Sometimes it makes sense to borrow money, but many times, it doesn’t. While it’s possible to live debt-free, many of us wouldn’t be able to pay for life’s big purchases without taking on some debt (i.e. buying a home, paying for college, etc.).
But when is it smart to borrow, and when is it better to wait until you have more money saved up? When used appropriately, debt can help you build wealth over time. However, many Americans have too much bad debt and need help getting it under control. We’ll take a look at some of the defining factors of good debt versus bad debt.
Good debt is used to pay for necessary assets. It is an investment that will grow in value or generate long-term income. One example of good debt may be a mortgage for a home you can afford. It may makes sense to do this if you aren’t able to pay for a house up front and in full, but you are able to comfortably make the monthly payments. Home mortgages generally have lower interest rates and are also tax deductible. Ideally, your home could increase in market value over time, helping you build overall wealth.
Student loans and business loans are other typical examples of good debt, because your initial investment will likely help you create long-term value. When you borrow money to obtain a higher education, it prepares you for a career and potentially increases your future earnings. If you take out a business loan, it is done so to help you run your business and generate income. The key here is, whatever you’re “buying” should earn you enough (or more) money to cover your debt. If it does, then it is good debt.
On the other hand, bad debt is something that is unnecessary or goes down in value immediately after you buy it. Sorry, but a vacation to Hawaii or a brand new winter wardrobe does not count as necessities. Simply put, if you can’t afford it and you don’t need it, you shouldn’t buy it. Some typical examples of bad debt are credit card debt and auto loans. When you make partial payments on your credit card accounts, you are charged interest and fees. That means, the items you bought will continue to lose value, while the total amount you’ll pay increases!
Auto loans technically shouldn’t always be considered bad debt (i.e. business vehicles). For many people, a car is a necessity, but the reason why I put it under the bad debt category is because people often buy cars that are more expensive than they need or can afford. Cars lose value over time, so it’s best to pay as much as possible up front so as not to spend too much on high-interest monthly payments. Remember, if it does not build value or contribute to wealth generation, then it is bad debt.
Many Americans do not realize how much their bad debt is hurting them. Sometimes, debt is brought on by shopping impulsivity. Other times, it is due to things beyond our control (i.e. job loss, medical issues, etc.). The decision to borrow should be weighed out carefully. Sometimes, it makes perfect sense to take on debt, but first figure out whether it is a good debt or a bad debt.