What Type of Debt Is Considered Good?
Many people will classify debt into two categories: good debt and bad debt. You may be wondering why they make this distinction. It is important to realize that debt may help you to achieve something better for yourself, and generally this is considered to be good debt. Bad debt does not do this, but it does tie up your income and makes it difficult for you to do the things you want to. You need to understand whether or not there is a difference between the two types of debt.
What Are Examples of Good Debt?
Good debt is called good, because many people believe that the outcome justifies borrowing the money. Some people will try to justify purchases by calling the debt good or saying that it is the only way to pay for a large purchase, but if it is going to depreciate in value while you are paying interest (like a car loan), you really cannot call it a good debt. There are two basic types of good debt.
Student Loan Debt
One example of this is student loan debt. This debt helped to raise your income potential, which can justify the need to borrow the money. However, you still want to limit the amount of money that you borrow. You can sometimes roll bad debt into a student loan—you do not need to borrow enough to live an expensive and extravagant lifestyle. You can deduct the interest you pay on your student loan, even if you do not itemize, which may put paying off this debt towards the bottom of your debt payment plan.
Another example of good debt is a mortgage. You build equity in your home, and the money you pay towards the home can be seen as investment. Many people view renting an apartment as just throwing your money away, whereas you build equity when you purchase a home. So a first mortgage is generally considered good debt. However, this too can turn into a bad debt decision. If you borrow too much for your home or cash in your equity to buy things right away then your mortgage debt is not a good debt.
What Is Bad Debt?
Bad debt is consumer debt. This is primarily made up of credit cards or personal loans. Often there is little to show for the debt once you borrow it. Additionally, the interest rate on credit cards or personal loans tends to be higher than that on mortgages and student loan debt. It is important to be able to justify any debt that you take on and spending it on things like movies out or entertainment costs are not good justifications. Some people justify car loans, since you often need a vehicle to get from place to place, however a car is a depreciating asset.
You can work on breaking the car loan cycle by driving your cars longer and saving up to buy a new one. Before you take on additional debt ask yourself these questions:
- Will I have something to show for this money in the next year or five years?
- Is it something that I need to purchase immediately (such as a car repair or pay for a medical emergency)? Can I save up for it instead?
- Is there an alternative way to pay for this?
Pay Attention to How Much You Borrow
Your choices of how you spend your money relate back to whether or not a debt is considered good or bad. It is important to remember that any debt that is excessive or used to purchase wants instead of needs should likely be avoided. Additionally, just because the debt is good instead of bad, does not mean that you should borrow all of the money that is available to you. Use good judgement when you make decisions to borrow money. You may regret purchasing a home if you end being house poor as a result.
To keep things comfortable try to keep your debt to income ratio below twenty-five percent of your income.
Work to Pay Off All of Your Debt
Even if the debt is considered a good debt, you should work to pay off your debts as quickly as possible. This will allow you to begin to build wealth. It can also help you pursue your dreams, because you will not be as dependent on your paycheck each month. There are many reasons to get out of debt. If you are serious about getting out of debt, you will need to set up a budget and great a debt payment plan that allows you to apply additional money to your loans each month. You can pay off your debt more quickly than you think you apply the money correctly.
It may mean for a short period of time or cutting back on your lifestyle, but the sacrifices will be worth the effort.