Some people think all debt is bad. If you can’t pay for something with cash, this philosophy goes, you don’t need it.
Others think debt is the normal way of life. You have to borrow to earn a decent credit score. Plus, life would have too many constraints if you couldn’t take out a loan to get what you want or need today.
The reality of debt lies in the middle. There are definitely instances in life where debt is a financial necessity. It can even be a benefit in the long term.
At the same time, there are examples of debt that can hinder you financially.
Here are three general rules about deciding what is good debt and what is bad debt:
- Debt is acceptable if it’s an “investment” and you can anticipate a return on that investment or an increase in your net worth. On the other hand, debt may be bad for your finances if you’re using it for material items you don’t need.
- Debt is fine if what you’re getting is truly worth the monthly payments and the interest you will pay. But be wary of going into debt for things you’ll be paying for after they’ve served their purpose or that depreciate over time.
- Debt is OK if it’s part of a larger financial plan. Debt may be a problem, however, if it results from a lack of planning.
With those rules in mind, here is an overview of common types of debt and whether you should consider them good or bad.
Generally speaking, borrowing money to buy a home or other types of real estate is an example of good debt.
For starters, you need to pay for housing anyway. So for many people, it’s more worthwhile to own their home rather than rent.
In addition, real estate typically appreciates in value. If you pay down your principal and the property increases in value, you can pocket some cash when you sell.
A mortgage can be bad debt, however. One example would be borrowing so much money that your mortgage payment is more than your budget can handle. You could also be getting into bad debt if the mortgage is on a property that will be difficult to resell later.
Student loan debt can be tricky.
On the one hand, it can be an investment in your career. Higher education often means higher earning potential plus the ability to work in a field of your choosing.
Student loan debt is a valuable tool if the salary you can make after you graduate will be adequate enough to cover your student loan bills.
On the other hand, if you borrow $200,000 to get a degree in poetry, you’re probably going to be paying off student loans your entire life. It’s not that you shouldn’t study poetry if that’s what you’re passionate about, but it’s not something that should require six-figure debt.
A business loan will typically fall into the good debt category. It’s an investment in yourself, and it may increase your earning potential and bottom line. In today’s economy, being your own boss may also help you be less reliant on an employer for your income. At the same time, starting a business can be risky so it’s not a guarantee that you will get a return on your investment in business financing.
Medical debt is a bit of a gray area. It’s difficult to consider it either good or bad debt.
Health care is not something people choose to spend money on. It’s often a necessity to living or to at least having a decent quality of life.
But because large health expenses are difficult to plan for, medical debt can cripple you financially. In fact, two-thirds of all bankruptcy filings are at least partially caused by medical issues.
You can minimize the chances of going into medical debt by being financially prepared before you need expensive health care.
In addition to having adequate health insurance, you may also want to consider investing in one or more of the following:
- Disability insurance, which replaces a portion of your income if an injury or illness limits your ability to work.
- Critical illness insurance, which can help you cover the cost of treating and recovering from expensive illnesses and procedures, such as heart attacks, strokes, and cancer.
- Hospital indemnity insurance, which provides a lump sum if you are admitted to a hospital or ICU for a covered sickness or injury.
- Accident insurance, which pays out a lump sum if you incur specific injuries, such as dislocations, lacerations, concussions, burns, and other serious injuries, as as a result of an accident.
- A health savings account (HSA), which is a tax-preferred savings account that enables users to set aside tax-free dollars to pay for health expenses, including regular medical care, dental and vision expenses.
Bad debt is typically financing for the stuff we want now: A new car, TV, or living room set.
What makes it bad debt is that the items we buy have little monetary value once we buy them. Plus, we buy these things with credit cards and retail cards, both of which carry high-interest rates.
The same is true for auto loans. The car you buy depreciates the moment you drive it off the lot. Loan terms for new cars are often five or six years. By the time you reach the end of your loan term, the value of the automobile may not be much more than those final monthly payments.
That’s not to say you have to avoid bad debt altogether. Think of bad debt like eating sugar or fattening cuisine. It’s best not to eat it, but consuming it in moderation won’t be too harmful.
Joel Palmer is a freelance writer and personal finance expert who focuses on the mortgage, insurance, financial services, and technology industries. He spent the first 10 years of his career as a business and financial reporter.
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