Types of “good” debt and examples of “bad” debt.
Many people do not realize that there are in fact some types of debt that are considered to be “good”, at least when the borrowing is done in moderation. However while there are definitely some instances in which it may be a good idea to borrow money, that can quickly be offset by the many types of “bad” debt. Find some examples of each of them below as well as some pros and cons of each type of debt.
It is critical for everyone to know the difference between these two. It is especially important for a low income family who may be struggling to pay the bills each month. In order to break a cycle of poverty and to gain financial stability, all forms of bad debt should be avoided at all costs. Also, when seeking to borrow money, always look into loans with a low interest rate. As if you borrow money, take on "bad debt", then that it will just perpetuate a cycle of hardship, poverty, and even worse.
On the other hand, there are times it makes sense to borrow money (if no other option). This will in effect be “good debt”. While borrowing money or using a loan should always be a last resort, when it is good debt it may be an option to consider.
Good debt is an asset that appreciates over time
Generally, good debt will be when you borrow money that can help you improve your earning power and that is also some form of asset that appreciates in value. This means that the service or good that is acquired will become more valuable over time. A good debt can help a low income family build assets, income, and otherwise improve their outlook. So what exactly does this mean? What are some examples of this? We will tell you more below.
Improving education through some type of work certification or technical school is a good reason to borrow money. Of course, paying for a college degree (either associate or bachelor) is also a good use, but that is much more challenging due to the tens of thousands of dollars that may be involved. So a low income family or someone looking to gain new skills may want to look into some type of technical skill vs. a degree. As the boost in income can occur much more quickly and the amount of debt taking on is usually a fraction of that from a college degree.
Using a loan to pay for a technical degree can increase a person's income by tens or hundreds of thousands of dollars over a lifetime. More education and skills is a huge asset for that person. That means any loans can be paid back in short order. Also, some educational expenses may be tax deductible. In other words, education and investing in yourself makes you much more of an asset to any employer.
Housing, particularly buying a home, is a great reason to borrow money. Homeownership is one of the main assets for any family to have, whether they are working poor, wealthy, or no matter their income. There are even government programs that can help a low income family buy a home. This is also a good debt. It puts a roof over your head, the interest is tax deductible, and a home value may appreciate over time as well; thereby building assets.
While not recommended, borrowing money to invest in stocks or some other financial asset would be a type of good debt. As the thought (hope?) would be that asset would appreciate over time, and the borrower would also be a tax break for that margin loan. As a stock or investment that appreciates is a good reason to borrow money as debt. Find how low income families can get started investing with little money.
Bad debt is an depreciating asset
It is a fact that tens (if not hundreds) of millions of people do not know what a “depreciating asset” is. This lack of knowledge is even more common in immigrants, the under educated, and unfortunately lower income households. Bankrate, the FDIC, and many other organizations are always reporting on the lack of understanding of this term. Unfortunately, if you do not know what the term of depreciating asset means, it is very difficult to build wealth and improve financial outlook.
A depreciating asset is when someone borrows money to buy something that declines in value over time. It will mean you are using debt to buy something that does not generate income and the value goes down as soon as the expenditure occurs. Many of these items, such as cars, TVs, consumer goods, etc. can of course be resold in the future, but the value will be a fraction of what the purchase price was. Buying an expensive car is one trap that many Americans fall into, as car depreciate as soon as your drive them off the lot. If you are in the bucket of depreciating assets, you can find help paying down debt.
Example of how bad vs. good debt works
For example, if you borrow $20,000 to buy a car and pay it off over 5 years, you may pay hundreds to thousands of dollars of interest cost over that timeframe. Then if you try to sell the car, or trade it in, after 5 years you may get several thousands dollars at most. So buying a car is a asset that is guaranteed to lose value over time. Such as a car going from $20,000 to say $7,000 over 5 years. Owning the car brought in zero income, it gives you zero skills around employment, etc. You are no more valuable for making that purchase.
Now contrast that type of bad debt (depreciating asset) of buying a car vs. borrowing money to pay for a technical skill. If you borrow $10,000 of debt to pay for a series of IT classes, you can increase your income. Say you are a low income person making $30,000 per year at a job. If you have specific IT skills (say web developer), maybe you can get a job that pay $45,000 per year.
This bump in income can easily pay off that loan, and more importantly, having a new skill is something that make you an asset in the future. Employers looks for people with new skills, no one can ever take education from you, and it will lead to higher income in the future.
So only take on debt to pay for something that goes up in value over time. Skills or education for yourself or a home can be great examples of good debt. Do not buy consumer goods (such as cars, clothes, electronics, etc.) in which provide no benefits to you or your family, and the value just goes down over time.