It is difficult to live completely debt-free. There are times when someone needs to borrow money, whether it be a house, tuition or an emergency. Debt is often necessary and 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 debt to build yourself for long-term financial success.
What is considered a good debt?
It may surprise you, but yes, there is a good debt. A good debt arises when the money owed is tied to something that can increase in value, such as a house.
"Good debt is debt used to acquire valuable assets," said Thomas E Murphy, CEO of Murphy & Sylvest Wealth Management. "These assets can be tangible as a home or intangible as a training. The assets are expected to be worth enough to offset the interest paid on the debt."
Here are some examples of good debt.
A mortgage on a house is a debt worth pursuing (as long as it makes financial sense). Having a home mortgage shows that a bank trusted you enough to lend you a large sum of money for a purchase ̵
Home equity loans / line of credit
Like a mortgage, a home equity loan or home equity line of credit confirms that a bank believes you are financially stable enough to amount. money or credit. It also shows that you have a home of considerable value to borrow against, while also having a manageable or paid-off mortgage. Home stocks are typically used to invest in home improvement, such as a remodel, which increases value and your total net worth.
Of course, an equity loan can easily go from "good debt" to "bad debt" if the funds are used to buy something that will be written off or of no value to begin with. For example, it is unwise 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 good as a house, but there is a financial benefit in the future. Student loans are an investment in an individual's future that can result in a much higher salary than if that person had not purchased training. A 2019 Federal Reserve study found that those with a bachelor's degree earn on average $ 30,000 more than those with a high school diploma. Certainly, not all degrees are created equal, and in the case of companies like Apple and Google, a four-year degree is no longer required for some jobs.
What is considered to be bad debts?
The easiest way to determine if something is bad debt is to evaluate the purchase with the money borrowed or used to secure the loan, also known as collateral. Is the debt purchase something that will keep its value over time, like a house, or will it fall in value, like a new car? The worst form of debt is not associated with collateral at all – like a vacation.
"Doubtful debtors are debts that are used to acquire a diminishing good or a value without value," said Howard Pressman, CFP partner at Egan, Berger and Weiner. In other words, bad debt arises when money is borrowed to buy something that loses value or has no market value in the beginning.
Nor is it a good indicator of financial stability if you have to borrow money for something you can & # 39; Don't pay back quickly, such as a vacation or jewelry. Lenders who review your credit report before you can borrow money can view these types of accounts and question your creditworthiness.
Here are some examples of bad debts.
Car / Boat Loans
The major problem with car or boat loans is that once the debt is acquired, these assets immediately begin to lose value. For example, new cars lose an average of 10% of their value in the first month after being driven off the lot. Of course, a car is an essential purchase for most people, and if you can't pay for it in cash (the preferred method), you can't be in debt. When borrowing money for a car, make sure you negotiate or specifically look for an interest-free loan, which 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 loans with high interest rates are called payday loans and they can cause more problems than they are worth. These loans are often taken out by individuals who need money quickly, whether for an emergency or to pay for something that needs immediate attention, such as rent. Avoid these loans at all costs. Not only can interest rates skyrocket to over 1,000%, but some individuals who struggle to repay these loans may find themselves in jail.
Loans to retirement account
Like flash credits, borrowing money from a 401K or other retirement account is a way of getting a sum of money without collateral, usually when there is an urgent need arises. The main drawback of these loans is that you find yourself investing less in your retirement while paying fees and interest. Due to the pandemic ofthe CARES law passed in March allows it to borrow money from a 401K for financial hardship without penalty. This is a great example of when borrowing against your 401K is a viable last resort. Otherwise, protect your future and avoid tapping your 401K.
A credit card can be very useful for your credit – and you can earn rewards at the same time. An account with a low balance and a high limit – & # 39; credit utilization & # 39; called – shows how responsible you are with money. Where things are going bad is when you have multiple cards with high credit usage and balances that are not paid monthly. This credit card usage behavior will quickly decimate your credit score.
One way to keep track of how debt can affect your credit score is with a credit security agency. For those looking to review their credit report, the three agencies offer free weekly reports due to the coronavirus pandemic.