For a lot of people, debt is a fact of life. Some big-money items are just too difficult to pay cash for, so people will borrow funds temporarily to facilitate their purchases.
Before you borrow any money, you should know the difference between good and bad debt (yes, there is such a thing as good debt). While certain purchases or investments are worth taking on some debt for, others can leave you in a deep financial hole.
This is how to tell the difference between good and bad debt.
What is Good Debt?
The old adage 'it takes money to make money' is how you can look at good debt.
In its simplest form, good debt is considered a sensible investment towards your future, strengthening your financial portfolio and net worth over the long term. Good debt should also have zero negative impact on your overall capital.
When taking on good debt, you should have a clear debt management plan with regular, controllable payments. It also shouldn't take you forever to pay the debt off, as interest will increase over time, too. Borrowers savvy with taking on debt will find the cheapest way to borrow the money, finding the best method for their financial position.
Examples of Good Debt
These are some examples of good debt that can improve your portfolio – financial and personal – over time.
Student Loans & Education
Education is a long-term game for a better future – just like taking on good debt. Ironically, one leads to the other, as student loans or investing in education is one of the worthiest reasons to take on debt.
Logically, the better your education is, the greater your earning potential becomes. Those with a higher level of education will provide avenues to higher-paying jobs, and will have an easier time being afforded these opportunities.
Like any investment, taking on debt for education will eventually pay for itself with higher quality job prospects after a few years. Over a longer term, the (ROI) return on investment will be substantial.
Real Estate Mortgage
Picking up a mortgage for a new property is another example of good debt. Let's be real - buying a home is virtually impossible without borrowing money, and taking on a mortgage.
But it's worth it. Once you've paid off your home, you've acquired one of the biggest financial assets you'll ever purchase in your lifetime. It's a solid investment as the property should increase in value over time, so it can be seen as a long-term move as well.
Consider the fact that renting a place to live in is money you won't see again. You pay for the service - a roof over your head - and the money is gone forever. Putting money towards a home is wise, if you can afford it, as you'll essentially get that money returned (and more) down the road. Renting can be costlier than a mortgage, too!
Small Business Investment
If you start a small business, your goal is obviously to grow that business and generate money. To get the business off the ground and running, you may need to take out a business loan or even a personal loan.
This is good debt, as long as you have a realistic business model and debt management plan to pay back the loan. The loan will be the beginning of your income generation through your business, which can scale higher and higher depending on how much work you put into your small business and how profitable you can make it.
A booming business can provide a serious ROI that manifested originally from some debt.
What is Bad Debt?
Bad debt bleeds out your wealth, is difficult to pay back, and doesn't offer any real advantages in terms of investment. This type of debt won't pay for itself down the road; your money won't make money.
People that wrack up bad debt often don't have a solid repayment plan. This type of bad debt generally is the result of impulse buys that are above and beyond what people can realistically afford.
As a general rule, if you can't pay the debt back pragmatically, it's considered bad debt.
Examples of Bad Debts
These are a couple of bad debt examples you should do your best to avoid.
A New Car You Don't Need
While you may need a car to get to and from work, or for other daily activities, keep in mind a new car starts losing value as soon as you leave the lot.
Buying a cheaper car with cash, if you can afford it, circumvents bad debt. Taking on a payment plan like a car loan adds interest, another expense on top of the loan. Paying interest on debt is simply letting your money waste away.
Swallowing your ego and getting a reliable car you can either pay off with cash, or pay off as quickly as possible, will minimize the downside of this bad debt.
Clothes, Consumables, and Other Goods
Remember the general rule of bad debt? If you can't pay it off reasonably, it's best to avoid borrowing the money.
This is often the case when people splurge on expensive items they can't afford - designer-brand clothes, jewellery, vacations, etc. You'll irresponsibly go into debt to impress your friends, with no means of paying off the debt. That'll manifest to the point of damaging your finances or credit. This is one of the worst uses of borrowed money.
Can't comfortably pay for that luxury item with cash? Then don't buy it.
When you're debating on whether to borrow money or not, ask yourself these important questions. Answering 'no' to any of them likely indicates you're heading towards some bad debt.
- Will borrowing this money better my finances over the long term?
- Have I searched for the best possible deal?
- Can I continue to pay off the debt comfortably, even if interest rates rise down the road?
- Will I easily be able to make monthly payments?
- Do I understand the the financial risks if things go awry?
Don't be afraid of taking on debt. As long as it's a means to an end - building your finances over time - then good debt is beneficial. Just stay away from borrowing money for no reason, or for mundane items. Be smart about debt management, and put your money to use.
Need help paying off bills on that good debt you've accumulated? Magical Credit's loan service provides $2,000-$10,000 installments as long as you have a steady source of income. Don't let interest pile up – give us a call today at 1-877-213-2088.