Published in: Credit Cards | Dec. 4, 2018
Here Are 3 Types of Good Debt (and 2 Types to Avoid)
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Having access to credit is a huge privilege that provides financial flexibility, allows for you to have things earlier on in life than might otherwise be possible, and many other benefits. Imagine if you couldn’t access a home loan, how would you ever become a homeowner before you’re 70? While it’s ideal to simply have the finances you need at your fingertips, that’s not realistic for most people.
That being said, all debt comes at a price. No debt is as good as having the cash to pay for your purchases and investments, but both “good debt” and “bad debt” do exist.
The difference between “good debt” and “bad debt”
Differentiating between good and bad debt is purely a numbers game. Good debt makes you more money than it costs you in the long run, and bad debt does the opposite.
In order to determine whether a debt is good or bad, you need to look at two things: interest rates and return rates. Generally speaking, the higher the interest rate, the worse the debt. On the flip side, some forms of debt come with interest rates so low they actually fall below the inflation rate, making them profitable. If someone loans you money at a 1.5% interest rate, and the inflation rate is 4%, they’re essentially giving you free money.
It’s also important to consider the potential returns of the debt you’re taking on. Some forms of debt offer no return, while others can be seen as an investment in something that will increase your net worth. If the profit you eventually earn outweighs the interest you pay on the loan, that debt can be seen as good debt.
The final factor is your credit score. Different forms of debt affect your credit score differently. Some can help you build your score, while others drag it down.
Three types of good debt
These forms of debt either come with extremely low interest rates, present a potential return on investment, or both.
1. Mortgage loans
Mortgage debt is easily one of the best forms of debt you can have due to low interest rates and return rates.
Not only do mortgage loans come with low interest rates if you have an excellent credit score -- at the time of writing this article, the average 15-year fixed mortgage rate is at 4.21%, just above the expected inflation rate of 2% -- but homes are also considered an investment that appreciate in value. A poll of analysts taken in June shows that home prices are expected to rise 5.7% by the end of 2018, a rate that’s more than double the inflation rate.
2. Student loans
Student loans don’t always come with low interest rates, although the current rates for federal student loans (5.05% for undergraduate students and 6.6% for graduate and professional students) aren’t incredibly high. Even with private student loans, refinancing options available to people with good credit can bring interest rates down to 3% or even lower, which is a great deal.
On top of that, student loans are considered an investment that should eventually increase your net worth. According to a study done by the Georgetown University Center on Education and the Workforce, someone with a bachelor’s degree earns, on average, nearly $1 million more than someone with a high school degree over the course of their lifetime. While the average college graduate in 2018 has to deal with a massive average debt burden -- $37,172, to be exact -- this number pales in comparison to their increase in lifetime earnings.
3. Small business loans
While often riskier than student loans and home-buying, financing a small business is considered an investment. So is borrowing money to invest in capital that’s meant to produce a profit, whether in the form of a small business loan or a personal loan.
However, this form of debt can quickly become bad debt if the investment doesn’t generate any additional income or increase the value of your company. If you choose to use a credit card to invest in your business and rack up a high credit card balance, that’s also not considered good debt, due to the high interest rate and the way that revolving debt affects your credit score.
Two types of debt to avoid
As opposed to good debt, bad debt is debt that charges a high interest rate, lowers your credit score, and is used to purchase things that do not increase in value.
1. Credit cards
Credit card debt is universally considered to be the worst form of debt due to high interest rates and the impact it has on your credit score. The current average APR on credit cards in the U.S. sits at 16.92%, so unless you find a fantastic low interest credit card or 0% intro APR offer, you end up paying high prices for your debt. And while having a revolving account can help your credit score, revolving debt can drag it down, especially if your balance is high.
Finally, credit card debt is rarely used to purchase things that appreciate in value. More often, credit cards are used to pay for groceries, clothing, and other goods which lose value immediately upon being purchased.
2. Payday loans
Payday loans are a predatory form of short-term, unsecured loan that come with high interest rates, hidden fees, and all kinds of catches that can make them difficult to pay off. One report shows that the average payday borrower ended up paying $793 in interest on a $325 loan.
The moral of the story? Always do your research before borrowing money. While it’s sometimes inevitable, make sure that the purchase you’re borrowing for is worth it in the long-run and that you get the best interest rate available to you.
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