Is There Really Such A Thing As ‘Good Debt?’

Hearing experts such as CNN Money, Forbes, and Fox Business talk about good and bad debt as it relates to different types of loans can get confusing. After all, isn’t all debt bad for your overall financial health? Trying to determine what types of debt you should and shouldn’t have can be daunting, so consider these three factors when making your decision.

Interest and Fees

When you borrow money to pay for anything, you must consider both the principal balance you are borrowing and the interest you will accumulate. Lenders, such as banks and credit card companies, don’t give away money for free; they expect to make a profit off of the loan they give to you. Interest rates vary from lender to lender, so it’s important to understand how your rate will affect your repayment.

Student loans and mortgages typically have low interest rates. Since the rates are low and therefore more affordable, experts tend to classify these as good debts. On the other hand, credit cards have notoriously high interest rates and are labeled as bad debt. Interest on credit card balances also compounds frequently, meaning any interest still owed is added to the original principal balance and earns interest itself. Between high rates and compounding interest, many people end up paying more in interest than the original amount of money they borrowed. Credit cards can also have different fees associated with their use that increase the overall cost of repayment. Be sure to understand all the costs associated with a loan before taking on any debt.

Assets vs. Liabilities

When determining whether a debt is good or bad, another factor to consider is whether the loan is for an asset or a liability. An asset is something that will earn money over time, and a liability is something that will eventually lose value. Historically, the value of a home rises over time, so it makes financial sense to take out a mortgage to pay for it. Student loans fall into the good debt category as well since education can lead to a high paying job. Usually, the earning potential acquired from taking on good debt is higher than the interest payments, so in the long run, you’ll end up ahead financially.

Unlike assets, liabilities quickly lose their value and do not provide any financial gain. Although a fancy car or exotic vacation may feel like a smart purchase, they eventually lose their value. Any debt accumulated to pay for a liability is usually bad debt. Liabilities are frequently wants instead of needs, so it’s best to avoid going into debt to pay for them. While most people can distinguish between wants and needs, Forbes does a great job of exploring why people still sometimes choose to go into debt for liabilities.

Can You Afford It?

Borrowing money means you will eventually need to pay it back, so make sure that you can afford your debt repayments. Many lenders look at what percentage of your income goes towards debt repayments and use it to determine credit worthiness.

Another important metric that factors into your credit score is your debt to available credit ratio. The more of your available credit you use, the worse your debt to available credit ratio is. Owing less money to lenders means you will have more money to allocate to other important areas of your life. Be sure that you still have money to invest and save after paying your bills. If you don’t, you probably have bad debt.

Staying away from bad debt is the key to financial success, so keep these tips in mind when taking out a loan.

Byline

Karl Stockton frequently writes on finance, insurance, politics and current events. This article was written on behalf of Compare Insurance Quotes. Be sure to contact them as this site allows you to compare multiple insurance quotes.

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