The Secret to Knowing the Difference Between Good Debt and Bad Debt
Personal debt is no longer a matter of “if,” but “how much.” These days, it’s how we pay for everything, including cars, houses, shoes, and handbags. It’s an inevitable fact of life.
Some will compare all debt to Satan and advise us to avoid it like the plague. But, as always, there are two sides to every coin — and a gray area in between. Not all debt is bad. In fact, some debt is (somewhat) welcomed. Other types? Well, the trick is to evaluate your true spending habits and see if the debt is helping you accomplish something that will provide for your future self.
Let’s do a little debt self-evaluation. Starting with the good, we’re breaking down the most common types of debt and comparing the good, bad, and ugly. What side are you on?
If seeing what you owe in student loan interest makes you want to pull hair from your scalp and punch walls every month, you’re not alone. However, take comfort in knowing education debt of any kind is worthwhile, as there’s a positive correlation between education and earnings.
Students with an advanced degree from Duke see an education return on investment after only 3.7 years. And Bureau of Labor Statistics data from 2016 reports a weekly median of $679 for high school graduates and $1,155 for workers with a bachelor’s degree. That’s almost double the earnings for those with a college degree.
Over the course of a lifetime, that return on investment could equal hundreds of thousands of dollars. And that is a welcomed sentiment considering the average student loan debt has reached upwards of $37,172.
Good: Small business endeavors
It takes money to make money, as they say. And success comes to those who work for it. Because the earning potential is uncapped for those who decide to take the entrepreneurship plunge, incurring this type of debt is OK.
To keep with the cheesy, yet accurate sayings, you must risk it to get the biscuit. The money and effort it takes to fund a startup is well worth the potential debt when you consider how nice it feels to be your own boss, unconfined by glass ceilings and position titles.
Good: Real estate
Most of us aren’t planning to buy a home with cash. But one of the best examples of good debt is a mortgage. Borrowing money to finance a reasonable home allows you to consistently make payments over time and improve your credit. Hopefully, the home increases in value generating a profit once sold.
The tax benefits associated with mortgage interests and second homes are large, and the income potential for rental properties are worth possible debt obligations. Even investing in commercial real estate can be considered good debt.
Depending on the risks you’re willing to take, short- and long-term investment opportunities are advantageous opportunities to grow wealth. Stocks, bonds, and other alternatives investments are an effective way to pad that retirement fund. But be warned: The stock market isn’t always here to make friends. Fortunes can be made just as fast as they can be lost.
Next: Ready to see how much bad debt you’ve incurred? Most of us have this next form of dangerous, yet maybe necessary debt.
Vehicular expenses are a double-edged sword. On one hand, it might be a necessity for those without access to public transportation. On the other, it can be a direct route to irreversible debt if you’re not financially responsible.
Many consider riding around on four wheels to be a luxurious indicator of wealth and status — regardless of your true wealth or status. Most new cars depreciate 20% in value for every year you own them. This is money you can’t get back. Ever. And let’s not even talk about the years of interest you’ve committed to when signing for a loan.
The next type of consumer debt is completely avoidable.
Bad: Clothes and other consumer goods
Speaking of dangerous stigmas and expensive egos, set them aside and stop spending your hard-earned cash on frivolous wants. This is what’s known as “disastrous debt.” Completely unnecessary handbags, TVs, and last-minute tickets to Bora Bora are often financed by borrowed money. But the instant gratification often accompanies mounds of debt on credit cards you can’t afford.
Bad: Credit cards
Credit card debt is like a snowball in Minnesota. It just keeps growing. With sky-high interest rates and aggressive payment schedules, it can be hard to get out from under its pull.
Even those who keep a small balance on a card so they can pay it off later to show better payment history are mistaken. Carrying a small balance doesn’t help you. In fact, you’ll probably forget it’s there. Then, two years later, that washing machine you charged has tripled in cost, and you’re stuck selling things at a yard sale to make due. It could take years to resolve this type of debt, depending on your interest rate and payment plan.
Bad: Store credit
Store credit cards are just as dangerous as traditional cards. This might feel like free money until you’ve spent half of your child’s college fund at Kohl’s. And 15% off your first purchase just isn’t worth it.
Michael Misasi tells Bankrate that “If you are a loyal shopper at a store, (retailers) don’t want to have the experience of telling you that you’ve been rejected for a card.” That means the underwriting standards for these cards are historically more lenient in their approval process than a traditional card. So not only are stores preying on those prone to making poor financial decisions, the APR on these retailer cards is usually higher than general cards, at a whopping 23.23%.
Bad: Borrowing from a 401(k)
When in need of a quick solution, it might be tempting to borrow from your 401(k), but that leads to one slippery slope. Do it once, and the key benefits of a 401(k) are lost. The entire amount borrowed could also quickly become due if you lose or leave your job. This should be money you don’t touch until retirement.
Still, people often borrow from their 401(k) or even withdraw money to fund non-emergency purchases, which are subject to taxes and a 10% penalty.
Bad: Payday loans
You gotta do what you gotta do to get by, but applying for a payday loan is one of the worst types of bad debt. This is when people receive a small amount of money with the agreement it will be paid back using the borrower’s next paycheck. No matter how normal Montel Williams makes these loans sound on TV, don’t fall for it. Those who apply for these loans are desperate. Therefore, the lenders charge insanely high interest rates that make it tough to pay back.
While some types of debts are awful any which way you slice it, others fall into a gray area. This is the debt that can be good or bad — and what you’ll want to pay close attention to.
OK: Credit cards (again)
But wait. Didn’t we already label credit cards as bad debt? Yes, we did. And thanks for paying attention. However, open credit cards with positive payment history remain on your credit report indefinitely, while closed credit cards usually disappear after 10 years. This is a good thing.
The length of your credit history accounts for about 15% of a FICO score, and a long credit history sprinkled with old accounts will help improve your financial portfolio. So, if you can withstand temptation and remain responsible, try hanging on to those good accounts by leaving them open.
OK: Credit card reward programs
Unlike store credit cards, other rewards programs have the potential to be both good and bad. Many allow opportunities to earn cash back, free airline tickets, coupons, special financing offers, and vacations. And if you play your cards right (pun intended) they could be yours.
These types of programs are great for those looking to establish any type of credit history. But watch out for low credit limits that could affect your utilization rate and program specifics that could bind you later. Often, these store rewards are only applicable with that retailer or are contingent upon spending more money at the same store. This can quickly negate any prior reward received.
OK: Borrowing for medical care
Who wouldn’t borrow any amount of money they could to save a loved one or treat a disastrous disease, no matter the cost? We get it. The problem lies within debt settlement options. More than 60% of Americans cite medical bills as the overarching reason for their bankruptcy. What’s worse is 75% of those people had health insurance but were still overwhelmed by their medical debts. As a result, many are forced to refinance, take out a loan, or pay with a credit card to resolve their debts.
OK: Consolidation loans
When you’re in debt up to your eyeballs and can’t see the light through the liabilities, it might be time to consolidate a few loans. With these loans, consumers can take out a new loan with a lower interest rate than all other debts combined. It’s a great way to save a boat load of money with one combined low interest rate. But the dangers are still lurking beyond rose-colored glasses. Often, this just frees up more money, creating new ways to garner debt.
Follow Lauren on Twitter @la_hamer.