As a nation, we run on debt. Student loans, auto loans, personal loans, credit cards and mortgages — many people have all of those forms of debt and more. In fact, the average consumer debt balance has risen to just over $104,000.
But not all debt is equal. While some financial gurus may advise that no debt is good debt, loans are sometimes necessary to pursue long-term goals, like buying a car or a house. So, what exactly does “good debt” mean? Here’s what you need to know about types of debt and how they may affect your financial health.
What Is Good Debt?
“Good debt” is an unofficial term some people use to label certain forms of debt. It refers to money you borrow to increase your income or improve your future earning potential.
For example, few people can afford to pay for all of the costs associatedwith healthcare, education, and other significant expenses out of their savings or with their monthly cash flow, so using debt to cover the cost is extremely common. In these scenarios, individuals leverage debt in order to make a purchase or more sustainably manage payments on a large bill.
The following examples are common forms of good debt.
Mortgages
In the United States, the average home price sits at $361,282. If you don’t have that much money tucked away in savings or investments (and very few people do), you’ll have to borrow money through a home loan or mortgage in order to purchase a home.
Mortgages are generally considered good debt because they can be used to purchase a type of asset which nearly always appreciate in value over time. Since average annual appreciation rate is between 3 and 5%, it’s highly likely that the longer you enjoy and pay for your home the more it will be worth when you decide to sell it. In this way, a mortgage is a useful kind of debt that gives you the opportunity to purchase a home and potentially better your net worth.
Student Loans
With rising college costs, the majority of students have to borrow money to pay for their educations. However, student loans are another common form of good debt because having a degree can increase your employability and earning potential. The National Center for Education Statistics reported the median earnings increase by education level, and college graduates were 59% higher than the median earnings of individuals with only a high school diploma.
The state of national student loan debt is an ongoing debate, and it’s important for parents and universities to help college students find ways to sustainably afford to attend college. But in general, taking out student loans could be considered an investment in your professional ambitions.
Business Loans
Speaking of ambitions, do you have a great idea for a unique product? Have you developed a service people can’t get enough of? Then maybe you’ve considered it into a fully-fledged business.
It’s common to need funds in order to get your business started, and when you have a sound idea and a ready customer base, you can quickly repay the loan and grow your profits. That’s why many financial institutions see business customers as a worthwhile way to invest in local communities.
What Is Bad Debt?
There are certain types of debt that are considered “bad” because they typically see no return and can negatively impact your finances. Let’s discuss a few common examples.
Credit Cards
Credit cards tend to have relatively high interest rates. In fact, currently the average interest rate across credit card types has fluctuated between 22.76% and 27.92% in the last few months alone. And, unlike an installment loan which has a set monthly payment schedule, credit cards typically require only a minimum payment, which is only a small fraction of what you actually owe. In other words, you can end up paying far more than you were initially charged for your purchase depending on how long interest accrues on your outstanding balance.
If you employ a consistent repayment plan, having a credit card can be a healthy addition to your credit strategy. Keeping a high credit card balance, however, could damage your credit score. The higher your balance is relative to the card’s credit limit (also called your credit utilization rate) the worse it is for your credit score.
Payday Loans and Other Short-Term Loans
If your credit is less than stellar, you may feel like you don’t have a lot of options. There are lenders out there that offer short-term, high-interest loans that can help in a pinch, but in almost every situation, borrowing money this way only makes your situation worse.
For example, the average annual percentage rate (APR) on a payday loan, which includes interest and fees, is nearly 400%. Moreover, 80% of payday loans are renewed or rolled over into new payday loans because the borrower can’t afford to repay the debt. With each new loan, you’ll get new interest and fees tacked on, making it increasingly difficult to escape the cycle.
Other short-term debt solutions, like auto title loans and bad-credit personal loans, often follow the same cycle due to high interest rates. And, in the case of an auto title loan, you risk losing your car if you’re unable to catch up.
Other Common Debt Scenarios to Consider
While some may argue that all of the following types of debt are bad, they have the potential to improve your financial situation as long as you are able to follow a consistent and sustainabale repayment plan.
Auto Loans
Auto loans can be good or bad debts, depending on the situation. Vehicles generally depreciate in value, and the price of the car itself is only one of the many costs associated with owning a car. However, as we’ve mentioned, a vehicle can be an essential asset for many families – families who might not have enough cash to buy one outright. Enter an auto loan.
The key consideration when applying for this type of loan is understanding what you can afford. If you borrow outside of your budget, or are only eligible for higher interest rates due to having average or poor credit, this kind of debt can feel impossible to overcome. However, with good credit, you may be able to get a relatively low interest rate, making it an affordable debt.
Personal Loans & Debt Consolidation
On average, personal loans charge lower interest rates than credit cards. They also have a set repayment schedule, so you can ditch the minimum payment trap. Using a personal loan to consolidate high-interest debt or finance a home renovation could be a good option. But if you’re thinking about borrowing money to fund a vacation or make some other large discretionary purchase, you may end up regretting the decision.
Balance transfer credit cards are another way to consolidate and pay down debt. These cards typically offer an introductory 0% APR promotion over as many as 20 months, depending on the card. This approach can make it possible for you to eliminate your debt interest-free, saving you hundreds of dollars.
Keep in mind, though, that debt consolidation tools like these are ineffective if you don’t reevaluate your spending habits and avoid accruing more debt on your original credit cards.
The Bottom Line
In certain situations, debt can be used as a tool to improve your financial situation. In others, though, it can be a major roadblock, making it difficult to achieve your goals.
As you think about your relationship with debt, it’s important to consider your reasons for borrowing money. It’s also a good idea to look for ways to avoid borrowing money — or at least taking on more debt than is necessary.
If you do need to take out a loan, be sure to research the best options and make a repayment plan beforehand. Sometimes, small amounts of low-interest debt may help you to pursue financial goals you may not otherwise be able to achieve on your desired timeline.
