Over 75% of American households carry some type of debt – credit cards, mortgages, or other types of loans. Though debt is a normal part of most peoples’ lives, it tends to get a bad reputation. We grow up learning about the dark side of debt. “Debt will hurt your credit score,” “you should avoid debt at all costs,” and “all debt is bad” are just a few of the myths we’re told. While we generally want to be careful about the debt we take on, it can be a huge financial advantage if you utilize it well.
What is good debt?
Good debt is something that can be used to boost your overall net worth. Additionally, this type of debt will be low-cost and have tax advantages. “Good debt can be used to purchase an appreciating asset or finance an income-producing business or investment,” writes Rachel Dalrymple of Leaders Media. Some examples of good debt include:
- Student loans – these loans are considered good because they can increase your potential income. On average, college graduates earn 84% more than those with lower degrees. Student loans also come with a tax deduction of up $2,500
- Business loans – Business loans can increase your earning potential and the interest paid on a business loan is tax deductible
- Mortgages – home loans are the most common kind of consumer debt that can greatly boost your net worth. With every mortgage payment, you earn home equity. You’ll also own ‘free equity’ as your home appreciates in value. Owning a home also offers great tax benefits
What is bad debt?
Bad debt often has higher costs (interest rates) and is used to purchase items for consumption or depreciating assets. Some examples of bad debt include:
- Credit card debt – not only does credit card debt comes with much higher interest rates than other types of debt, but it’s often used to purchase things for consumer
- Payday loans – a payday loan is a high-rate personal loan with a short payback period
- Certain car loans – car loans can be considered bad debt because the payments go toward an asset that has a rapidly depreciating value. However, purchasing a car could be good if it increases your earning potential and your loan is low cost
How to determine if a debt is good or bad
If you’re considering taking on a new debt, ask yourself these questions:
- Can this debt increase my net worth or earning potential?
- Are the rates relatively low (below 15%)?
- Are there any tax advantages?
If you answered “yes” to these, then your debt is probably good!
How to avoid bad debt
- Start building an emergency savings fund
- Try to stick to a budget
- If you do take out a loan, have a repayment plan ready
- Work on establishing good credit habits
If you have any questions, let us know!