In the world of personal finance, there are some topics that can be confusing when you first encounter them. One of those topics is good debt vs bad debt. If you have recently heard these terms for the first time, you may be wondering: What is good debt? What is bad debt? Fortunately, the answers to these questions are easy to understand once they are clearly explained. Learning the differences between good debt and bad debt will help you make sound financial decisions in the future.
What is Good Debt?
Good debt is basically any type of debt that helps you move in a positive direction toward your goals. For example, a home loan is considered good debt. When you purchase a home, you get a place to live that can increase in value over time. You will pay interest on that loan, but in many cases, the value of the home increases quickly enough to offset the cost of the interest. Student loans can also be considered good debt when you look at the benefits of getting a college education. You will pay interest on the student loans but your increased earning potential over a lifetime can more than cover the interest you accrue on the student loans. The key to keeping debt in the good category is to compare the cost of interest to the long-term benefits that come from the item you use the debt to pay for.
What is Bad Debt?
Bad debt is debt that does not help you move in a positive direction toward your goals. An example of this is using debt to increase your lifestyle to a level your current income cannot support. Using credit cards to increase your lifestyle will cost you interest but will have little to no positive impact on your future. For example, you may use a credit card to upgrade your seat on a flight during a vacation. You will experience a short-term benefit – more comfort during the flight – but will end up paying much more for that upgrade in interest if you are unable to pay the credit card off in full with your current income.
If you are thinking about taking out a loan, take a careful look at your reasons for taking out the loan. Will the money help you move in a positive direction financially in the future? Good debt should bring positive things to your future self. There is a caveat to consider in the good debt vs bad debt debate. Sometimes debt is necessary to pay for the bare necessities of life. If you cannot pay for the basics for one month then you may need to take out a loan to bridge the gap. In those situations, the debate is not about good debt or bad debt, it is simply a tool to help you make ends meet. Ultimately, staying on track financially is about educating yourself on your options and being thoughtful about the amount and type of debt you incur.