Good Debt vs. Bad Debt
Debt is a word that often carries negative connotations, but not all debt is created equal. Understanding the distinction between good debt and bad debt is crucial for sound financial planning. In this module, we’ll explore what makes debt “good” or “bad,” provide examples of each, and offer tips on managing debt wisely.
What is Good Debt?
Good debt is an investment that will grow in value or generate long-term income. It’s the type of debt that can improve your financial position in the long run. Here are some common examples of good debt:
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Student Loans
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Why it’s good: Education can significantly increase earning potential. Investing in a degree often leads to higher-paying jobs and better career opportunities.
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Think about: Do research to find out if the degree you plan to pursue is in a field with strong job prospects and earning potential.
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Mortgage Loans
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Why it’s good: Real estate typically appreciates over time, though not always. Owning a home can build equity and provide financial stability. (Home equity is the difference between the value of your house and how much you owe. As the value rises so does your wealth.)
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Think about: Buy within your means and in a location with a long history of rising property values. Keep in mind that the cost of a home is more than the mortgage payment. You’ll also have to pay property taxes and insurance. And don’t forget the costs of home maintenance; a new furnace will cost thousands of dollars.
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Small Business Loans
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Why it’s good: Starting or expanding a business can increase income significantly—if the business succeeds.
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Think about: Have a solid business plan and ensure you understand the risks involved.
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Investing in Real Estate
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Why it’s good: Rental properties can provide a steady income stream and appreciate in value over time.
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Think about: Understand the market and the many responsibilities of being a landlord. Did you know you can invest in real estate without all the expense and hassles of being a landlord? A Real Estate Investment Trust (REIT) is one way to do it. They can be bought and sold like a mutual fund and don't require all the cash that's required when taking out a mortgage.
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What is Bad Debt?
Bad debt is incurred when you purchase items that quickly lose value or do not generate income. This type of debt can hinder financial growth and stability. Common examples include:
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Credit Card Debt
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Why it’s bad: High-interest rates can lead to spiraling debt that’s hard to pay off. Credit cards are often used to buy consumables and non-essential items that lose value quickly.
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Instead: Only charge what you can pay off monthly to avoid interest charges.
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Payday Loans
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Why it’s bad: Extremely high interest rates and short repayment periods can trap borrowers in a long-term cycle of never-ending debt.
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Instead: Avoid payday loans and find alternatives like personal loans from a credit union.
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Auto Loans for Luxury Vehicles
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Why it’s bad: Cars depreciate quickly, and luxury vehicles lose value even faster.
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Instead: Buy within your means; consider pre-owned vehicles to reduce the impact of depreciation.
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Personal Loans for Non-Essential Items
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Why it’s bad: Using loans to finance vacations, expensive gadgets, or other non-essential items can lead to financial strain without providing any long-term financial benefit.
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Instead: Save up for non-essential items instead of borrowing.
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Tips for Managing Debt
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Prioritize Paying Off Bad Debt: Focus on eliminating high-interest debt (credit cards, payday loans, etc.) first to reduce financial strain.
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Use Good Debt Strategically: Borrow only what you need and ensure it’s for investments that will grow in value.
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Budget Wisely: Create a spending plan that allows for debt repayment while also saving for the future.
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Build an Emergency Fund: Having savings can prevent the need to incur bad debt during financial emergencies.
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Seek Professional Advice: A financial advisor can provide personalized advice tailored to your situation.
Action Plan
Here are three concrete steps you can take to take control of your debt:
1. Analyze Your Current Debt
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List Your Debts: Create a list of all your debts, including the interest rates, balances, and minimum payments. This will give you a clear picture of your current situation.
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Categorize Your Debt: Identify which debts are good (e.g., mortgage, student loans, etc.) and which are bad (e.g., credit card debt, payday loans, etc.).
2. Create a Debt Repayment Plan
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Debt Snowball Method: Focus on paying off the smallest debts first to build momentum.
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Debt Avalanche Method: Pay off the debts with the highest interest rates first to save money on interest.
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Automate Payments: Set up automatic payments to ensure you avoid late fees and never miss a payment.
3. Understand the Terms of Your Loans
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Read the Fine Print: Ensure you understand the interest rates, repayment terms (some loans impose a penalty if you pay them off early), and any fees associated with your loans.
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Contact Lenders for Better Terms: If you’re struggling, contact your lenders to negotiate better terms or explore refinancing options.