Some financial experts will tell you that having any type of debt is a bad thing. After all, debt reduces your net worth, strains your cash flow and costs you extra money in interest charges.
That said, it’s not always realistic to go through life paying cash for everything. And when done right, borrowing money can give you access to tools and opportunities that can actually lead to greater wealth down the road. That’s where the concept of “good” debt and “bad” debt come in. Let’s take a closer look at what they mean.
What Is ‘Bad’ Debt?
Bad debt is used strictly for consumption and is often a result of living above your means, according to Jason Dall’Acqua, a CFP and president and advisor at Crest Wealth Advisors.
Examples of bad debt include credit cards, high-interest personal loans and payday loans. Auto loans are also usually considered bad debt because vehicles quickly depreciate in value. “These loans do not provide any upside investment potential and can lead to high interest costs over time,” Dall’Acqua said.
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What Is ‘Good’ Debt?
Good debt, Dall’Acqua explained, helps you to purchase an asset that is likely to increase in value or provide cash flow. Examples of good debt include:
Mortgage: The average person can’t afford to buy a home without some financing. Over time, real estate tends to appreciate in value. It’s also a key driver of generational wealth, and there are several tax breaks for homeowners. Mortgage loans can also be used to buy an investment or rental property that will provide additional cash flow and appreciation.
Business loan: In order for a company to scale, business owners often need to secure financing for equipment, inventory, payroll and other major expenses. A business loan, such as an SBA loan, can be critical for spurring growth and making a business successful.
Student loan: These are generally considered a good form of debt because they help borrowers gain specialized knowledge that results in landing a better job. Federal student loans, in particular, have low fixed rates and there are tax write-offs for the interest.
Auto loan (sometimes): Even though an auto loan is generally considered a bad debt, there are instances when it can be beneficial. For example, if financing a moderately priced car allows you to commute to school or work when you otherwise wouldn’t be able to easily get there, it may be considered good debt.
Prevent Good Debt From Going Bad
Even though a certain type of debt may be considered good, it still comes with certain risks and costs. “Good debt can often be bad debt in disguise,” said Tara Unverzagt, CFP, founder and chief advisor at South Bay Financial Partners.
For example, buying a house can help grow your wealth over time, but it’s not guaranteed — especially in the short-term. Similarly, taking out a business loan without a solid plan for how you’ll use the money can result in being overleveraged.
So if you do decide to borrow money, there are some steps you should take to ensure it benefits your bottom line, according to Taylor Venanzi, CFP, owner and financial planner at Activate Wealth, LLC:
Always make your payments on time. Missing payments not only results in expensive late fees, but can harm your credit considerably.
Set up autopay so you never forget a payment. Just be sure you maintain enough of a buffer in your bank account so that you don’t accidentally overdraw.
Choose fixed interest rates over variable interest rates. This will ensure that you don’t have to worry about payments ballooning in rising interest rate environments.
Refinance debt when it makes sense to do so. You’ll want to crunch the numbers and see if the interest savings outweigh any closing costs.
Maintain a debt-to-income ratio of 36% or less. This means that your monthly debt payments should never take up more than 36% of your gross monthly income.
The Bottom Line
Unverzagt emphasized that debt requires a lot of thought and understanding of what results could happen. “People like to be optimistic and only look at the bright side of the equation,” she said. “And that’s fine as long as you are prepared to deal with the downside also.”
So be sure you have a good plan when taking on debt … even if it’s good.
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