Good Debt vs Bad DebtSep 21, 2020
Debt is a necessary part of life – most of us can’t get by without debt, and it’s important that we manage our debt carefully.
There are two types of debt – good debt and bad debt. The names say it all. Bad debt can ruin you financially and damage your credit report. Good debt should help you in a few ways, but its effects may vary depending on how smart you are with it.
Let’s uncover the truth about good and bad debt and what you can do to enhance your net worth and overall credit.
What Debt is Good Debt?
Good debt should help you increase your net worth. Whether it helps you directly, by giving you the skills to get a good job, or indirectly by giving you the ability to buy a house.
Good debt may be any of the following:
- Student loans – If you borrow money to get an education, it’s good debt. Chances are when you finish college, you’ll get a higher paying job than you would have if you didn’t go to college. This increases your net worth eventually, making student debt a good debt. Student loans include any loans for education, whether it be for trade school, real estate classes, or any other education that furthers your chances of getting a higher paying job is good.
- Mortgages – A mortgage helps you build your net worth by allowing you to invest in real estate. Whether you invest in a primary residence, a home you fix and flip or rent out, it increases your net worth. As you make your mortgage payments, you earn more equity in the home, which increases your overall assets.
- Small business debt – Starting your own business requires capital that not everyone has. If you borrow the funds to start your business, and it takes off, you increase your net worth. Not only do you not have to rely on someone else for your paycheck, but you increase your overall assets as your business grows.
Does Good Debt Help Your Credit Score?
You need some debt to get a credit score, so it might as well be good debt, right? Eventually, you’ll need at least one revolving debt account to show that you can manage all types of debt, but don’t start with it or open a credit card just to get the credit.
Focus on your good debt and building a strong foundation. Once you have your budgeting under control and know you won’t spend just because you have a credit card, you can open a credit card to further strengthen your credit score.
Take a mortgage for example – it’s the best form of good debt you can have. Housing debt holds a lot of weight when figuring out your credit score. If you make your payments on time, it will reflect positively in your credit score.
What is Bad Debt?
Bad debt is anything that takes away from your net worth so it’s the opposite of good debt. Any time you invest in something that depreciates, it’s bad debt. You’re sinking money into something that won’t give anything back and even has the potential to drag you under (especially credit cards).
Bad debt may be any of the following:
- Car loans – Financing a new car is like throwing money out the window. The car loses value the minute you drive it off the car lot. Ideally, you should pay cash for a car, and keep it reasonable. Financing a car only encourages you to spend more than necessary, putting you further in debt. You won’t see a return on your investment with a car loan – you’ll be lucky to make a fraction of the debt back when you sell the car.
- Credit card debt – Credit cards are an invitation to overspend or spend what you don’t have. Don’t do it. Most items you buy with a credit card are consumables and carry no value. Have you ever tried selling something you bought, such as a TV, clothing, or sporting equipment? You probably only got a fraction of what you spent for it originally, right? That’s bad debt but with credit cards, you add interest on top of it – making it even worse.
Is Debt Ever Good?
Debt can be good in certain situations. Aside from helping you increase your net worth, debt can help you build a credit score. If you aren’t supposed to be in debt, why would you care about a credit score?
Your credit score does more for you than helps you get a credit card. You’ll need a credit score to get a mortgage (good debt), get student loans (good debt), secure certain types of insurance, sign up for some cell phone plans, and sometimes even get a job.
More companies check credit scores today and not just companies issuing credit. Your credit score is a sign of your financial responsibility and many companies use that to determine your character.
What Should You Do?
Try keeping your debt under control. Don’t borrow money to buy things you don’t need and/or can’t afford and think long and hard before taking on the new debt to see if it will increase or decrease your net worth.
That’s the easiest way to look at it. If you know there’s no future value in the debt and it’s only going to sink you further into debt and take away from your net worth, don’t use it. If you can’t pay for it in cash, don’t buy it.
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