According to most financial gurus, one of the best ways to improve your financial situation is to get rid of debt. In general, this is good advice. Owing money you can’t afford to pay back can haunt you for a long time, and it could potentially wreck your credit if you’re not careful.
Not all debt is created equal, though. Even though having too much debt is bad, there are some situations where going into debt can actually help you get ahead. So how do you tell “good debt” from “bad debt”?
What is Good Debt?
When people talk about “good debt,” what they actually mean is making an investment in something that will help you generate more income and improve your net worth.
One of the best examples of this is taking out a student loan and going to college. Generally, more education means you’re a more attractive applicant to companies, which means you’ll have an easier time getting hired and will make more money. The idea being that by taking out a student loan, you can end up earning hundreds of thousands of dollars over the course of your lifetime in return for the tens of thousands of dollars you borrowed in student loans.
Another example of good debt is investing in real estate. Buying a house and maintaining it for a few years usually results in turning a profit when you sell it, and buying a house to rent or lease can also be a source of income that is well worth the initial price of the loan.
Starting a small business, while riskier than student loans or real estate, might also be considered good debt. If a business succeeds, the loan you took to get your business started could turn out to be the catalyst that made you very wealthy.
Even an auto loan might be a good example of getting debt, since a car is necessary for almost every aspect of your life. However, this does depend on when you’re upgrading your car and the new car you’re planning to buy. Taking out an auto loan to buy a new family car when your old family car has died is good debt, but taking out an auto loan to buy a new Porsche after watching “Fast and the Furious” is not.
What is Bad Debt?
While good debt is an investment in your future that will pay off over time, bad debt is debt that ultimately hurts your financial situation.
High-interest loans are the most common example of bad debt. If the interest rate on any loan is greater than 20%, you may be spending more on interest each month than you are actually paying down on your debt. This is especially common with credit cards.
Taking out loans for entertainment (or “discretionary”) purposes, like buying new clothes, taking an expensive vacation or buying a sports car is also bad debt. Granted, this isn’t always a bad thing. You might want to go into debt to finance that once-in-a-lifetime trip to Hawaii, for instance, or maybe you want to buy a new wardrobe because you just got that new job you wanted.
The final example of bad debt is a payday loan. While high-interest loans and loans used for entertainment purposes might be put to some good use, payday loans are utterly toxic. The average interest rate on these loans is around 400%, and if you, like most people, can’t repay that loan within two weeks, your interest rate rockets to 521% and keeps rising.
One thing to keep in mind about bad debt versus good debt is that there is no clear dividing line. As we discussed earlier, an auto loan might be good debt or bad debt, depending on what type of car you buy and why you buy it. Using your credit card to have a fun, memorable vacation isn’t an investment in your future, but it will be an incredible experience, and as long as you have a repayment plan set up your debt isn’t going to be hurting you.
Getting Rid of Bad Debt
If you do find yourself saddled with bad debt, don’t despair. You have several options available to you from transferring your credit card balance to a card with a lower interest rate to consolidating your debt or refinancing an existing loan at a lower interest rate. Contact First Alliance, and one of our lending advisors will work with you to find a solution that will work for you.