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October 06, 2023
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Invest in your well-being: In this financial wellness series, we're diving into how to better budget for your physical, mental, and emotional health. Welcome toWellth Check.
Debt is a four-letter word that can keep you up at night. But it can also be a means to an end.Understanding the difference between the two types of debt and managing both are key to your financial health.
Here's what you need to know.
What is good debt?
Often debt is deemed good if it allows you to obtain an asset to grow wealth—think business loans, home mortgages, and student loans, for example.
"They are considered good because of the opportunity to either generate income or grow an asset that will be worth more money later on," says Caitlynn Eldridge, a certified public accountant and founder of Eldridge CPA.
He adds that student loans can be a positive investment, considering that individuals with a bachelor's degree earn around 55% more than those with only a high school diploma over their lifetime. Similarly, business loans can allow for expansion and growth, potentially increasing profitability by a significant margin.
What is bad debt?
If you're wondering what distinguishes the good from the bad, bad debt is labeled as such if it comes from buying things that go down in value, such as cars, and credit card purchases for furniture and clothes, for example.
Bad debt also typically has high interest rates, causing you to pay even more than the original price if you don't pay off the bill in full when it arrives. The median rate of interest across all credit cards in the Investopedia card database for September 2023 was 24.12%.
The rates are worse for payday loans. "They can exceed 400%," says Rose.
The consequences of bad debt can be severe. Your credit score may decrease, your borrowing capabilities may be more limited in the future, and that heavy debt burden could get in the way of your saving and investing goals. You could end up filing for bankruptcy.
The consequences aren't just financial, though.Serious money woes can be detrimental to physical and mental health, as well as marriages, and often are the chief culprit in a divorce.
Rules of the debt game
Truth is, all debt should be managed carefully and monitored. "Even 'good' debt can become bad if you have more than you can pay off," says Eldridge.
You want the lowest interest rates possible on any debt and to pay it off as quickly as possible.
Be savvy about debt. "You need to really evaluate costs. If you are buying something on 12 months at 0%, then it goes up to 18%, can you pay it off in the 12 months?" asks Gina Knox, CEO and financial coach and Gina Knox Coaching.
If you can't pay it off within 12 months, you're not getting the great deal you think you are. When the interest rate switches to 18%, can you say that cost will be worth it? "This is the type of question you want to answer prior to buying," says Knox.
You won't go too far astray if you stick to this rule. "Before you take on debt, whether good or bad, first have a positive cash flow from your current income," advises Raymond Quisumbing, a registered financial planner at BizReport.
Secondly, save a decent amount of money to serve as your emergency fund (equal to at least six to 12 months' worth of monthly expenses); only then should you consider borrowing, and it should be for good debt.
Stephen Chang, managing director at Acts Financial Advisors, also says before undertaking any type of debt, to do a bit of soul searching. "Do a needs-versus-wants analysis. Evaluate where the purchase falls within that rubric," he says.
If it's a want that you can't really afford, vow to start saving up for it instead.
Have a payoff plan
Much as in an ideal world you would be debt free, that's more wish than reality for many people. But what's key is to have a plan to pay off debt.
"Whether healthy or unhealthy, debt is not something you want to live with. Get a simple budget in place (app, spreadsheet, pencil, and paper), and incorporate payments for whatever plan you've chosen," says Sean Fox, president of debt resolution at Achieve, a digital personal finance company.
The best option is to pay off the bill in full when it comes so you avoid interest charges. But that may not be possible. One way to reduce debt is to use the snowball method, paying off debt starting with the smallest amount owed to largest. Make minimum payments on all your debts except the smallest, where you pay as much as possible until finished. Follow suit with your remaining bills. Knocking off a bill is a victory that keeps you encouraged.
Tamma Trenta, founder and CEO of Family Financial, says, "The line between good and bad isn't always clear-cut. It's all about how the loan balances with your financial goals, your career, and your life. Crunch the numbers and consider your future earning potential before taking on a significant financial commitment."
FAQs
What separates good debt from bad debt is that bad debt funds depreciating assets, while good debt can give you access to an asset that will increase in value over time. In terms of interest rates, bad debt tends to carry higher interest rates than good debt.
Do you think the debt is a good thing or a bad thing? ›
Debt can be considered “good” if it has the potential to increase your net worth or significantly enhance your life. A student loan may be considered good debt if it helps you on your career track. Bad debt is money borrowed to purchase rapidly depreciating assets or assets for consumption.
What is considered good debt and bad debt? ›
What's the Difference? A simple rule about debt is that if it increases your net worth or has future value, it's good debt. If it doesn't do that and you don't have cash to pay for it, it's bad debt.
Is it good or bad to go into debt? ›
Think of good debt as money borrowed to help build important things in your life. Good debt ultimately contributes to your wealth and happiness and means obtaining something useful. It also helps you raise your credit score (assuming you keep up your payments).
What is an example of a bad debt? ›
Bad Debt Example
A retailer receives 30 days to pay Company ABC after receiving the laptops. Company ABC records the amount due as “accounts receivable” on the balance sheet and records the revenue. However, as the 30 day due date passes, Company ABC realises the retailer is not going to make the payment.
What are examples of good vs bad debt? ›
Examples of good debt include mortgages that provide a home and a valuable asset and student loans that provide job skills. Examples of bad debt include unchecked credit card debt and payday loans.
Why do people think debt is bad? ›
Having too much debt can make it difficult to save and put additional strain on your budget. Consider the total costs before you borrow—and not just the monthly payment. It might sound strange, but not all debt is "bad." Certain types of debt can actually provide opportunities to improve your financial future.
What are examples of good debt? ›
Here are some examples of "good debts":
- Student loan debt. Student loans can be “good debt" if they help you earn a degree and launch you into a well-paying career. ...
- Home mortgage debt. ...
- Small business debt. ...
- Auto loan debt. ...
- Credit card debt. ...
- Payday loans. ...
- Borrowing to invest. ...
- Predatory/High interest loans.
Bad debt is an amount of money that a creditor must write off if a borrower defaults on the loans. If a creditor has a bad debt on the books, it becomes uncollectible and is recorded as a charge-off.
What is a good debt to? ›
Your debt-to-income (DTI) ratio is how much money you earn versus what you spend. It's calculated by dividing your monthly debts by your gross monthly income. Generally, it's a good idea to keep your DTI ratio below 43%, though 35% or less is considered “good.”
High-interest loans -- which could include payday loans or unsecured personal loans -- can be considered bad debt, as the high interest payments can be difficult for the borrower to pay back, often putting them in a worse financial situation.
How does bad debt affect you? ›
Creditors often report charged-off accounts to the credit bureaus. A charge-off as bad debt reflects poorly on your past payment history. Considering that 35 percent of your FICO score is based on payment history, you can expect your credit score to be adversely affected.
How much debt is healthy? ›
Ideally, financial experts like to see a DTI of no more than 15 to 20 percent of your net income. For example, a family with a $250 car payment and $100 of monthly credit card payments, and $2,500 net income per month would have a DTI of 14 percent ($350/$2,500 = 0.14 or 14%).
Is a car payment considered debt? ›
The auto loan itself would be considered the "debt." The payments toward it would be considered "debt payments." With regard to your credit report, if you are applying for another loan somewhere and they looked at your debt-to-income ratio, the monthly auto loan payments would be included on the debt side.
Who has the worst debt? ›
United States. The United States boasts both the world's biggest national debt in terms of dollar amount and its largest economy, which resolves to a debt-to GDP ratio of approximately 128.13%.
How do rich people use debt? ›
Wealthy individuals create passive income through arbitrage by finding assets that generate income (such as businesses, real estate, or bonds) and then borrowing money against those assets to get leverage to purchase even more assets.
Why is debt considered good? ›
"Good" debt is defined as money owed for things that can help build wealth or increase income over time, such as student loans, mortgages or a business loan. "Bad" debt refers to things like credit cards or other consumer debt that do little to improve your financial outcome.
Is debt bad for the US? ›
A nation saddled with debt will have less to invest in its own future. Rising debt means fewer economic opportunities for Americans. Rising debt reduces business investment and slows economic growth. It also increases expectations of higher rates of inflation and erosion of confidence in the U.S. dollar.
Why is it good that the US is in debt? ›
The national debt enables the federal government to pay for important programs and services even if it does not have funds immediately available, often due to a decrease in revenue.
Why is it good to avoid debt? ›
There are several benefits of not getting too deep into debt. Debt can drain your cash. Once you free yourself of debt, chances are you will have more money to spend on things you want or enjoy without having to worry about interest payments. Mishandling debt can lead to a bad credit history.
