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The Differences Between Good Debt and Bad Debt

When a lot of people hear the word “debt,” they immediately think of something negative that needs to be avoided. In many cases, this opinion is correct. A lot of people struggle with debt problems and these issues make it difficult to achieve their financial goals. Once you get into debt, it’s tough to get out and you can wind up in serious financial trouble.

However, there are some debts that could be considered “good.” After all, there are some high price items that most people simply cannot afford without going into debt.

Here are some examples of debts that could be considered “good.”

Education

Post-secondary education is expensive and, in many areas of the country, it continues to get more expensive every year. However, in general, the better education a person receives, the greater their earning potential. This, obviously, isn’t 100% true in 100% of cases, but in most cases spending money on education is investing in your future. If a debt is being taken out to better your future and potentially improve your financial situation long-term, it can be considered a good debt.

However, student loans can be incredibly difficult to repay and you could find yourself stuck with a lot of debt when you graduate if you’re not careful, so try to only borrow what you can afford to pay back and make sure you have a plan for repaying your debt.

Home Ownership

Most people, especially those who live in hot housing markets, can’t afford to buy a home without getting a mortgage. However, buying a home builds equity and it can potentially save you money in the long run when compared to renting. For this reason, your mortgage debt could be considered to be good debt.

However, it’s important to make sure that you do not borrow more than you can afford to repay. Before you take out a mortgage, sit down and do a budget. In general, you shouldn’t be spending more than about 25-30% of your gross income (that’s your income before taxes) on housing costs.

It’s also important that you consider the market before you take out a loan. In some cases, people have ended up owing more money than their house is worth. For instance, consider a situation where a person has $100,000 saved and they take out a $400,000 mortgage to buy a home for $500,000. If the housing market drops and the value of the home decreases to $385,000, this person could end up owing more than the house is worth. You can avoid situations like this by assessing the market and by only borrowing a reasonable amount.

Small Business Ownership

A business loan wouldn’t be considered good debt in all situations, but borrowing money to start or expand a business can be a good idea. After all, this money can be used to help you earn more money and further your career. As long as you have a strong business plan and you’ve fully considered your chances of success, it might be a good idea to take out a business loan.

What is Bad Debt?

Most bad debts are debts taken out to purchase items that will depreciate in value or that have a negative impact on your overall financial situation. For example, borrowing money to buy a new TV is typically considered bad debt. The TV won’t increase in value and owning a TV likely won’t help you earn any additional money. Therefore, this is a debt that doesn’t help you.

Of course, every situation is different and, for some people, a debt can be considered good while that same debt would be bad for someone else. Consider the situation of getting an auto loan to buy a car. If you live in an area where getting around by public transit isn’t feasible, borrowing money to buy a car can mean that you’ll be able to get to work, earn an income, and improve your life. However, cars depreciate in value very quickly and borrowing too much money to buy a car can hurt your financial situation. You may wish to consider purchasing a used car instead of a new one to save money.

With any loan, it’s important to make sure you can afford the payments, that there is a long-term benefit to making the purchase, and that you’re not taking on too much risk with the debt. If there’s a good chance that you’ll have a tough time paying back the money or if making the payments will put you in a difficult financial situation, it’s often best to say no to the loan and come up with a different plan instead.

Debt should not be taken on lightly and you should always think about it for a long time before you go into debt.