Good debt. There couldn’t possibly be such a thing, right? Well it turns out not all debt is bad, because without debt, nobody knows your creditworthiness, and that actually makes things very, very tricky when it comes time to consider you for a loan or anything else in the financial space.
It’s time to take a look at good debt vs bad debt so we can understand the differences between them, and try to utilize good debt to our advantage as much as possible.
What Are Examples of Good Debt?
Good debt can be beneficial to your creditworthiness and help you in the long run. It can even be used as collateral (depending on what the good debt is), and equity can be drawn off of it. Good debt needs to be well thought-out, properly executed, and with a healthy level of risk assessment involved. This is what good debt looks like.
- Education: We see this all the time. While there is a student loan debt crisis going on in the United States, it doesn’t mean you’ll be joining that crisis by taking out education loans. Truth be told, a lot of education loans come across as predatory, but if you’re smart about your choices and you know what you want to do, this can actually help you in the long run. Education loans are tricky and you have to make sure you pay them back properly, but they can help your creditworthiness during your early adult years, when building credit matters most.
- Business Endeavors: Starting up a business is difficult, but when it’s off the ground and running and you know the business model works, small loans to purchase inventory, expand operations when you know it’s going to work (or, as well as you could possibly know), and when other well thought-out, well-executed business strategies come into play, will benefit you in the long run. These loans are seen as good debt because business loans are often paid back relatively quickly (nowhere near as long as a 15-year mortgage), so you’re building long-standing accounts and showing that you can pay them down completely. Just be sure you don’t pay them off early, otherwise you’re not using all the time that you could use to build up your business credit.
- Personal Property: Personal property can appreciate in value, especially if you plan out your purchase properly. That’s why even though this is often the biggest financial decision that anyone will make in their life, it can still be seen as an investment. Properties are supposed to increase in value over time, so if that’s the case, your investment and continued maintenance of your home will increase its value over time, and be seen as an asset, not a liability. This is good debt.
- Rental Property: This is listed separately because it’s an entirely different ordeal. This is something you’ll make money off of immediately, and it’s one of the most common ways that individuals begin a real estate empire: they begin renting out one property. This is good debt since there will be income gained from it, so you have more leverage when you negotiate the terms of your loan, and your credit continues to rise when you show that this property and business endeavor hybrid works out. This has a higher level of risk than personal property depending on the size, but rental property or income property debt is good debt.
- Auto Loans: These can be volatile, because auto loans generally have more complex terms than other loans and can be tricky, but once again, knowing what you’re doing before you sign your name on a loan is completely key. If you’re able to look over the terms properly and understand what you’re getting yourself into, and you don’t take out anything too massive, auto loans can be good debt.
Is Good Debt Really Good?
Yes it is. Good debt is manageable debt that you could completely wash away with liquid assets at a moment’s notice, if you had to. We saw examples of good debt, but we didn’t really talk about why it’s good and how to make sure it isn’t volatile.
If you lost your job tomorrow and had to use your current assets to survive off of while you found a new job, and you quickly realize you’re living paycheck to paycheck and can’t afford anything for even one week with no inbound money coming in, you’re not in a position to take on good debt.
If you were to lose your job tomorrow and had enough money to survive off while you look for a new job, and it’s not contingent on that last paycheck coming in, then you’re most likely in a position to take on good debt. If you can use your assets to wipe away all your good debt and not shaft yourself, you’re in a good position.
Good debt is helpful to your situation and doesn’t hurt you. Good debt is manageable by your current assets without a second thought, so if you did lose your job or you were put in a position where your income was interrupted, you could use your capital to wipe away these debts and not go into bad debt just because of a little life disturbance.
Good debt doesn’t put a chokehold on your life. All it does is bring up your creditworthiness and help your overall financial situation in the long run. If it’s manageable and won’t sink you, it’s good debt.
How Much is a Good Debt?
A good debt doesn’t have a specific percentage, but suffice to say, that percentage should be relatively low. Your good debt can’t feasibly be wiped away in an instant, even though that’s an ideal situation, so if it is something like your education or your business, you don’t want it to run your life.
Any level of good debt should be an amount of money that won’t completely put you out. Remember that debt can be stressful and frustrating, so your good debt shouldn’t be something that adds to that.
It’s safe to assume that, if you’re talking about personal credit cards and debt for the sake of building your credit history, it should be less than about 10% of your total income. If you bring in $4,000 per month, your good debt shouldn’t be more than $400. It’s a good rule of thumb to live by, because as long as your living expenses aren’t more than 50% of your income, you’ll have free cash floating around to wipe out debt if need be, such as if your situation changes.
Why Exactly Any Debt is a Good Debt?
If you don’t have credit history, you’re losing out on the potential to increase your creditworthiness going forward. That may sound like it doesn’t matter if you pay for everything upfront or in cash, but not having credit can and will hurt you in the long run.
Credit comes up when you go to buy a car or a home, two of the biggest purchases that the average American makes in their lives. Even if you typically have a lot of liquid cash, simply paying for a home and missing out on equity and the ability to build your credit even further is a big mistake. You can use a big down payment to avoid PMI, but apart from that, you should be using credit to your advantage in an intelligent way.
Some debt is good. Investment debt is good (education, property, etc.). In today’s market, you can’t afford to not have debt, as silly as that sounds. You need to build your credit history.
Speaking of which, there are a lot of factors that go into your credit score, and one of those is history. Having a credit card for one month and paying the bill is less impactful than having a credit card for twelve months and paying the bill on time. Institutions want to see that you can be trusted over an arc of time, not just in the short-term.
Good Debt vs. Bad Debt (Main Difference)
There’s one key difference between good debt and bad debt. We’ve been over good sources of debt, but now it’s time to discuss what makes them good, and what makes a source of debt completely bad.
Good debt can be managed, and used as leverage to increase your creditworthiness. Good debt is seen as an investment because it is low-risk and offers a much more beneficial payout, such as education, property, and business expenses. There’s something monumentally valuable to be gained, and a careful, tactical investment strategy is in place to ensure it works out.
Bad debt doesn’t help you in any way. Bad debt is a personal credit card that was used on frivolous purchases, or debt that you take out but have no idea how you’ll pay it back. Bad debt will hurt your creditworthiness and make it more difficult to be trusted by lenders in the future.
Source: crediful.com