From the moment we swipe our first credit card, the debt we incur is either good debt or it is bad debt. If you have aspirations of achieving your financial goals and building wealth for the future, it is important to know the difference. While it is better to have zero debt, it’s difficult to go through life completely debt free. Generally, when debt is used strategically to improve your financial situation, it is good debt. When debt has the potential to be an obstacle to achieving your financial goal, it is bad debt and should be avoided. Here is how to tell the difference between good debt and bad debt.
Good debt can make you money
When debt is used to purchase an investment, it can increase the net return on the investment. For example, if you purchase a $500,000 property using $250,000 of your money and $250,000 of debt and the property value increases to $600,000, your return on investment is double what it would have been if you had to invest the entire $500,000. That’s called leverage and, when debt is used in that way, it can be good debt. It can be bad debt if the investment doesn’t perform as expected or was a bad investment from the outset.
Good debt is used to buy appreciating assets
Although your own house should not be considered an investment, it is an appreciating asset that builds equity over time. For that reason, a mortgage is considered good debt.
Good debt increases your financial potential
A college degree can improve your chances of securing a good-paying job, which make student loan debt good debt. However, if your student debt exceeds your capacity to repay it, it is bad debt. The rule-of-thumb is your total student debt should not exceed your first-year earning potential.
Debt used for capital investments in a business can also be good debt when used wisely. Most businesses rely on financing to increase their capacity to grow and increase their revenue.
Bad debt is used to purchase consumable products
When debt is used to purchase products that ultimately lose their value, it is bad debt. An example would be purchasing groceries and household goods with a credit card. If credit card balance is not paid in full, debt is owed on products that have already been consumed or that lose their value. A loan used to buy a car is considered bad debt because the car can lose more than half its value by the time the debt is fully repaid. Consumable products or products that depreciate in value should always be paid with cash.
Bad debt buys things you can’t afford
The worst use of a credit card or an installment loan is to purchase something you otherwise can’t afford to purchase with cash. That is how people get into trouble with debt. Debt used to spend beyond your means is always bad debt.
The biggest difference between good debt and bad debt is, good debt is used to improve your financial situation and bad debt almost always makes it worse. You know you have too much bad debt when you your credit utilization ratio (the amount of consumer debt in relation to available credit) begins to creep above 30 percent. You are also carrying too much bad debt when you find yourself making the minimum payment on your credit card balances. Bad debt needs to be paid off quickly or it can become an obstacle to achieving your financial goal.