Personal debt has become a problem for many people. If a person has accumulated a lot of debt, this can significantly affect their financial future. In 2014, U.S. consumers owed $11.74 trillion in total debt, which was an increase of 3.3 percent over the previous year.
All debt is not created equal. There is, in the most simplest of terms, what is referred to as "good debt" and "bad debt". While all debt is money owed which must be repaid, there are distinct differences between these two types of debt.
Generally, good debt has the potential to lead to future wealth, while bad debt leads to becoming a heavy financial burden that could be difficult to emerge from; it also offers no long-term benefits.
In order to protect yourself from amassing a significant amount of the type of debt that will drag you into a financial pit that may be hard to climb out of, it is important to gain a thorough understanding of the differences of each form of liability. Keeping in mind, people can overextend themselves on the "good" type as well.
Characteristics of Good Debt
Examples of good debt are mortgages, school loans, real estate loans, business loans or, in some instances, generating debt to make some stock or bond investments. The reasons why these are classified as a positive form of debt is because these expenses can lead to something of tangible value. Refinancing a loan to reduce high interest rates is also considered a form of good debt.
Mortgages and real estate loans lead to ownership of homes and land, which is considered a valuable asset that, in many instances, can be resold in the future for a profit. This is especially true for investment properties which are strategically bought with the intention to build wealth. Of course, those strategies have to pay off, as the money on the property investment will still come due. However, there is potential to profit from the investment.
Educational loans lead to a college degree(s), which in turn offer a person the potential to reach a better earning income once that degree is added to a résumé. In other words, borrowing money to gain a college education can create more wealth.
However, it is important to know that student loans can turn into "bad debt" if certain conditions are not met after taking out the loan and earning the degree. 4 This is an important consideration to think about before incurring this type of debt.
Experts also generally recommend, if you're going to take on debt, take ones that are tax-deductible.
If you want to buy a home, you will incur a large debt which will need to be repaid, however, it is considered to be a type of "good debt". At the end of the loan, you will own a valuable asset.
Characteristics of Bad Debt
Bad debt generally is a liability which will end up offering the individual no tangible or long-term value. This is the type of debt that often leads to people ending up in the financial hole. Bankrate states:
"The concept of bad debt comes in when discussing the purchase of disposable items or durable goods using high-interest credit cards and not paying the balance in full." 1
Credit cards, store credit and auto loans are forms of bad debt. The reason for this is because the goods typically associated with these types of purchases do not have long-term value or are associated with a poor resell value. There is also no real potential to lead to anything of value. Bad debt cannot increase wealth. With most of these purchases, the item goes down in value immediately and/or has fast depreciation. Consider how quickly your car loses value as soon as its driven off the lot. It's always a good idea to consider resale value when purchasing a car, some cars will lose value more quickly than others. 2, 3
Photo credit: Leigh Goessl
It is important to understand that debt also impacts your credit rating. Borrowers of bad debt should watch what they owe and try to pay off these expenses more quickly to avoid additional interest rates, some of which might be pretty high. Better yet, pay in cash.
The general idea when borrowing money is to try and spend where you can either (a) increase your wealth or (b) save money through making the purchase. For instance, buying a more efficient type of car will result in lowering gas costs.
Too Much Spending Opportunity?
One of the issues in today's society appears to be directly related to the fact there is too much opportunity and convenience to spend. Credit card banks and store credit financiers create appealing terms, only to later raise them or entice consumers to spend more (discounted coupons, percent off, free merchandise, etc). While some of these carrots are initially attractive, in the long run this type of spending has a tendency to lead to bad debt if the consumer isn't careful.
Too much "bad debt", like soda, is unhealthy for you in the long-term.
We have evolved into an instant gratification society and, as a result, many of us find ourselves stuck buried in debt because of purchases made which may not be necessary ones. Eric Gelb, CEO of Gateway Financial Advisors and author of "Getting Started in Asset Allocation points out that a person's total debt should be less than 36 percent of his or her total income in an article by BankRate. 1
In order to avoid falling into the bad debt trap, it is best to make a strong effort to only buy within budget, meaning the money owed can be paid back quickly, or to simply stick to the "all cash" rule wherever possible. (Yes, many cashiers will probably look at you oddly when you pay cash in places like the grocery store, but you'll get used to it!)
You can walk away satisfied that you won't overspend your budget this month if you can stick to paying for your goods and services primarily in cash.
This is essentially the difference between good debt and bad, however, having a solid understanding of both can help consumers, who may be at risk, to stay out of financial difficulty.
[Related reading: How to Get Debt-Free and Live a Debt-Free Lifestyle ]
Tim Maurer, a Maryland-based financial planner and educator, suggests in the below YouTube video that there is no such thing as "good debt". Instead, he refers to the two as being "better debt" vs. "bad debt" in this short video.