Good Debt vs Bad Debt: What You Need to Know?
A common misconception among most of the working population is that all debts are bad, and hence they should avoid debts at any cost. Now, it is possible that you may never take any debt/obligation throughout your lifetime. However, this is not a very smart move.
Many times, taking debts to reach your goals can be a wise action and can help people succeed in the long term. As a matter of fact, all those who run a business or have a winning mindset know that – “Not all debts are bad!”
Although buying luxury goods through debt on your credit card should definitely be considered as a bad debt, however, sometimes, it is okay to take a debt to start a business, buy your new house, for getting a higher education, etc when the possible returns in future are higher compared to the interests paid.
In this article, we are going to discuss good debt vs bad debt. By the end of this post, you’ll completely understand what good debts, bad debts, their characteristics, examples, and more are. Let us start with Good debts.
Good Debt vs Bad Debt
1) Good debts
There is a common saying in the business world– “Money makes money.” In other words, it means that you need money to make more money.
Concerning good debt vs bad debt, if you can use your debt to generate more money/value or simply increase your net worth, then it can be considered as good debt.
In general, these debts have lower interest rates than the potential returns and, therefore, treated as an investment for the future.
For example, if you’re starting a business, it is not necessary that you should have enough savings to get it off the ground. Here, if the future growth potential and expected returns from your business are high, you can take a business loan. The business loan can be considered as a good debt (on the condition that your business is fruitful).
Here are a few other common examples of good debts:
— Education loans:
“The more you learn, the more you can earn.”
If taking a degree can increase your earning potential as an employee (or an employer), it’s okay to go for that debt. You are more likely to be better paid if you have higher knowledge and degree. Always be ready to “Invest in yourself,” and hence, taking a student/college debt can be considered good debt.
Anyways, please note that an education loan may turn out to be bad debt if you do not get employment as per your developed skills after graduation. Therefore, always choose the degree/program carefully because if there’s no substantial earning potential after you have completed the education, it may not be a good debt.
— Business loan:
If taking a business loan can increase sales, earnings, and improve your company’s financial health in the future, it can be a good debt. Moreover, having a balance in the account can also reduce the financial stress of owners as they do not have to worry about running out of cash constantly. And therefore, they can make better decisions for their business.
With time, the owners can slowly pay down the debt when their business becomes profitable and moreover stable. Anyways, a business loan can also become a bad debt if the businessman is blindly taking money for a risky business idea.
Mortgages for buying a house or real estate debts for property ownership can be considered as good debt.
Generally, buying a house or property involves a massive upfront cost. If you do not have saved a lot of money to invest in a house/property, but the potential earnings that you can make from your real estate investment are way high, then taking a loan may be a good idea.
Here, you can buy the property, live in it for years, save money on rent, and also sell it in the future for making money. Else, you can buy the property and rent it out to make money as rental income. As you are taking a loan to build an asset that increases in value, mortgages can be considered as good debts in the long run.
The Risks of Good Debt:
Although good debts may sound like a viable option for a better future, however, they are always dependent on a lot of assumptions. There’s no guarantee that the future will turn out to be the same as planned. For example:
- You can get a college degree from your education loan but may have no job offer.
- Your business loan may be a waste if your business/startup fails
- You may be paying high mortgages for your house and may be left with no savings for the future.
Even for good debts, there are a lot of risks involved as people are forecasting the future based on their assumptions. Therefore, before taking an obligation, carefully assess the risks and rewards.
For example, if you are planning to get an education loan, choose to take the loan for a degree/program that you’re confident to be fruitful. Know the expected salary after graduation so that you can plan to pay the money back.
Besides, considering the worst-case scenario may also help here as you can even plan for it. Overall, always act smartly as a good debt may not always be right for everyone.
2) Bad debts
Bad debts are the money that is borrowed to purchase depreciating assets or liabilities. In other words, if the value of assets doesn’t go up or generates income in the future, you should not buy it by borrowing money as they are bad debts.
In general, bad debts have a higher interest rate, and people can prevent taking these debts by making smart use of money. Here are a few examples of bad debts:
— Debts to buy fancy cars:
Cars cost a lot. While having a vehicle can be a necessity as it saves money and time, however, taking debt to buy an expensive car is never a good idea. The value of a vehicle depreciates over time, i.e. becomes less than what you paid for in the future. And hence, borrowing money to buy fancy cars can be considered as bad debt.
— Debts to buy luxuries:
Taking consumer/personal loans to purchase luxuries like expensive watches, clothes, dining in fancy restaurants, services, etc. are again bad debts. Personal loans have incredibly high-interest rates and are usually caused by living beyond one’s means. The money spent on these goods/services could have been used somewhere else.
— Credit Card debts:
Credit card debt is the worst form of bad debt. The interest paid on credit card debts is significantly higher than the rates on consumer loans. Moreover, as the outstanding amount accumulates each month, it makes it easy for the people to fall behind and become prey to the credit card companies.
Mixed/Special Cases of Good Debt vs Bad Debt:
The world is not just ‘Black’ and ‘White’. There’s also ‘Grey’!
Similarly, a debt cannot always be classified as good debt or bad debt. Sometimes, it can be both. It depends on your financial situation and preference. Here are a few examples:
— Borrowing to invest:
If you are getting money at a lower interest rate and making more money by investing it, then it can be considered as good debt. In the trading world, this is called leveraging, and it can help the traders to make a lot of profits using other people’s money.
Anyways, if the interest rate on the borrowed money is way high and the profits earned from your investment is low, then this money can be considered as a bad debt.
Overall, there’s a risk involved in borrowing money to invest. Until and unless, you’re trained and experienced to do so, this approach can be dangerous.
— Credit card rewards:
Although relying too much on credit cards be harmful, however, they are also a lot of benefits of using credit cards. Most of these cards come with amazing rewards like free airline tickets, movie tickets, cashback, etc. If you can use the credit cards efficiently, it can be considered as good debt.
— Consolidation loan:
In finance, consolidation occurs when someone pays off several smaller loans with one more jumbo loan. Here, the individual gets this loan at a lower rate to pay off the higher interest rate loans. In general, it can be considered a good idea to get rid of high-interest debts. However, the problem arises when the individual is not able to pay off the bigger loan or when the debts pile up.
Let us quickly summarize what we discussed about Good Debt vs Bad Debt in this article.
Good debt is a debt for getting product/service that has the potential to increase its value with time. As a thumb rule, if it increases your net-worth or value, it is good debt. The right amount of good debt can increase your net worth, value, and help you get the things that you want in your life without taking unnecessary risks.
On the other hand, if you are borrowing money to spend over depreciating assets or liabilities, it is bad debt. Bad debt tries to lure people for instant gratification. However, they do not create any significant long-term value. Try to avoid getting bad debs for luxury products/services or borrowing high-interest rate money.
Finally, there’s no fixed boundary for defining good and bad debts. A good debt for one can be bad for another, depending on their financial situations.
Hi, I am Kritesh, an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting