Good Debt or Bad Debt

Good Debt or Bad Debt?

Before considering taking on a debt, it’s important to determine if it will help or harm you as you strive to achieve your financial goals. Although taking on any debt has its risks, some debts may be necessary for most people as they try to pay for their education or buy a house. 

If you are aiming to manage debt, take a hard look at your credit report. It you are planning on taking out a loan in the future, lenders will check your credit report and view some debts more favorably than others. Understanding the difference between good and bad debts can help you decide which loans to apply for and which debts to pay off first. 

First, let’s tackle the definition of a good debt.

An example of good debt is a low-interest loan that can help you manage your finances more effectively, increase your wealth, and help you buy the essentials. Basically, a good debt is an investment that will increase in value and contribute positively to your overall financial health. 

The following are examples of good debt.  

Mortgages 

With low interest rates compared to other types of consumer debt, a mortgage loan is a good way to increase your net worth and build wealth over time. Not only can you potentially sell your house for a profit down the line, you can rent out your home, enjoy tax breaks, and establish equity. 

Equity is the percentage of your house that you have paid off and own. This is especially important because your equity can be used to as collateral for other low-interest loans like HELOCs that can be used for an emergency fund, home upgrades that will increase the value of your home, and more. 

Student Loans 

Student loans are often a necessity for students to help pay for their education. Because of this, they typically have low interest rates, especially if they are federal loans. Although students may take on thousands of dollars in debt, they are more likely to receive a well-paying job after graduation that can help pay of their loans and build their wealth over time.  

However, not all degrees are created equal. Consider the field you’re choosing and if it makes financial sense for you. Our partner Edmit can not only help you understand the earning potential of the degree you're interested in, but they can also help you find a school that will work with your budget and estimated future income. 

Auto Loans 

Although auto loans could be considered a bad debt due to a car's depreciating value, most people rely on their car to transport them to the job they need in order to increase their wealth. Southland believes that auto loans are ultimately a good debt because of their low interest rates.

But even with the lower interest, it is important to be smart about purchasing a car. Because new cars so quickly depreciate, consider buying a used car. Or, opt to purchase a reliable car that maintains its value better than others. In addition, be diligent about calculating how much you can afford. Save as much as you can for your down payment and be realistic about the car you choose. 

What is considered bad debt?

Debt that can drag down your financial situation is considered bad debt. Bad debt can include loans with high or variable interest rates — especially when used for discretionary expenses or for things that lose value. 

The following are examples of bad debt. 

Personal loans for non-emergency purposes 

Taking on a debt for expenses like a vacation, furniture, or clothes is a perfect example of a bad debt. Instead of paying high interest rates for non-necessities, consider postponing your trip or large purchase and save for it instead. 

On the other hand, personal loans may be a necessary option for emergencies or consolidating debt. If that's the case, make sure to shop around for the lowest rate to make your personal loan less of a risk. 

High interest rate credit cards

Credit cards can be considered bad debt because they can easily be mismanaged. It’s easy to overspend if you're using your credit card for everyday items like food and clothes. Before you know it, you are carrying a balance that you can’t pay off each month. Then, that balance may yield an interest rate of 20% or more.  

If you are going to use a credit card, be extremely diligent about only spending what you know you can pay off when the bill comes. Otherwise, you can find yourself in an expensive debt cycle.  

Payday loans 

Payday loans are short-term, small-amount loans that are meant to be repaid with your next paycheck. With interest rates that can add up to 300-400%, payday loans are the worst kind of debt. They are high-risk and can easily lead to endless debt cycles. 

Lenders who offer payday loans take advantage of those in crisis. But rather than falling victim to expensive payday loans, consider alternatives such as borrowing from a credit union or asking family members for help.

Strive for good debt

As you’re making your financial plans and goals, keep these debt types in mind. It’s important to be thoughtful and seek guidance for the best ways invest, spend, and save your finances. 

Of course, you can always consult with one of our Financial Service Representatives by visiting your nearest Southland Branch. Southland Credit Union has many low-cost loan options that can contribute to your good debt.