All debt is not created equal. In the simplest of breakdowns, there are essentially two forms of debt: good debt and bad debt. Most people carry some form of debt during their lifetime, but the differences between the two types will determine whether a person ends up financially OK or buried under excessive financial obligations.
Good debt is essentially debt that can either lead to (a) future wealth or valuable assets or (b) decreased current expenditures as a way to save money. Examples of good debt are mortgages, loans to purchase real estate, education loans, business loans and, sometimes, investments such as stocks.
Why are these financial obligations considered to be “good” debt?
Mortgage and real estate loans are considered to be good debt because they generally lead to ownership of a tangible asset. Homes and property typically increase in value over the course of time and can be resold for a profit. Education loans offer a tangible financial benefit because a college degree can lead to higher earning potential. Business loans can lead to entrepreneurial growth, and smart investments can lead to growing more wealth.
What about the “bad” debt?
Loans, such as those approved to buy a car, are not considered to be good debt because the vehicle depreciates as soon as it leaves the lot and, in most instances, does not regain value. The same goes for purchases made with credit or store cards; most goods purchased on plastic typically do not provide any long-term value.
What’s the right balance?
According to CNN Money, experts say that, ideally, recurring long-term debt payments, such as mortgage and credit cards, should “not exceed 36 percent of your gross monthly income.” Anything beyond this amount may lead to financial difficulty down the road. Lenders often consider this metric when they assess whether or not they will agree to loan to a hopeful borrower.
While carrying good debt is not a bad thing, it’s important to remember any debt can become overwhelming if too much is taken on. However, bad debt can quickly spiral out of control and lead to being in a financial hole which can be difficult to escape from. Unfortunately in today’s quick-spend society, many people buy now and worry about payments later. This makes for a dangerous financial situation because of high interest rates which, if the debt is not paid off in a timely fashion, can lead to increased debt.
In order to avoid falling into this pitfall, consumers are wise to spend with the future in mind. If a large purchase is a concrete asset where value can be recouped, this is smart spending. Amassing credit card bills is not. In the case of the latter, consumers are wise to stick to the rule that if the debt cannot be paid upon monthly statement to avoid interest charges, or at least shortly thereafter, then the purchase is not a good one.
Good debt, in its most basic form, is debt that leads to something of value and does not deplete your resources or hinder your ability to pay.