Most people borrow money at some point in their lives, but many may not realize that having the right kind of debt – and paying it off as promised – can show money management smarts rather than poor spending habits. Here’s how to sort the good from the bad when it comes to owing money.
What is good debt?
Think of good debt as an essential element to making substantial purchases you can’t otherwise afford now but should help you produce value later, such as paying for college or a major business expense. In the long term, this borrowing is worthwhile because of its anticipated future benefits. Here are some more examples:
A mortgage is a necessary debt for most people who want to own their own home. It’s considered smart debt because a house will likely appreciate in value at a faster rate than the interest on the loan. Additionally, the interest paid on a mortgage is usually deductible from income for federal tax purposes, which effectively reduces the cost.
Borrowing for Business
Financing a business with a commercial loan is smart because it probably will generate increased value for the operation. The money needs to be used to improve products and services offered, or in other ways that will grow the company.
Paying for an education is one of the best ways to invest in yourself. Taking out loans is considered good debt on the assumption it will produce a lifetime of benefits by equipping you to qualify for better jobs that result in higher income. But make sure to not borrow too much.
What is bad debt?
Bad debt, on the other hand, doesn’t increase your wealth over time and often comes with a high interest rate. It’s the type of borrowing frequently used to pay for things you don’t really need. Some examples of bad debt are:
High-Interest Credit Cards
Credit card balances and the resulting interest are considered bad debt because there’s no anticipated gain. In fact, if balances mount too high or interest rates rise, it can quickly turn into a vortex of financial difficulties.
This form of very short-term borrowing is described as a debt trap by the U.S. Consumer Financial Protection Bureau, partly because of the high fees and the checking account access given to the lender. If you can’t pay right away, the fees can quickly become exorbitant; the average annual percentage rate for a payday loan is about 400% and can run as high as 5,000%. And most people who use them can’t pay them off on time and must refinance repeatedly, according to the government agency. It’s easy to get into a big financial pickle with payday loans, so they are best avoided.
Not every form of debt will fit neatly into “good” or “bad” categories. For example, a car loan may be smart if you get a low interest rate and can pay it off while you still own the vehicle, particularly if having the transportation means you can get a better job. It’s bad debt, though, if the amount borrowed and the interest rate are so high that payments will probably continue long after the car is gone. The key thing to consider is whether the purchase being financed will gain or lose value over the long run.
Spencer Tierney is a staff writer for NerdWallet, where he covers all aspects of personal finance.
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