Good Debt, Bad DebtUnder the right circumstances, debt can have a positive impact on your finances, but the key is to maximize good debt and minimize bad debt.
The 2016 NerdWallet survey of Americans debt shows overall U.S. household debt increasing by 11% in the past decade. Today, the average household with credit card debt has balances totaling $16,748, and the average household with any kind of debt owes $134,643, including mortgages.1
Good Debt Increases Your Net Worth or Helps You to Generate Value.Think of good debt as an investment, just like a stock or bond. You spend money now with the expectation of getting your money back, and perhaps some profit on top of that, at some point in the future.
⚫ Mortgage Debt – Most of us cannot afford to pay for a home with cash. Borrowing to finance a home allows you to pay back a home loan over time, with the hope that the home itself will increase in value, so that when it is sold, you can realize a profit. In addition, the interest you pay to a bank or mortgage company is usually tax-deductible, so while you are paying for the privilege of borrowing money, you are saving on your tax bill. Residential and commercial real estate can also be an excellent source of rental income, so borrowing money to invest in this way can be considered a form of good debt.
⚫ Student Loans – In general, the more education a person has the greater his or her future earning power. While a higher education alone is not a guarantee of wealth and success, taking out a student loan is almost aways considered a wise option. Whether the money is for college, technical school, the loan is more often than not merely an investment likely to pay for itself many times over.
⚫ Business Loans – Good ideas, hard work, ambition and luck are not always enough to launch or support an entrepreneurial endeavor. Seed capital or small business loans are often a necessary component of building and sustaining a profitable commercial enterprise. Borrowing money to build wealth is another example of taking on good debt to create future value.
Bad Debt Finances Something That Will Not Return Your Investment.This can happen if you finance items for consumption like dinners out, clothing, or vacations, but it can also happen if you finance items of value for too high a rate or too long a term.
⚫ Car Loans – Cars are depreciating items. They are worth less every month. If you borrow money to buy a brand-new car, the moment you drive it off the lot it has lost a big chunk of its value. You are stuck with paying the initial price, plus interest. It is not the worst form of bad debt by far, as you use the car during and after your loan repayment period. You may be overpaying for the use of a car, but at least you get some value out of it -- especially if you need the car to commute to work.
⚫ Financing Furniture – leasing to own a brand new living room or bedroom set can cost you a pretty penny, and the resale value of your used furniture will likely be pennies on the dollar, especially if you have a situation with children and/or pets that will add to the regular wear and tear of the furniture. Pay for these items with cash.
⚫ Credit Cards – Credit cards are rarely used to finance items that will return value to you - dining out, admission to a movie or concert, and new clothing cannot be re-sold for more than you paid down the road. On top of that, the interest rates and fees can be staggeringly high -- sometimes above 20%, versus the single-digit rates of most other forms of debt. If you do not pay off your balance in full each month, then the interest payments can quickly get out of hand.
⚫ Vacations – Even though it might help you feel better and be more productive once you return, a vacation does not appreciate in value. Never use debt to pay for a vacation and especially to pay for a vacation you cannot afford.
When Good Debt Goes BadThis can happen if you finance items for consumption like dinners out, clothing, or vacations, but it can also happen if you finance items of value for too high a rate or too long a term.
⚫ Using Good Debt to Pay Off Bad Debt – Repaying debt with debt is never a good idea. For example, getting a mortgage for $110,000 instead of $100,000 and using the extra to pay off credit card balances ends up taking longer to pay off the mortgage than it would have otherwise and increases your monthly payments plus the time it takes to build equity in your home. Use cash to repay debts, not more debt.
⚫ Holding Too Much Good Debt – Even if it’s good debt, your monthly debt payments, including mortgages and credit cards, should take up no more than around 36 percent of your gross monthly income. If you’re overloaded with debt, you may get into a situation where you cannot handle timely payments which can affect yoru credit and trigger high fees and possibly increased interest rates for some credit cards.
⚫ High or Variable Interest and Fees – If the interest rate on your loan is variable or higher than otherwise available, you have bad debt. Adjustable Rate Mortgages can be an example of good debt that turns bad when the rates increase, but watch out for low interest credit card offers that can increase fees and interest due to late payments or after the 12 month initial offer is through. If the amount you pay in interest, late fees and any penalties may exceed the value of the product or service you finance, your debt is a bad one.
⚫ Borrowing That Lowers Your Credit Score – Borrowers who are interested in improving their credit scores should make timely payments. They should also keep their balances for each credit account below 30 percent of their credit limits, and overall debt payments under 36% of their monthly available budget. Cancelling unused credit cards can also negatively affect credit, but personally checking your credit score will not. Only the "hard" inquiries [e.g., applying for a new line of credit] will negatively impact credit scores. 3
1 - https://www.nerdwallet.com/blog/average-credit-card-debt-household/
2 - https://www.debt.org/advice/good-vs-bad/
3 - http://www.cnbc.com/2016/10/25/plenty-of-confusion-about-good-debt-vs-bad-debt.html