Good and bad debt: here’s the difference

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Not all debt is created the same.

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It is difficult to live your life without any debt. There are times when a person needs to borrow money, whether it is for a house, school fees, or an emergency. Debt is often necessary and, in fact, it can even be good. If you are considering borrowing or reviewing your budgetIt’s important to understand the difference between good debt and bad debt to prepare for long-term financial success.

What is considered good debt?

It may surprise you, but yes, there is good debt. Good debt occurs when the money owed is tied to something that may increase in value, such as a house.

“Good debt is debt used to acquire valued assets,” said Thomas E Murphy, CEO of Murphy & Sylvest Wealth Management. “These assets can be tangible like a house or intangible like an education. The asset is expected to appreciate enough to offset the interest paid on the debt.”

Here are some examples of good debt.

Mortgages

A mortgage is debt that is worth taking on (as long as it makes financial sense). Having a mortgage shows that a bank trusts you enough to lend you a large amount of money for a purchase – your home – which is very likely to increase in value over time. This type of debt has the potential to increase your equity, as the value of your home could exceed the amount you owe the bank.

Home equity / line of credit loans

Like a mortgage, a home equity loan or home equity line of credit confirms that a bank believes you are financially stable enough to get a certain amount of money or credit. It also shows that you have a home with significant value to borrow while still having a manageable or paid mortgage. Real estate stocks are typically used to invest in home improvement, such as a renovation, which increases its value and your overall equity.

Of course, a home equity loan could easily go from “good debt” to “bad debt” if the funds are used to buy anything that will depreciate or have no value to begin with. For example, using home equity to pay for vacations or a car is not a good idea.

Student loans

The money borrowed to go to school may not be associated with a physical asset like a house, but there is a financial benefit in the future. Student loans are an investment in a person’s future that could result in a much higher salary than if that person had not purchased an education. A 2019 Federal Reserve study found that bachelor’s degree holders earn, on average, $ 30,000 more than with a high school diploma. Granted, not all degrees are created equal, and in the case of companies like Apple and Google, a four-year degree is no longer required for some jobs.

What is considered bad debt?

The easiest way to tell if something is bad debt is to assess the purchase made with the money borrowed or used to secure the loan, also known as collateral. Will the purchase that gives rise to the debt retain its value over time, like a house, or will its value decline, like a new car? The worst type of debt is associated with no collateral, such as a vacation.

“Bad debt is debt used to acquire an asset that is impaired or worthless at all,” said Howard Pressman, CFP partner at Egan, Berger and Weiner. In other words, bad debt occurs when money is borrowed to buy something that will lose value or have no market value to begin with.

It’s also not a good indicator of financial stability if you need to borrow money for something you can’t pay off quickly, like vacations or jewelry. Lenders who review your credit report before allowing you to borrow money may be looking at these types of accounts and questioning your creditworthiness.

Here are some examples of bad debt.

Auto / boat loans

The big problem with auto or boat loans is that once the debt is acquired, those assets immediately start to lose value. For example, new cars lose an average of 10% of their value in the first month after they leave the lot. Of course, a car is an essential purchase for most people and if you can’t pay for one in cash (the preferred method), there’s no way you can get into debt. When borrowing money for a car, be sure to negotiate or specifically seek out an interest-free loan, which is the best way to buy a car with borrowed money; if you pay interest, future lenders will criticize that debt.

Payday loans

Short term loans with high interest rates are called payday loans, and they can cause more problems than they are worth. These loans are often sought after by people who need quick cash, whether it is for an emergency or to pay for something that needs immediate attention, such as rent. Avoid these loans at all costs. Not only can interest skyrocket over 1000%, some people who have trouble repaying these loans can end up in jail.

Retirement account loans

Like payday loans, borrowing money from a 401K or other retirement account is a way to get money without collateral, usually when there is an urgent need. The biggest downside to these loans is that you will find yourself investing less in your retirement while incurring fees and interest. Because of coronavirus pandemic, the CARES law passed in March allows you to borrow money from a 401K, without penalty, in the event of financial difficulties. This is a good example of borrowing against your 401K is a viable option of last resort. Otherwise, protect your future and avoid dipping into your 401K.

Credit card

A credit card can be very useful for your creditworthiness – and you earn rewards at the same time. An account with a low balance and a high limit – called “use of credit“- shows how responsible you are with money. Where things go wrong is when you have multiple cards with high credit usage and balances that are not paid monthly. These behaviors are bad. use of the credit card will wipe out your credit rating quick.

One way to keep track of how debt can affect your credit score is to use a credit monitoring service. For those who want to review their credit report, the three agencies offer free weekly reports due to the coronavirus pandemic.

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