You might have heard that getting into debt is bad. However, debt isn’t such a black and white concept. There are many reasons why getting into debt can be helpful. That is why it’s important to distinguish between good debt and bad debt. If you do, you’ll know when it makes sense to use debt to your advantage and when you should avoid adding debt to your financial plate.
Good debt
In some instances, debt can be a valuable tool for getting ahead in life. It can be used to pay for high-priced expenses, like a new car or house. For instance, most people can’t afford to pay €500,000 in cash for a new home, but by taking out a mortgage, they can put a small percent down as a down payment and use debt to finance the rest of the purchase.
The most common forms of good debt include:
- Mortgages
- Student loans
- Small business loans
What do all of these forms of debt have in common? They can help build your future wealth.
- A mortgage to secure a property could add wealth through the increase in home prices in the future.
- Student loans could help secure a higher-paying job
- And a small business loan could help grow your own small business and secure more profits in the future.
As you can see, good debt isn’t just about obtaining the financing to spend today; it’s about spending that money in a way that could generate even more wealth in the future.
Low-interest rates and good debt
When interest rates are low, there are more reasons to take out debt. Imagine you want to buy yourself a new car. Also, imagine that the interest rate on a car loan is a mere 3%. Even if you had the cash to cover your new car expense, it might make sense to take out a car loan to finance the new purchase. That’s because the interest rate you are paying is so low that your investments may return more than the 3% rate of interest on the loan.
In other words, you could use the cash that you would have otherwise spent on the car and invest it at higher returns. If you can return more than 3% on your investment, then, over time, you will have benefited from taking out this debt rather than paying for the car in cash upfront.
Bad debt
Unfortunately, in today’s world, many people are all too familiar with bad debt. Bad debt is the type of debt that gets you in over your head; you’re unable to pay back your obligations, and your interest payments keep rising. Bad debt will only get you into trouble and isn’t as good as it may seem at the time you’re swiping your credit card. The most common forms of bad debt include credit card debt and high-interest personal loans.
For instance, you can use credit card debt to pay for just about anything you desire. But this is a form of bad debt used to make purchases that can’t be paid back or when the debt is used to finance a purchase that depreciates in value. So, you could use debt to finance the purchase of that €500 handbag or gaming console you’ve been dreaming of, but because it will lose value over time, you could end up hurting yourself financially in the long run.
How to avoid bad debt:
- Only take out debt you are sure you can pay back on time
- Think about the purpose of your debt before taking it on
- Ask yourself how important the debt is to your life
- Only use debt as a means to build wealth
The (not so) ugly truth
Debt isn’t good or bad in and of itself; it’s about how you use it. Even supposedly bad debt like credit cards can be helpful as long as you can pay back the debt on time. That’s why there is no one correct answer as to whether or not you should take on debt. It’s dependent on your current financial standing, how you will use the debt, the rate of interest, and other factors.