The Power of Good Debt in Your Financial Arsenal

‘Debt’ or good debt can often seem like a scary word. A reminder at the back of your mind that you have to cough up money to give to someone else whether an individual, a business or an institution. Although it may seem like a burden, not all debt is bad.

Good debt; What is an OK amount of debt?

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In fact, if you consider how banks work, you’d realise they take up debt in order to make money! It means there’s such a thing as good debt and bad debt. For example, home loans and loans for investing in your studies or business are examples of good debt. Why?

In this article, we’ll look at what makes a debt good or bad, and the different types of debt that fall into each category.

What is debt?

Debt is a financial concept that involves borrowing money from another party or entity with the agreement to pay it back in the future, typically with interest. It is a common practice used by individuals, businesses, and governments to finance various needs and aspirations.

By borrowing money, individuals can fulfill their immediate needs or invest in long-term goals that could improve their lives, such as acquiring new skills, starting a business, or owning a home. Similarly, businesses often rely on debt to finance their operations.

They might take loans or issue bonds to fund expansions, invest in new equipment, hire employees, or develop new products. Debts in this instances can be seen as an investment in the growth and profitability of a business, with the expectation that the returns generated will outweigh the costs of borrowing.

Some common types of debt are credit card loans, bank loans, mortgages, overdrafts, and so on. But not all debts are bad. Depending on the purpose, the potential returns, and how well they are managed, taking up debts can be a good decision.

Good debt

Is there anything like good debt? The short answer is yes. Even though the words ‘good debt’ might seem like two contradictory words, it emphasizes the idea that certain types of borrowing can be advantageous and contribute to long-term financial well-being.

Simply put, good debt refers to borrowing money for investments or assets that have the potential to provide long-term benefits or appreciate in value. In other words, it’s debt that is considered a strategic and wise financial decision because it can improve your financial situation or generate income over time.

Some types of good debt:

Small business loans

Small business loans are often seen as good debt due to the numerous advantages they offer to entrepreneurs. By getting money from these loans, entrepreneurs can break free from typical jobs and create businesses that match their passions and dreams.

Firstly, small business loans provide entrepreneurs with the financial resources needed to fulfill their vision and turn their ideas into realities. Starting a business requires initial investments in equipment, inventory, marketing, and other essential aspects. With a small business loan, entrepreneurs can access the funds necessary to cover these startup costs and kickstart their ventures.

Moreover, small business loans can fuel business growth and expansion. Business operations can also face unexpected setbacks or face cash flow issues. During such periods, having access to a small business loan can serve as a lifeline, allowing entrepreneurs to cover expenses, bridge temporary gaps, and continue operations smoothly. This financial flexibility can be crucial in overcoming obstacles and ensuring the survival and resilience of the business.

Furthermore, small business loans can help establish and build a positive credit history for the business owner. By responsibly managing and repaying the loan, entrepreneurs can demonstrate their ability to handle financial obligations and establish a solid credit profile.

This, in turn, can enhance their credibility when seeking future financing opportunities, negotiate better loan terms, and access additional capital for future business endeavors.

Student loans

Another example of good debt is education loans. By taking on student loans to pursue higher education, individuals get to invest in themselves. By going to school, they acquire knowledge and skills that can significantly increase their earning potential and open up better career prospects. In this case, the benefits gained from education are expected to outweigh the cost of the loan.

Additionally, using student loans to finance college might result in long-term financial security. Individuals with greater degrees of education earn more during their lifetimes than those with lesser levels of education, according to research. Borrowers can then improve their overall financial well-being and dramatically increase their future income by earning a college degree.

Also, certain student loans provide favorable terms and repayment options. For example, federal student loans often offer flexible repayment plans based on income and may even provide options for forgiveness or loan discharge for individuals pursuing specific career paths such as public service or teaching. These features can alleviate the burden of repayment, making student loan debt more manageable in the long run.

Home Mortgage debt

Home mortgage debt is often looked at as “good debt” for several reasons. A mortgage is a purpose-built loan that enables individuals or families to purchase a home, offering a range of long-term financial benefits.

Firstly, it empowers individuals to go from renters to homeowners. Instead of paying monthly rent that provide no equity, mortgage payments contribute towards building ownership in a property. Basically, as they pay their mortgage, their equity in the home increases. This equity represents the portion of the home’s value that the borrower truly owns. Therefore, a mortgage serves as a means of building wealth and establishing a valuable asset.

Additionally, homeownership can bring financial benefits beyond simple equity accumulation. One potential advantage is the potential for appreciation in the value of the home. History has shown that real estate tends to appreciate in value over the long term. By owning a home, individuals stand to benefit from a rise in their property’s value, which can provide a significant financial return on their initial investment.

Furthermore, mortgage interest may be tax-deductible in some cases. This means that the interest paid on a mortgage loan may be deducted from taxable income, potentially reducing the overall tax burden and saving homeowners a significant amount of money over the life of the mortgage.

Homeownership also provides stability and security. Unlike renting, where landlords can change terms or even decide not to renew a lease, homeowners have more control over their living situation. They can modify and personalize their home to suit their preferences, knowing that they have the security of stable housing.

While home mortgage debt is often considered good debt, it is crucial to approach it with a clear understanding of the long-term financial commitment it entails. A thorough evaluation of available mortgage options, interest rates, and repayment plans is vital to ensuring that homeownership becomes a sustainable and advantageous investment.

Getting a Home Equity Loan or Line of Credit

Both home equity loans and lines of credit involve using a home as collateral for borrowings. 

Home equity loans can be a suitable option if you have a specific project or expense in mind, like consolidating high-interest debt or funding a home renovation. It works by giving homeowners a lump sum of money which they can then repay in regular monthly installments over a specified period.

On the other hand, a HELOC offers a flexible line of credit that people can draw from as needed. This makes it a good choice if you anticipate varying expenses over time, such as ongoing home improvements or educational costs. Instead of a lump sum, it operates like a credit card where homeowners can ‘top-up’ by repaying the loan and then borrowing from it again whenever the need arises.

Both are considered good debts when used appropriately, and deciding which one to take depends on certain factors like

  1. Purpose: Assess your specific financial goals and intended use for the borrowed funds. Determine whether a lump sum is preferable or if the flexibility to access funds incrementally aligns better with your needs.
  2. Interest Rates: Compare the interest rates associated with home equity loans and HELOCs. Choose the option with the most favorable interest rate, as it can save you money over the course of the loan.
  3. Repayment Plan: Consider your preferences for repayment. If you prefer fixed monthly payments for a set term, a home equity loan might appeal to you. If you prefer more flexibility in accessing funds and making varying payments, a HELOC might be more suitable.
  4. Personal Financial Situation: Evaluate your financial stability and ability to meet repayment obligations. It’s crucial to choose a debt that you can comfortably afford and repay according to the terms.

Ultimately, both home equity loans and HELOCs can be considered good debts if used responsibly and aligned with your financial goals.

Read Also: Best finance books: The ultimate guide

Bad debt

Bad Debts: Meaning and provisions for bad debts under Income Tax Act

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Bad debts refer to borrowing money for things that decrease in value or provide immediate gratification without long-term benefits. This occurs when borrowed funds are used to buy assets that lose their value over time, like luxury cars or electronics. As the loans are being repaid, the items lose their worth, leaving you with a financial burden and assets that are worth less than what was paid for them.

Another form of bad debt occurs when money is borrowed for nonessential or excessive spending. This includes using credit cards or loans for vacations, fancy dinners, or other discretionary purchases that don’t bring long-term benefits or hold significant value. While these experiences may bring immediate gratification, they don’t contribute to long-term financial well-being and can lead to challenging debt to repay.

Borrowing money at high-interest rates also contributes to bad debt. This could be from high-interest credit cards, payday loans, or other forms of borrowing with exorbitant interest charges. These debts can quickly accumulate, making it difficult to pay them off and trapping you in a cycle of struggling to repay.

The consequences of bad debt can be quite significant. Firstly, it creates a heavy financial burden, as you find yourself struggling to make repayments while witnessing your assets lose value. This ongoing financial stress can make it challenging to meet essential expenses. Moreover, bad debt tends to accumulate over time, especially if you consistently borrow money for nonessential spending. The high-interest rates on such debts further compound the problem, making it tough to pay them down and often leading to a cycle of borrowing more.

Bad debt also has an impact on credit score, as failure to repay debts and accumulating bad debt can lower creditworthiness. This makes it harder to secure future loans, credit cards, or favorable interest rates. It can also affect other aspects of your financial life, such as renting apartments or obtaining insurance.

Additionally, bad debt limits financial opportunities and options. With a significant portion of income going toward debt repayment, there is less room for saving, investing, or pursuing other financial goals. This can hinder your ability to plan for the future and achieve financial stability.

Lastly, the weight of bad debt and financial worry can take a toll on your mental and emotional well-being. Constant stress, anxiety, and fear about the financial situation can negatively impact your overall quality of life and relationships.

Examples of Bad Debt

In everyday life, there are financial decisions that help build wealth and some that are generally considered bad for your financial future. When it comes to borrowed money, some provide a lasting benefit which are great for your net worth but not all.

Car loan

An auto loan can become bad debt when borrowed funds are used to purchase a luxury car or a vehicle that quickly loses its value. While a car loan itself is not inherently bad, if the car depreciates rapidly or is beyond what the borrower can comfortably afford, it can result in a debt burden and a situation where the car’s value decreases faster than the loan is being paid off.

Payday loans

Payday loans are short-term loans with high-interest rates and fees. While they may provide immediate cash, they often come with exorbitant interest charges and strict repayment terms. Many individuals turn to payday loans out of desperation, but the high costs and potential debt traps associated with these loans can lead to a cycle of borrowing and struggling to repay.

High interest loans 

Taking out personal loans with high interest rate can contribute to too much debt. These personal loans may be used for nonessential purchases or other reasons that don’t lead to long-term financial benefits. With high-interest rates, the debt can quickly grow, becoming a burden that is challenging to pay off.

Credit Card Debt 

Credit card debt is a common form of bad debt, especially when it is accumulated through nonessential or excessive spending. Using credit cards for luxurious vacations, expensive dinners, or unnecessary purchases can lead to high balances and high interest rates. If the borrower cannot pay off the full balance each month, the debt can quickly accumulate and become difficult to manage.

Carrying a high interest credit card balance or being close to the credit limit can also impact credit utilization, which is the ratio of how much credit a person is using compared to their total credit limit. High credit utilization can negatively affect credit scores, which in turn may lead to higher interest rates on future loans or credit applications. Here, individuals may need credit counseling to manage the credit card debt payments.

Read Also: The Cost of Debt: Understanding Its Impact on Finances

Good debt vs bad debt

The difference between good and bad debt is mainly the purpose for which they are used and how they are managed. Student loan debt and consumer debt may be considered bad debts if there are no returns over the next few years. In the case of student debt, more education probably did not increase their gross monthly income, making the student loan a bad choice.

The distinguishing factor between good debt vs bad debt lies in whether the borrowed funds are invested in assets or experiences that can potentially appreciate in value, build good credit, increase home prices thereby raising rental income, and provide long-term benefits, among other factors.

Borrowing to invest

Taking on debts is not all bad; sometimes, they are necessary to unlock more wealth-making opportunities. For instance, owning a credit card debt can open you up to lower interest rates.

Also, in certain cases like whole life insurance policies where there is a cash value component, borrowing money from the policy to pay off expenses can prove to be beneficial if the right principles are applied. Want to know how? Check out how to get started with infinite banking.