When it comes to looking at money you owe, not all debt is created equal. While there are many shades of gray in life, there is absolutely good debt and bad debt. And the difference matters, whether you’re taking financial steps to buy a home or prepare for retirement. Let’s take a look at some of the distinctions between them.
In a nutshell, a good debt is one that can have a clear benefit to you, such as a long-term investment, even if the purchase isn’t a tangible item you can touch. Here are a few examples:
- Mortgage – This may be the ultimate in good debt. Not only can buying a home be a smart decision now, the equity being built up typically improves your financial situation in the future. And there can be an immediate payoff – the interest may be tax deductible, so consult your tax advisor about that.
- Student loans – Many can’t afford the yearly tuition outright, so taking out a loan for a degree is a long-term investment in your future. Many jobs require a college degree or professional certification, some pay higher for a candidate with a degree. And student loans tend to be at a lower interest rate.
- Auto loan – If you don’t live in an area where public transportation is plentiful, a car is pretty much a necessity to get to work. So in that sense, a car loan may be required. Buying a previously owned model can help – you aren’t incurring the immediate depreciation that comes with that new car smell. But be careful…this can show up on the bad debt list, too.
Another way to look at this is deferred gratification vs. instant. Is this debt getting you something long term or just a quick fix? If it’s a quick fix, it’s likely a bad debt.
- Credit cards – This one isn’t a surprise, of course. And it applies whether it’s a major credit card or a store credit card. With higher interest rates and minimum monthly payments that look small but multiply over time, using plastic for those just-out-of-reach items really reduces your financial freedom. If medical emergencies come up, look to your medical provider for financial aid or payment options instead of credit cards. Many will work with you.
- Cash advances – Also called payday loans, these are extremely high in interest and often have an additional fee. They are the ultimate quick fix that keeps charging you, big time, and should be avoided.
- Auto loan – That’s right, auto loans could be considered BOTH good & bad debt. Although it’s not inherently bad debt, the interest rates on auto loans can be quite high, especially if your credit isn’t great. But there’s a smart way to stay off this list when you buy a car. Make as large a down payment as you can afford to keep those high-interest payments as low as possible.
As a general rule, as long as you’re using debt for long-term benefits that can enrich your future and net worth, instead of consumables that depreciate quickly, there’s a good chance your debt won’t be considered bad debt. Your financial professional can help you understand more.
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