Good Debt vs. Bad Debt. What's the Difference?
One of the biggest topics in the personal finance world is the concept of debt. Some personal finance experts say that all debt is bad, and you should want to be rid of it completely. Others say that it is smart to have some debt if it allows you to make money or increase your net worth. My parents have told me that debt is bad and there are certain things that aren't worth going into debt over such as taking on a car note, loan for furniture, tv, clothes/shoes, and even vacations; I agree with that. However, it wasn't until I started learning more about personal finance that I learned about smart debt and if used correctly, it can increase your wealth. We've seen the devastating effects of how bad debt can ruin an economy (2008 market crash), but there are also examples of how good debt can help. In this post, I want to talk about both sides of the debt story.
Consumer/Credit Card Debt
As I've said before, I think going into any type of consumer debt or credit card debt does not make sense at all. If you can't pay for it in cash, then you shouldn't buy it! By taking on consumer debt you are not showing discipline in your finances. Many times it is because you are trying to keep up with others or create an appearance that seems like you have money when you really don't. There's no need to fake it! I've read articles about people taking trips and going on vacations so they can post pictures of living a luxurious life but they can't really afford it, so you have to ask yourself, is all that really worth it? You can have nice clothes, car, vacations, etc. but you should save up for it. The feeling you get from knowing it's yours and not owing anyone anything will just add to that feeling!
Payday Loans or Cash Advance
In Charge Debt Solutions illustrates how bad taking on a payday loan is. "The loan amounts vary from $50 to as much as $1,000, depending on the law in your state. If approved, you receive cash on the spot. Full payment is due on the borrower's next payday, which typically is around two weeks. Payday lenders usually charge interest of $15-$20 for every $100 borrowed. Calculated on an annual percentage rate basis (APR) – the same as is used for credit cards, mortgages, auto loans, etc. – that APR ranges from 391% to more than 521% for payday loans. For example, the average payday loan is $375. Using the lowest finance charge available ($15 per $100 borrowed), the customer owes a finance charge of $56.25 for a total loan amount of $431.25."
If you knew how much interest you would be paying there's no way you would take money from them. However, you might be stuck in a hard place and need to still pay a bill or person back and need the money, so what do you do? You can borrow from friends or family, community banks and credit unions. There are also debt management programs, as well as local charities and churches.
In simple terms, leverage is just borrowing money. Leverage is often used by companies and investors to increase the potential return of an investment. When one refers to a company, property or investment as "highly leveraged," it means that item has more debt than equity. "Investopedia”. When times are good, being leveraged can amplify returns, but when times are bad and you are overleveraged, you can lose everything.
Overleveraging occurs when a business has borrowed too much money and is unable to pay interest payments, principal repayments or maintain payments for the businesses' operating expenses due to the debt burden. Companies that borrow too much and are overleveraged are at the risk of becoming bankrupt if their business does poorly. "Investopedia"
On a personal side, you can be overleveraged as a home buyer. That is why it is important to not buy "too much house" because in the case that you lose your job and don't have enough backup savings, you wouldn't be able to make your payments and you could lose your house. Finding the right balance of debt/equity and not getting to the point of overextending yourself is very important when looking at bad debt vs. good debt.
One of the great debates now does it still make sense to go to college in today's world. With the price of college rising and students taking on more and more debt to pay for it, does that make good financial sense? Currently, federal student loans have a relatively low-interest rate. As of today, the current interest rate for undergrad is 5.05% according to studentaid.ed.gov. According to Georgetown University, a study found that on average, college graduates earn 1 million more in earnings over their lifetime. Another recent study by the Pew Research Center found that the median yearly income gap between high school and college graduates is around 17,500.
If you are taking on student loans, you are hoping that you graduate with a good paying job and therefore it would have been worth it. I think that many times that is the case depending on what career field you go into. There are certain careers like STEM where you are usually compensated well after college and are able to pay your student loans off relatively quickly. However, if you choose a career where the earning potential might not be as great after college, it might make sense to go to a cheaper school because your earning potential isn't as great, and you don't want to be burdened down with student loans later in life. I think there is a point where the amount you can take on too much student loan debt and then it turns into bad debt. It can be smart debt if you are very deliberate about what you are majoring in and have a purpose for why you are taking on the debt but you should be able to justify it with the possibility of a well-paying job to alleviate the hardship of having to pay your student loans while trying to start your life post-college.
Each person's individual situation is different and not everyone needs college especially in today's economic environment where barriers to entry to start a business are very low and there are many ways to make money outside of the traditional route. However, I still believe college is a good investment if used correctly and can be a form of good debt.
For most people, you aren't able to buy a house in cash so you have to rely on a bank to supply you a loan to cover the part of the house you can't pay for. According to Quicken Loans, their current 30 Year Fixed Rate with 20% down is 4.375%. That is a pretty low-interest rate if you look at historical values. It can also be a good investment due to appreciation. Depending on where you live, your home could appreciate more or less but on average but according to Zillow, houses usually appreciate at an average annual rate between 3 and 5 percent. To show that as an example if you bought a house for $300,000 and it appreciated 3% every year for 30 years, at the end when you've paid off your mortgage your house would be worth $728,178.74 using the Future Growth Formula. Your return on ROI (Return on Investment) would have been 142.73%! Now that would be an optimal scenario and that doesn't always happen, but you can see how a mortgage can be a form of good debt.
Leverage for Investment
As previously stated, leverage in the right investments can lead to massive gains. Three areas where you use leverage for investment purposes are in stocks, real estate, and small businesses. In the stock market. "This is usually called trading on margin because you are trading using borrowed shares from your broker to increase your position size in a play so you can potentially make more money on the other side." An example would be that you have $1,000 to invest but you want to invest $2,000. You can borrow the other $1,000 from your broker and if things work out and the stock goes up, you would sell and then return the $1,000 you borrowed and then keep the profit. We already looked at an example with real estate but another smart leverage play can be taking out a loan to start your business. Starting your own company can be risky but it can also be rewarding. Your earning potential is unlimited and if you become successful you will make a lot more than as an employee working for someone else. If you have a good idea or product, are able to execute and get through the tough stages, then you can often end up with a lot of money. It's not for everyone, but the freedom and rewards that come with it are worth it for some.
I hope this breakdown of what good vs. bad debt is was helpful. You may have other ideas on what counts as good debt or bad debt, but at the end of the day understanding the difference between the two and how to accelerate your wealth journey by using different forms can make all the difference. If you have more thoughts on this, please let me know in the comments below!