdays during the year is a good financial habit.
Gray Areas For Good Vs. Bad Debt:
While some debts can easily be categorized as smart debt or stupid debt, there are also some loans that could potentially fall into different categories depending on the situation.
Personal loans: Personal loans tend to have lower rates than credit cards and they can be used wisely. For example, if you take out a low interest personal loan to consolidate and refinance other kinds of debt, this could make debt payoff cheaper. However, if you take out a personal loan for a vacation or wedding, this is bad debt because you’re paying interest on unnecessary purchases that don’t improve your finances.
Auto loans: Car loans can also have relatively low rates. And, taking out an auto loan to buy a safe, affordable, reliable used car can be a good idea if you need a vehicle to get to work or school. But, borrowing a substantial amount of money for a luxury car every two years is a clear example of bed debt – you’re just borrowing money and wasting cash on interest to buy an item that immediately isn’t worth what you paid for it. Plus, the second you drive a vehicle off of the car lot you are losing value on the asset you just bought, especially if you purchase new!
Taking On Debt For Business Ventures:
There is a world of opportunity out there when it comes to making money or entrepreneurial pursuits.
However, there are a variety of ways to fund the start of a new business venture, and numerous factors should be considered before taking on business related debt.
Firstly, it is important to ask yourself the question: can I bootstrap this?
Bootstrapping a company refers to building a company from day 1 with your personal savings and the cash flow you generate from early sales. Bootstrapping is vastly different than companies that are funded through loans or venture capital, and these companies are generally quite lean in terms of operation and timelines.
It can be tempting for entrepreneurs to take on debt to accelerate their progress, but funding can only go so far. Sales, customer feedback, product quality, logistics, and the road-map for company growth are just a few of the other factors that need to be considered. Are early product tests/sales providing promising signs? Does your business even have room to grow, and if so, what is the cap?
Secondly, you should always have a plan in mind for these 2 scenarios:
Business failure: If you take on debt to start a business and fail, how can you recover? If you have to leverage your mortgage or entire life savings against your business to survive, bootstrapping and taking a slower growth path may be the right idea. You can also look to bring on business partners to help lessen the risk and increase your total working capital.
Exit strategy: If your business doesn’t fail, what is your long term plan? Good debt should serve as a means to an end, so consider where you see your business in the next 5-10 years. Have you sold it, franchised it, or are you planning to spearhead additional growth? Why are you even taking on debt to start a business in the first place?
At the end of the day, taking on debt to start a business venture can either be a calculated risk or a foolish decision based on your business plan, the amount of debt you need to incur, and many other factors.
Be Smart About The Debt You Take On – Avoiding Debt:
The bottom line is, no debt is good if you can’t afford it or if use it to buy something with little value.
However, debt is a simple reality we all experience. In fact, the average household in the United States has over $130,000 of debt according to a 2018 NerdWallet study, which includes a variety of debt types (i.e. mortgage, credit card, auto loans, and student loans).
People incur debt for a variety of reasons, and some are truly unavoidable.
But, there are a few ways to either reduce the amount of debt you take on, or to avoid it completely, including:
Learning how to budget: This is a basic component of financial literacy, and is vital for tracking your spending.
Living within your means: No overpriced vehicles, frequent restaurant trips, or frivolous purchases you can’t afford.
Taking care of your health: Unexpected health conditions can arise, but you can greatly reduce the odds of needing expensive medical treatment if you lead a healthy lifestyle.
Tackling existing debt quickly: Debt from sources like credit cards or payday loans can compound quickly, so paying them off as soon as possible is vital. Whether this is through working longer hours, 2 jobs, or starting a side gig, eliminating existing debt should be a priority.
As long as you are responsible and learn how to harness debt for constructive purposes, like building equity in a valuable asset or as fuel to grow a successful business, you can greatly reduce the chance of incurring bad debt. Additionally, if you generally borrow the minimum you need to accomplish your financial goals – and always research loan options to find the most affordable funding – you should be in good shape!
Nate Matherson is the CEO and Co-founder of LendEDU, a personal finance site that helps consumers learn about and compare financial products. Nate launched LendEDU in ’14 while he was a student at the University of Delaware. Nate graduated in ’16 with a B.S. in Finance, and over $55,000 in student loan debt. Nate is passionate about financial literacy, debt payoff, and investing for the future.