Beginners trying to tackle their personal finances for the first time see debt as sort of a “boogeyman,” a specter that looms overhead, trying to trap people into inescapable cycles of minimum payments and late fees. Or at the very least, something to be avoided whenever possible.
Deep down, we all know this is not really the case. Having a healthy amount of debt is almost an essential part of growth but taking on lots of small debts frequently can also be very dangerous to your bottom line.
Distinguishing Good Debt from Bad Debt
When we talk about “good debt”, it usually refers to debt that was taken on to help advance your future income or increase your net worth. Bad debt, on the other hand, is debt that is taken on with no real long-term gain.
Examples of Good Debt
Good debt can include things like
- Student loans to get a new degree or certification that improves your job prospects
- A mortgage on a house
- Refinancing a loan on your house for home improvements
- A car loan
- Short-term credit card debt
In all of these cases, the debt is taken on to serve some specific purpose. A student loan to pay for education is a long-term investment in making yourself a higher income earner. Taking out a mortgage to buy a house can greatly increase your net worth in the long run, and mortgage payments can frequently be lower than rental payments. Refinancing your home means taking out a loan based on the equity you have built up through past payments. This can allow you to reduce your interest rates or to finance home improvements that can make your home more valuable before selling it. Car loans can greatly increase your job prospects by providing a flexible transportation option. Short-term credit card debt can be beneficial to your current financial situation, depending on your bank fees and credit card perks.
When Good Debt Goes Bad
All of the examples above are examples of debt taken on for exactly the right reasons. But this debt can still turn bad, becoming burdensome to your personal financial situation.
- You may drop out of school or not finish your degree, but you are still responsible for repaying your student loan
- The interest you pay on your home mortgage may be greater than the property’s increase in value over the course of the loan
- You may refinance your home loan at a less favorable interest rate
- You may take out a car loan and end up with a car in constant need of repairs
- A crisis may hit, causing you to make purchases that increase your credit card balances
All of these transformations can happen with little notice, but good financial planning helps you identify the risk before you take on debt and helps you plan for when things go wrong.
Identifying risk before taking on debt is an exercise in financial planning – looking at what you are expecting and determining the chances that something might go wrong. Other lessons in this course will provide more details on how to identify certain types of risk, but here are some of the factors to look for in the debt we have covered in this lesson.
Before choosing what to study or your specific career path, make a list of your top 5 areas of interest. Then research jobs in each of those fields. Look for answers to questions such as “How much does each job pay?” and “How much competition will there be in this job field when I am ready to apply?”. This simple exercise can help you visualize not just what you need to do to succeed in each of these desired paths, but it will also help you determine how likely taking on this debt is going to pay off.
Before you decided to buy a home, there are many questions you need to answer. How long do you plan on living in this home? Five years or 30 years? How have property values changed in this area over time? How do property values in this location line up with the property market as a whole? If you lose your job, how long can you keep paying the mortgage? Remember that when you are renting, it is much easier to move somewhere cheaper than it will be to try to sell your home.
Refinancing A Loan
Before you refinance a home loan, carefully consider how much you need that loan. Refinancing for a better interest rate is usually a smart move, but investing in home improvements can be trickier. Will those home improvements increase the value of your home when it’s time to sell? It is not a good idea to refinance a mortgage just to deposit the cash in your bank account, but if you have other debts that need to be paid, the cash acquired through refinancing can help.
Keeping Your Debt Good
How can you keep your debt from turning bad?
The key is being able to look realistically at your potential purchase and try to remove emotions from the decision. Is this debt something that will really help your position in the long run? If yes, take time to make an itemized list of the potential risks so you are thinking ahead.
Next, evaluate how taking on this debt will impact your budget or your spending plan. Long-term debt is considered a “fixed need” while short-term credit card debt is a “variable need.”
If all of this sounds like a lot of work before making a purchase, you’re right. It is! Taking on debt is something to always carefully consider. Debt will make a significant dent in your ability to meet your other financial goals.
If you are in control of your personal finances, you will likely have good debt taking up a sizable piece of your monthly spending. As long as you can afford this debt, making on-time payments regularly, you will feel good about the progress you are making in improving your self-worth. But if things start to get out of control in your life, you might find your good debts turning bad. If this happens, find a way to resolve them as quickly as possible.
This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!Learn More
- In your own words, explain the difference between good debt and bad debt.
- How might good debt become bad debt?
- How can emotions cause you to increase your debt?
- When refinancing homes, what risks should people be aware of?
- Are there ways in which people can take to minimize their debt?