Understanding the Difference Between Good Debt Vs Bad Debt
So, you are in debt. You've borrowed money for whatever reason and now you have to pay it back. That's a bad thing, right?
Maybe not. The debt you have may be essential to your future wealth, and that's probably a good thing. There's a discussion going on about good debt vs bad debt.
The problem with your debt may be the way you're thinking about it. Debt can come in a number of ways, and there certainly is such a thing as bad debt. You may not be in as big of a whole as you think, though, and we'll explain why.
Good Debt vs Bad Debt
The discussion around debt comes as no surprise, what with over 75 percent of Americans having some debt to pay. It's everywhere. Debt is even a driving topic in many political campaigns.
Students are experiencing higher tuition rates, leading to overwhelming debts that can't be paid in a timely manner and credit card debt is ubiquitous among twenty-somethings. Whether it be a mortgage or a degree, you or someone you know is in debt.
But is it all that bad? What's the difference between good and bad debt?
What is Bad Debt?
Bad debt comes from any loan that is not foreseen to accrue in value. It comes when we borrow in order to get something that we don't need and won't benefit from.
This kind of debt has no potential of gaining in value and will only accrue interest and put you further in the whole. Let's go over a few sources of bad debt.
You're likely to come across payday loans when you're in need of some quick cash. This, at least, is how payday loan companies market their services.
When you're in need of money for a hospital bill or car repair, you're going to look for places to find money to solve those problems quickly. You may have seen commercials that advertise the ability to put a thousand dollars in your bank account within 24 hours.
These services might seem like a great option if you're in need of money. Where else can you find that kind of money at a moment's notice? The balance of the loan, however, is due on your next payday.
Hence the name, "payday loan." That may seem like a fair price to pay for the ability to get money fast. The tricky part about these loans, though, is that you won't likely be able to pay the balance after one pay-period.
First, you won't have the ability to cover expenses and pay back the loan in most cases. Even if there was no interest, one thousand dollars is a lot of money to take out of a paycheck. Second, the interest is ungodly.
Some payday loans have annual interest rates that rise over a one-thousand percent. That means that you will have to pay ten thousand dollars one year after your payday loan is taken out. Now, you can pay these off immediately without much interest, but you will find yourself deeply in debt if you can't pay right away.
Most credit card debt can fall into this category as well.
Credit Card Debt
A credit card can be a great way to establish good credit and have the ability to afford some things. Credit cards are certainly wiser options than payday loans, but the reality is that most credit cards are used for non-essentials.
You should take out a credit card if you are positive that you can make the payments. Period. This isn't to say that you'll definitely fall into terrible debt if you use a credit card here and there, but it's best to avoid them if you can.
Missed payments can significantly harm your credit score and prevent you from taking out loans that will be considered "good debt."
In general, if you don't need something, don't buy it. Especially don't buy it with a credit card. The fancy watch that you think you need will probably break by the time you can afford to pay the credit card bills for it. This is because cards have really high interest rates.
You can get lower interest rates with good credit, but even with decent rates, you might not be able to pay the interest. The best bet is to use a credit card only if you know that you can make the payments and avoid buying things that you don't need with it.
General Personal Loans
You may have an inclination to go on a vacation or buy a new suit for that big interview. The way to get those things is by saving for them, not taking out a loan.
There are times when you need to have access to fast cash, though. Personal loans are a wiser alternative to payday loans, but they should be used as a last resort.
Personal loans can be decent options if they're backed by a reputable lender. There are, however, a number of internet lenders that have bubbled up recently. Don't consider a lender if you have the smallest inkling that they are not legitimate.
The rates on these loans can range from five to 36 percent annually, depending on your credit. You may also be subject to additional fees. Additionally, you may be charged for paying your balance before the allotted time. If you have a sudden windfall and decide to get rid of your debts, for example, some lenders will fine you because they missed out on gaining your interest.
What is Good Debt?
Good debt is any loan that will result in gains for you. If you take out a loan for something that is likely to make you more money, the debt you have is good debt. Good debt also comes from loans for things you need.
Let's look at a few examples of good debt.
Loans that assist in paying college tuition result in good debt. A college degree will help you earn income that outweighs the cost of your loans. You are expanding your professional options and moving toward a better life in most cases.
Additionally, loans for college tuition generally have lower interest rates than credit cards or personal loans. They are manageable, and your investment will help you get a job that allows you to get a return on your loan.
Taking out a mortgage is considered good debt because it allows you to own a home.
Finding the right mortgage is key, though. It's a long-term process and you're locked into it. It's essential to find a mortgage with a reasonable interest rate.
You should seek to find a plan that requires you to pay no more than one-third of your monthly income in payments. Any more than this and you are setting yourself up for failure. You may need to work on your credit score to find the right mortgage.
Making timely credit card payments and avoiding bad debt will help you manage a good credit score. You will also get a better interest rate on your mortgage if you offer a significant down payment. Lenders will favor you if you can put 20 percent down on your home.
This may seem like a lot, but it will certainly pay off in the years of lower interest rates. If you're experiencing trouble making payments on your mortgage, consider options like refinancing or moving to avoid further debts.
Loan for a Car
A car loan is another essential and is generally considered good debt. Car loans should be no more than one-fifth of your monthly income and shouldn't be paid in more than four years.
Try to find a plan that allows you to own the vehicle as soon as you can. You'll get better rates if you can put a down payment in. Just like with mortgages, lenders will favor you if you can manage a 20 percent down payment.
Too Much "Good Debt"
The term "good debt" implies that you have borrowed a reasonable amount. These loans still have considerable interest rates and fees. At a certain point, good debt becomes bad debt.
The tipping point is when the debt you owe outweighs the value that you will get from your investment. If your projected earnings don't match up to your college debt or your mortgage payments start to seriously outweigh your earnings and home value, you've crossed the line.
There are a number of ways to get out of debt though, so there's still hope for you if you have bad debt. There are always options for those who are in the throes of financial trouble.
Take Out Smart Loans
The ideas of good debt vs bad debt can mix together at times. What matters is that you make financial decisions that work for you.
This means being able to make timely payments and avoiding taking out loans that you don't need. If you have poor credit and are looking for loans, we have the information you need.