What’s the Difference Between Good and Bad Debt?

Question of the Week

"Hey Treyton, what’s the difference between good and bad debt?"

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When thinking about debt, it's easy to think that all debt is bad.

However, that's not always the case.

Good debt is considered a debt that can be used to build wealth or help increase income over time. Good debt also tends to have low interest rates (under 6-7%).

While it may not feel like student loans are considered "good", the purpose of taking the loan was to get a degree, which can help get a job, which can help increase future income. This may not feel like a reality at the moment, but that's a whole different problem that we'll talk about a different week.

Another form of good debt may be a mortgage. They generally have low interest rates and after you've paid it off, you have an asset under your name. This may be your primary home or even investment properties, both of which may be able to help increase your net worth and build wealth over time.

Bad debt is considered debt that does not help improve your financial situation and has high interest rates (over 8%). The most common form of this is credit card debt. It doesn't help improve your financial situation at all and usually has higher interest rates, reaching higher than 20% at times.

Unlike a mortgage, once you pay off credit card debt, you're only back to $0. This is because with credit card debt, you're essentially taking money from your future self. By overspending, you must use future paychecks and money to cover those previous expenses so it makes it almost impossible to get ahead.

Also, car loans are typically considered bad debt but like most things in personal finance, it depends. You may be in a situation where taking out a small car loan is your only option to be able to get to and from work so in that situation, taking on a little "bad" debt may make sense.

The key thing to think about when understanding the difference between good and bad debt is: what is this debt doing for me?

If it's funding a lifestyle you can't afford at the moment, it's bad. If it's being leveraged to help improve your financial situation and has a low interest rate, it may be good.

Ideally, you would never have to use debt because even with low interest rates it's still costing you extra money, but in the world we live in sometimes it makes sense to take on debt if it's being used correctly.

Financial IQ #4 - 5.9.21

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