Will all types of debt drag you down or just bad debt? How different is it from other types of debt?
If one type of debt is bad, it follows that there is also a good type of debt. But growing up, people always mentioned that debt should be avoided at all costs. This gave people the impression that all debts are bad and will not do us any good. But now, money experts are pointing out that there are actually some good types of debt that can help you manage your finances better.
Debt, in itself, should be avoided if possible. It is a difficult task to have to keep paying a lender every single month. Especially so that you really do not have any assurance on your regular pay. The health crisis proved that where in one fell swoop, a lot of people lost their income. They were either placed on furlough or let go completely.
This shows how vulnerable our finances are when we rely on a single income. Good thing single-income families with children aged 18 and below only consisted of 30% of the population between 2015-2017 according to BLS. The past few years also underscored the importance of having a side hustle and even an emergency fund. But what do all these have to do with bad types of debt? How are they related and is there a way to stay away from debt of this kind?
What is bad debt?
When you borrow money to pay for something – that is essentially the most basic definition of debt. This is why most people would advise you to just save up for what you need. Though this is a logical approach, it would not work every single time. Imagine if you needed a house for your family. But you decided to save up for it so you can pay cash for the house. That would take you a long time to buy one.
In these instances, there is a mortgage loan you can take out to help you buy a house. But that is debt, right? So what is the difference between bad and good debt? The one thing you need to keep in mind when you talk about the bad type of debt is that you are borrowing money for depreciating assets. Or even when you are simply trying to fund an excessive lifestyle or giving into an impulse purchase.
The reason this is bad is that your decision to borrow money does not help you improve your finances. Yes, you read that right – there are types of debt that can help you. But before that, let’s take a look at some of the examples of what constitutes a bad type of debt. This can help you identify and eventually stay away from them.
Types of debt to avoid
Here are some of the debts you need to be careful about.
There are times when it might seem that you have no way out of your financial problem. This is true, especially during the health crisis where a lot of people lost their jobs. As most of them had to rely on savings and credit, some did not have that option. As a result, they believe that taking out a payday loan is their best option. Not only is this dangerous but it can keep you in debt for a very long time. The reason for this is that the interest rates are very high. And if you are already having a hard time making ends meet, you might not be able to pay back the money. This is the reason this is a bad debt.
If you are trying to fund an excessive lifestyle and getting in debt because of it, then it is another type of bad debt. There is nothing wrong with enjoying life but if it results in getting into a huge debt, you better reconsider your lifestyle. This usually happens when you are trying to copy or mimic the lifestyle of someone else. Stay within your budget and stay away from mimicking the lifestyle of other people. If you can, take on a frugal approach to spending as well. This can help you save money along the way.
Cars have long been a necessity rather than a status symbol. But this can also give you a false sense of power thinking you have the right to buy a car anytime you want. This boils down to your wants and needs – if you need it, then a car purchase is necessary. But if you want to have the same car as your neighbor or favorite star, then this now becomes a bad type of debt. It pays to know that only about 15 million cars were sold in 2021 according to New York Times. This was well below targets mainly due to the health crisis. The same thing applies to clothes and other consumables – go back to your wants and needs and determine if the purchase is necessary.
What is good debt?
If there is bad debt, there is also good debt. This is when you borrow money for the purpose of improving your finances in the future. Here are some examples of what makes a debt obligation good for you.
Most people coming out of college would have student loan debt after graduation. This is because the cost of attendance for most private colleges and universities across the country needs to be more in reach for most people. This is the reason why young people are taking out student loans to help them fund their college education.
This is considered by most people graduating as a huge burden. And to some extent, it is especially for young people who are just starting to get a job. But you have to keep in mind that college graduates stand a better chance of landing higher-paying jobs when compared to applicants with high-school credentials.
This is the reason why student loans can be considered good types of debt – it gives you a better chance of earning better in the future. As a result, you pay off your debt and start to have better control of your finances as you reach for your goals.
Same with student loans, business loans help you get a business idea off the ground and running. Granted that not all business ideas succeed, it is still better to try than not have an idea of you can make a business work. If you do not succeed, then that was a learning stage in your life to help you prepare for the next one. But if managed well, business loans can help you fast-track your long-term goals in life.
Probably one of the biggest debt accounts any person would have at any given time is mortgage debt. As mentioned earlier, you can try and save up for it but it could take you a lot of time. By then, you might not be able to enjoy the house anymore. When you are able to meet your monthly payments, a mortgage loan not only gives you a place to live but also helps increase your equity. It gives you a fixed asset increasing your net income as well.
Credit card debt
There are times when you need to get a handle on your debt payments and debt consolidation is a good choice for that. When consolidating debt, there are instances when a 0% credit card can help you stay on top of your payments. It cuts down your payments to one a month. This is easier to keep track of especially when you have been juggling multiple payments every month.
Can You Avoid Bad Debt?
Yes, you can avoid certain types of debt but it would take a lot of self-control, especially with your impulse purchases. Remember that even good types of debt can turn bad when you mismanage it. That is one thing that separates the two – how you manage and pay for your debts.
This opens up one great point as well, you need to conduct due diligence as well when taking on any type of debt. You need to make sure that you need it and that you have the ability to pay it off. Otherwise, it can become more of a burden rather than a way to help you improve your finances.
Here are 3 things to look into before taking on any type of debt. These can help you decide if you are making the right decision or not.
- Why do you need it? – You need to make sure that you are taking on debt because you need it and not just for impulse purchases.
- What is the monthly payment? – Before pursuing and finalizing any type of debt, you need to know how much the monthly payment will be. You need to plot this in your household budget and make sure that you can meet that payment every month.
- Does it fit in your long-term goals? The debts that you take now should help bring you closer to your long-term goals. If it is doing the opposite and keeping you away from your goals, then you need to quickly look into it before you proceed any further.
Bad debts will usually pull you away from your long term goals so it is best to avoid them. But keep in mind that even good types of debt can have the same effect if you do not manage them well.