Today’s personal finance tip is about the concept of good debt and bad debt.
Financial gurus and websites these days often classify debt into two categories – good debt and bad debt – in order to prioritize debt repayment plans. However, this kind of labeling can be misleading because it encourages consumers to think certain types of debt are acceptable while others are not.
If you enjoy reading quotes and proverbs about money and personal finance, you have probably come across the saying that equates debt to a modern form of slavery. These kinds of blanket statements do not apply to everyone but there is some merit to them.
Let’s dig a little deeper and see which type of debt falls under each label (i.e. good debt and bad debt).
What is considered good debt?
Long term debt that helps consumers build assets is considered good debt, and examples of good debt include home loans as well as student loans. It is important to note that these assets help create more money, which can theoretically be used to repay the loan. Read more about good and bad debts at CNN Money.
What is considered bad debt?
On the opposite end of the spectrum are short term consumer loans that are acquired through credit cards or other lenders. This type of borrowed money is often used to buy consumable goods and services that do not appreciate in value unlike long term assets (such as real estate).
Credit cards are often used to pay monthly bills, buy groceries and cover other routine expenses, which means these loans will not help create money or generate income that can be used to repay the debt itself.
To add to this, the interest rates on credit card debt is extremely high, and the debt will multiply quickly if not promptly repaid.
Which kind of debt is actually good for you?
There is no correct answer here but the following factors can be used to determine if you should hold on to the debt:
- Some types of debt create a better future – Student loans may be needed to boost to your career,
- Some debts can generate income – money borrowed through a long term, low interest rate loan, can be invested in the stock market to generate a return that is higher than the interest paid,
- Some debt can be used for asset building – a home loan makes home ownership possible for millions of people (but the home does not belong to these people until the last loan installment has been paid)
- Credit cards used to earn points and rewards – we have mentioned that a credit card debt isn’t considered good debt, however, there are many benefits of using credit cards correctly too.
- Mishandling debt harms your credit score – the credit score can be improved over time, though, but a low score can hamper your financial options.
There are certainly upsides to using debt in some cases, but consumers should be aware about the risks of credit before relying on it. Thousands of people face the prospects of bankruptcy because they have been unable to repay their home loans and student loans (i.e. good debt), and thousands more have already faced the harsh reality of losing their homes and other personal assets because they were unable to repay their ‘good debt’.
You can read about these worrying consequences of student loans in an article by The Huffington Post and another one TalkPoverty.org.
Perhaps, financial gurus can be more tactful in labeling asset-building long term debts as ‘less risky’ instead of ‘good’, and consumers can then fully understand the consequences of acquiring home loans and student loans.