Not all debt is created equal. Knowing the difference can change the way you look at your spending.
Good debt adds value. Good debt often leads to financial growth, because the product or service being purchased adds more value than the debt that comes with it. Student loan debt is usually considered one of the good debt examples because the related education typically allows you to earn more income.
Some purchases result in value more directly. Taking on a mortgage, for example, can be valuable simply by giving you access to a place to live while building equity. Additionally, a mortgage is often considered good debt because your property can be used as collateral for other debt once you’ve paid down the principal or your home has gained in market value. Even better, good debt often comes with a tax deduction on the interest you pay on things like your mortgage or student loans.
Bad debt adds expense. Credit card debt is almost always bad debt. Especially since interest rates on credit cards are higher than most other types of debt. Plus, most items purchased with credit cards do not contribute to personal financial growth. In fact, interest expense is so high that credit card companies are now legally required to display the cost of this debt directly on their billing statements. Another example of bad debt is auto loans. Because cars usually lose value quickly, more money is owed on the debt than the car is worth!
But even good debt can turn bad if there is too much of it. Take out too large a mortgage and you may struggle to make payments!
Debt always means higher cost. Debt’s big benefit is allowing you to pay for something over time. But the drawback comes in the form of interest, which can add up to tremendous amounts. Map out the differences between buying on debt and saving up the cash to purchase without interest. Is the extra interest worth the benefit? Comparing the cost of the purchase with interest, to the value you stand to gain by purchasing the asset, can help you determine whether using debt is a good or bad choice for you.
How to manage good debt vs bad debt.
- Consider carefully what you can afford and make a plan for how you will pay off any debts before you take on the debt.
- Never carry a balance on a credit card unless it is an emergency. Pay the balance in full every month.
- Calculate the entire cost, including interest, of anything you purchase using debt. This is the REAL cost of an item.
- Use savings, whenever possible, to purchase goods and services that would otherwise be considered bad debt.
- Pay off high-interest debt.
- Financial growth is often the key measure for defining good debt vs bad debt, but not always. Other factors, like personal interest, growth, and well-being can also be measures for your debt decisions, as long as you can truly afford the payments.
Reach out for help if you aren’t confident whether a potential debt will lead to more harm or good. Making the right choice could save you money.