Debt is an integral part of our life. Now because not many of us are billionaires and we don’t have a seven-digit bank balance throughout the year, it can get pretty difficult to be in a good position to buy big-ticket items – say, a home, car or college education. I completely relate that none of us like paying interest but we also can’t save enough cash for these huge purchases. So, what option do we have? Borrowing money. Practically, that’s the only solution. So, it is highly likely that you will have to take on debt at some point in your life. The question is, how do you know when it is worth it? The key to this lies in understanding the types of debt. There are two types of debt — Good Debt and Bad Debt. In this article, we will understand everything regarding: Good Debt vs Bad Debt.
You can certainly make an argument that no debt is good debt. True that. Absolutely agreed. All debt are the same: You technically borrow now and repay the amount along with interest in the future. However since debts can have a positive or negative consequence, they are typically thought of as good debt or bad debt. Read till the end so that you don’t miss out on any topic. You will also find good debt vs bad debt examples in the following sections to help you understand the topic better.
What Is The Difference Between Good Debt And Bad Debt?
The simple rule is that if a particular debt generates income or increases your net worth in the long run then it is good debt. If it doesn’t work like that and you don’t have the cash to pay for it, it’s bad debt.
I know you must be wondering how do you know you have too much debt? Fortunately, we have a metric to measure that. It is known as the debt-to-income ratio. This parameter is basically the ratio of all your monthly debt payments divided by your monthly gross income. Multiply this ratio by 100 and you have the percentage. Anything over a 43% debt-to-income ratio is a red flag for you and for all the lenders you may reach out to. It indicates that since a good portion of your income is lost in clearing debts, you may not be able to manage your finances well.
If you have calculated this ratio and the figure scares you then you must read this blog: How To Lower Your Debt-to-Income Ratio: Top 5 Ways.
Coming back to the topic, on one hand, good debts can help you achieve aspirational goals while on the other hand bad debts are expensive and can derail them. Bad debts function in the exact opposite way (obviously!). They make it even more difficult for you to meet your financial goals. Long story short, good debt benefits your financial future, while bad debt harms it.
What Are The Types Of Good Debts?
Starting on a good note, let’s first understand what a good debt is exactly. A debt that helps you increase your income or net worth is an example of good debt. It helps you manage your finances in a much more effective manner and leverages your wealth to buy things that improve your financial health in the long run.
Keep in mind that too much of any debt is bad debt.
There are types of Good debts that improve your and your family’s life in many significant ways. A few examples where it is often worth going into debt include:
Education – Investing in yourself is definitely a good idea. Education is one such investment that is regarded as an investment in your future. It is directly proportional to your earning potential. It also has a positive correlation with the ability to find employment. Hence, taking student loans classifies as good debt.
You might also like to read: Signature Student Loan – The Most Popular Type of Unsecured Loan
Your Own Business – Money borrowed to start your own business can also come under the heading of good debt. Starting a venture comes with a lot of risks but those risks are minimised if you choose a field that you are passionate and knowledgeable about. Also, being your own boss is often both financially and psychologically rewarding.
Your Home or Real Estate – Real estate provides ample ways to make money. The simplest way is taking out a mortgage to buy a home, living in it for a few decades, and then selling the home at a profit. It can also be rented out to generate a secondary source of income but you should know at all times what you are doing.
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Good Debt vs Bad Debt: Types Of Bad Debt?
If you are borrowing to purchase a depreciating asset then that is definitely a bad debt. In other words, if the value of a particular asset won’t go up in value or generate income, then you shouldn’t go into debt to buy it. types of bad debt include:
Cars – While it may seem impossible to live without a car, going into debt to buy one isn’t a great idea from a financial perspective. The vehicle is already worth a lot less the moment you drive it out of the showroom. If buying a car is a necessity for you, then look for a loan with low or no interest.
Recommended Reading: Affordable And Cheap Car Insurance For Students
High-Interest Credit Cards – High-interest rates, such as those greater than 20%, can make your debts more expensive.
Clothes and Consumables- Of course, you need clothes—and food, and furniture, and all kinds of other things—but taking on debt to buy them by using a high-interest credit card isn’t a smart use of debt. However, do not lavishly spend all your earnings on such perishable items that aren’t going to add any value in the future.
Good Debt vs Bad Debt: The Golden Debt Question
Whether you are borrowing for a degree, home, car or new business, the final determinant of whether the debt you’re amassing is good can be determined by this question: Will this debt pay me back much more than what I put in?
This question may be simple but it requires a lot of thinking. You will have to factor in various components such as principal, interest rate, alternative uses and much more. This entire calculation will help you understand if this debt is worth the risk or not. More importantly, whether the time and money you are investing, is there something better you could have done out of it?
Always remember — the debt should always do more than what you do for the debt!
Thank you for reading this blog ‘Good Debt Vs Bad Debt: Must-Know Differences’. If you enjoyed reading this blog and would like to continue reading more about debts then do check out our following blogs.