At one time, the only two things said to be certain in life were death and taxes. Today, however, debt is slowly climbing the ranks as a certainty for Americans, who continue to charge beyond their means and pull out plastic more than checks or cash. Credit card debt isn’t the only source of financial instability, however; there are two main types of debt: Good and Bad.
Of course, you’ve probably never considered any type of debt to be good, which is why this article is so important for today’s consumers. The reality is that escaping life without some form of debt is unlikely, so you might as well manage your life responsibly with the right types of financial obligations.
What is good debt?
Good debt is loosely defined as debt that brings some form of long-term benefit to the consumer. The best example of this would be your mortgage, which is definitely good. When you apply for a mortgage, you might sink a couple thousand dollars in debt, but you gain what is arguably your biggest asset as well as a way to build equity.
Each time you make a payment toward your mortgage, you increase the equity in your home while shrinking the amount of debt you’ve accumulated.
Other types of good debt include student loans, which further your education and guarantee more lucrative job opportunities; business loans, which enable you to start an enterprise that will eventually bring you wealth if managed correctly; and home improvement loans, which will increase the value of your home, thereby increasing your equity.
You can also think of good debt as something that appreciates over time. Your home will probably increase in price as the years go by, which makes it a great investment in your financial future. With an education purchased with student loans, you can continue to climb the ranks of the corporate ladder, thereby increasing your overall wealth. It is always a good idea to be in a cash-positive situation with debt and investments combined, but not all debt is bad.
What is bad debt?
Bad debt is incurred when you purchase something that depreciates over time with an interest-accruing account, such as a credit card. For example, let’s say you pay 11% interest on your credit card, and you purchase $500 worth of clothes. As soon as you pay for your purchases at the register and walk out the door, the value of those products depreciates considerably, but you’ve still incurred debt that you must pay off.
In addition to the price of the clothes, you’ll pay interest on your purchases until you satisfy the debt in full. While the clothes depreciate in value, the amount you pay for them increases. This is a classic case of bad debt.
Another example would be your car loan, which might be necessary but still falls under the category of bad debt. When you purchase a car, the vehicle depreciates considerably as soon as you drive it off the lot, but you’re still saddled with the principle of the loan plus any accrued interest. In fact, many people discover that they owe more on their vehicle than it is actually worth.
Satisfying Long-Term Financial Goals
What all of this boils down to is that good debt will build financial freedom and wealth, while bad debt will continue to mire you in old financial obligations. As you increase the amount of bad debt in your name, you decrease your total net worth, and add to the amount of money you might owe in the future.
Bad debt, for example, can include the rent you pay for your home. If you rent rather than own, you are basically flushing money down the toilet, but you still owe next month’s rent if you want a place to live. Mortgage payments, on the other hand, continue to build equity in your name, which can be liquidated in the future. There are no cash benefits to renting, so it falls into the category of bad debt.
Of course, it is almost impossible to avoid bad debt entirely, provided you aren’t a trust fund baby or a lottery winner. The goal, however, is to put yourself into a situation where your good debt and your investments come out equal, and your bad debt is miniscule. This places you in a cash-positive position, which is financially healthy.