Debt is one of the most significant issues Americans face, affecting almost everyone. It comes in two different forms. Some debt will cause you to go broke (Bad debt) and some debt helps you grow your wealth (Good Debt). Understanding the difference between Good and Bad Debt is crucial to ensure that your financial choices are helping you pave the way toward success rather than failure.
Most people view debt as something negative; but what is Good Debt, and when is it worth taking on? In this article, we will start by explaining what debt is, then we will talk about the differences between Good Debt and Bad Debt and how each one affects your finances.
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What is Debt?
Debt is an important part of our daily lives. It is often used to explain a person’s financial health. Debt is money that one party borrows from another; the borrower then pays that money back at a later time, typically with interest. Many businesses and individuals utilize debt to finance significant purchases they would otherwise not be able to make. Loans such as mortgages, car loans, personal loans, and credit card debt, are the most prevalent kind of debt. It is a common misconception that debt is a bad thing. In fact, debt can be divided into two categories: Good Debt and Bad Debt.
What is the Difference Between Good Debt and Bad Debt?
Spending money using credit on consumer goods is considered Bad Debt. It does not mean that you should not spend money on consumer goods; it means you should not borrow money for these things. Some examples of Bad Debt include: short term loans with high-interest rates, overspending on credit cards along with carrying a high balance, and generally borrowing more than you can afford to repay.
Good debt is slightly more complicated than Bad Debt, so let’s break it down. Some examples of Good Debt include: borrowing money to start or improve a business, purchasing a home, and paying for higher education. Good debt is considered an investment and helps build your net worth over time.
As you can see, both types of debt involve borrowing money, one improves your financial situation and one does not.
How Do You Know if Debt is Good or Bad?
In the previous section, we gave examples of Good Debt and Bad Debt. The truth is there is no specific border-line between Good Debt and Bad Debt. A loan at the same time can be considered Good or Bad Debt for two different people. Different factors determine if a debt is good for you or not. In what follows, we provided a list of these factors.
- Return on investment
If a debt offers a good return on the investment, it can be considered Good Debt.
- Lender
Working with a reputable lender can lead to Good Debt. On the other hand, working with an unknown or shady lender may lead to various issues including higher payments and high interest rates that make repaying the loan difficult.
- Debt to income ratio
Debt to income ratio (the amount you owe compared to the amount you earn) determines whether the debt is considered Good or Bad. Keeping your debt to income ratio below 28% is ideal.
- Loan term
Good Debt and Bad Debt can be determined by the type of loan and the loan terms. For example, a loan with a high interest rate, short repayment period, and high fees can be considered a Bad Debt, while loans with low interest rates, longer repayment periods, and low fees may be considered Good Debt.
- Repayments
If you have Good Debt but do not make consistent and regular payments in line with your loan agreement, your debt can easily change into Bad Debt.
How to Avoid Bad Debt and Benefit from Good Debt?
Having the right debt can make all the difference between financial success and failure. It takes time and effort to develop the habit of taking on Good Debt and avoiding Bad Debt. Good Debt is acquired by smart financial planning and thoughtfulness. We recommend adopting the two suggestions below to avoid Bad Debt and improve your financial situation:
- Avoid overusing your credit cards for unnecessary expenses.
- When taking out a loan, consider all the factors above and how they relate to your situation.
If the overall determination is that the debt will result in an increase in your net worth in the future, then it can be considered Good Debt. Whether it is getting a mortgage or a small business loan, when it comes to debt, it is important to do your research and know how it will affect your financial future before signing any documents.
What Can You Do to Get Out of Bad Debt?
You could get stuck with Bad Debt even if you try to avoid it. Most people feel overwhelmed when they face their debt and are unable to pay it off. Despite how difficult it may appear, it is possible to get out of debt. Negotiating with lenders, debt consolidation, and balance transfers are some options that can help. Most importantly, it helps if you create a pay-off strategy.
This process can be confusing and requires some financial knowledge. We suggest not doing it alone and to get help from professionals who can set up a debt repayment strategy that will help you become debt-free as soon as possible. The Mortgage Ready Program can help if you are overwhelmed with your debt and are looking to improve your financial future. They can also help remove negative items from your credit report and improve your credit score.
How Will You Be?
Hopefully this article has changed your perspective on debt and you will be one of those people who live debt-free. Remember, debt is not always bad; if handled properly, it can help you improve your financial situation. Remember to avoid taking on debt that does not help build your net worth. It is okay to take out loans for items whose value will rise over time. Contact us if you find yourself with Bad Debt, we are here to help.
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