It is difficult to go through life completely debt free. There are times when a person needs to borrow money whether it is a home, a university education or a crisis. Debt is often necessary and in fact it can even be good. If you are considering borrowing or reviewing your budget, it is important to understand the difference between good debt and bad debts in order to create yourself for long-term financial success.
What is considered good debt?
It may surprise you, but yes, there is good debt. Good debt occurs when owed money is tied to something that can increase in value, like a home.
"Good debt is debt that is used to obtain valuables," says Thomas E Murphy, CEO of Murphy & Sylvest Wealth Management. "These assets can be as concrete as a house or intangible as an education. The expectation is that the asset will appreciate enough value to offset interest on the debt."
Here are some examples of good debt.
A home loan is a debt worth running (as long as it is financially sensible.) Having a home loan shows that a bank trusts you enough to lend you a large The amount of money for a purchase ̵1; your home – that is likely to increase in value over time. This type of debt has the potential to increase your net worth, as the value of your home can exceed the amount you owe the bank – that difference makes your home a very valuable asset that is only made possible by the debt.
Home Loan / Credit Limit
Like a mortgage, a home loan or equity loan confirms that a bank believes you are financially stable enough to receive a certain amount of money or credit. It also shows that you have a house with significant value to borrow at the same time as you have a manageable or paid off mortgage. Home equity is usually used to invest in home improvement, such as a rebuild, which increases its value and your total net worth.
Of course, a housing loan can easily go from "good debt" to "bad debt" if the funds are used to buy something that will be amortized or has no value to begin with. For example, it is badly recommended to use equity to pay for a vacation or a car.
The money borrowed to go to school may not be associated with a physical asset like a home, but there is an economic benefit in the future. Student loans are an investment in an individual's future that can result in a salary that is much higher than if that person did not purchase an education. A 2019 Federal Reserve study showed that those with a bachelor's degree earn an average of $ 30,000 more than a high school diploma. To be sure, not all degrees are created equal, and companies like Apple and Google no longer require a four-year degree from some jobs.
What is considered bad debt?
The easiest way to tell if something is bad debt is by evaluating the purchase with the money borrowed or used to secure the loan, also known as collateral. Is the purchasing debt something that will hold its value over time, like a home, or will it decrease in value, like a new car? The worst kind of debt is associated with no collateral at all – like a vacation.
"Bad debt is debt used to acquire an amortization asset or one that has no value at all," said Howard Pressman, CFP partner at Egan, Berger and Weiner. In other words, bad debt occurs when money is borrowed to buy something that will lose value or has no market value to begin with.
It is also not a good indicator of financial stability if you have to borrow money for something you can't pay back quickly like a vacation or jewelry. Lenders who review your credit report before letting you borrow money can look at such accounts and question your creditworthiness.
Here are some examples of bad debt.
Car / boat loan
The big problem with car or boat loans is that once the asset has been acquired, these assets begin immediately For example, new cars lose an average of 10% of their value in the first month after driving away from the lot, of course, a car is an essential purchase for most and if you can't pay for one in cash (the When you lend money to a car, make sure to negotiate or specifically look for an interest-free loan, which is is the best way to buy a car with borrowed money; If you pay interest, future lenders will be critical of this debt.
Short-term high-interest loans are called payday loans and they can cause more problems than they are worth. These loans are often pursued by individuals who need money quickly, whether in an emergency or paying for something that needs immediate attention, such as rent. Avoid these loans at all costs. Not only can interest rates skyrocket to more than 1,000%, but some individuals who have trouble repaying these loans may be in jail.
Loans to retirement account
Like payday loans, borrowing money from a 401K or another retirement account is a way to get a sum of money without collateral, usually when an urgent need arises. The main disadvantage of these loans is that you will find yourself investing less in your pension while you charge fees and interest. Due to thepandemic, the CARES Act, which was adopted in March, allows borrowing money from a 401K, without penalty, for financial difficulty. This is a good example of when borrowing against your 401K is a viable option for the last resort. Otherwise, you can protect your future and avoid tapping your 401K.
A credit card can be a great help to your credit status – and earn your rewards at the same time. An account with a low balance and a high limit – called "credit use" – shows how responsible you are with money. Where things get bad is when you have several cards with high credit utilization and balances that are not paid out every month. These credit card usage behaviors will reduce your credit score quickly.
One way to keep track of how debt can affect your credit score is with a credit monitoring service. For those who want to review their credit report, the three agencies offer free weekly reports due to the coronavirus pandemic.