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Good Debt vs Bad Debt – What’s the Difference and Why it Matters

Good Debt vs Bad Debt – What’s the Difference and Why it Matters

Got debt? You’re not alone. But some debt is worse than others. What is good debt vs bad debt, what are some examples of bad debt, and how to use good debt are all important questions that you’ll know the answer to after reading this post. Getting clear on where your finances are is the first step to make them better. Learning good debt vs bad debt examples will help you decide which debt to pay off first. Let’s go!

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Understanding Good Debt versus Bad Debt

You can argue that there can’t be such a thing as “good” debt. However, many people need to take out a loan to be able to afford a home or make any other big purchase.

Although you can consider buying a home with a loan as justifiable since it provides value to the debtor, there are other cases where people take on debt without much consideration. Usually you can tell if it is good debt vs bad debt; however, there are cases you can’t easily judge.

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What is Good Debt?

In talking about good debt vs bad debt, let’s start with good debt. You can regard a debt as good debt if the money you borrow generates income or increases your net worth.

A debt can also be considered positive if it helps significantly improve your and your family’s life. Below are a few situations where you can consider taking out a loan.

Education

Higher education increases your earning potential, and can be considered a good debt versus bad debt.

The more educated you are, the likelier you’ll find employment. If you are well educated, you are more likely to find work in well-paying jobs. You can also switch jobs easily if you need to.

If you invest in a technical or college degree, the investment will likely pay for itself shortly after entering the workforce.

You’ll find that not all college degrees have the same value when finding employment. Thus, before choosing a field of study, consider the short-term and the long-term prospects.

Starting a Business

If you take out a loan to start your own business, that can also be an example of good debt vs bad debt.

It can be gratifying, but you’ll need to put in a lot of effort.

Just like taking out a loan for education, taking out a loan for starting a business also has its risks. Many endeavors fail, and thus, you should choose a line of business about which you know a lot.

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Buying Real Estate

Real estate is usually considered good debt versus bad debt.

There are several ways to make money in real estate. In the case of residential real estate, you can apply for a mortgage to buy a home; you can live in the house for a couple of decades. Afterward, you can sell off the property for a profit.

Renting out your home is also an option for generating income.

If you know the subject, you can also use commercial real estate for cash flow and capital gain.

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What is Bad Debt?

Bad debt is when you take out a loan to purchase an asset, the value of which depreciates with time and usage.

If the value of the item you’re buying with a loan doesn’t go up and doesn’t let you use it to generate income, it can easily be called a bad loan. Some examples of bad debt are as follows:

Buying a Car

The importance of owning a car can hardly be overstated. However, It is not recommended that you take out a loan to buy one. Buying a car on loan is an example of bad debt vs good debt.

Whenever you sell it, you’ll get less price for it than what you paid at the time of purchasing it. If you have to opt for a loan, you should try to get a loan with low or 0% interest.

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Clothing and Consumables

People say that the actual price of clothes is less than half of what you pay for them. You’ll get far cheaper rates at used clothing stores.

Credit card debt for consumables and clothing is an example of bad debt.

Clothes, food, and furniture are necessary, but you shouldn’t buy them using a high-interest credit card.

Having a credit card does make life easier, but you should ensure that you make timely payments so that you don’t have to pay any interest. If that is not possible, you should pay cash.

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Good Debt vs Bad Debt: The Gray Area

Some debts cannot be easily classified as either good debt vs bad debt. Whether it is good or bad for you would depend on your current financial position and a few other factors.

Debt Consolidation

If you already have multiple high-interest debts, you can take out a debt consolidation loan.

You can take out a debt consolidation loan from a reputed lender or a bank. Generally, they charge lower interest rates than other credit cards.

Not only will you be able to pay off your debts, but also you’ll be able to make some savings on the interests you’re going to pay in the future.

Remember that you should only pay off your debts with your money and not spend it on other things.

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Margin Account

Having an account with a brokerage firm would enable you to open a margin account.

With a margin account, you’ll be able to buy securities with money borrowed from the brokerage. You’ll get money provided the security value increases before the loan is paid back. However, you’ll lose money if your securities lose their value.

To do this successfully requires some experience. Also, if you can’t afford to take the risk, you shouldn’t invest in it.

Instead do this.

How Can You Avoid Getting into Debt

Generally, you get into debt when you’re not keeping proper track of finances. You might feel unable to control it. However, it is possible to stay out of debt. Follow the steps below.

1. Don’t buy something that you cannot buy without a credit card

It is easy to accumulate bad debt vs good debt by constantly reaching for the credit card. A credit card can make you think you can afford something you don’t have the money for.

But doing this might get you into debt, and you might have difficulty getting out of it. You should be mindful that if you can’t pay for an item in cash, you shouldn’t buy it with a credit card.

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2. Have an emergency fund

It is prudent to have an emergency fund in place if you need money suddenly.

Your emergency fund amount should be worth six months of your salary. You can utilize your emergency funds if you lose your job or cannot earn money for injuries sustained or any other sudden expenses.

3. Pay off your credit card dues as soon as possible

One of the best ways to control your spending is by paying your credit card balance as soon as possible. While buying something with a credit card, try to pay the dues by the next day.

If you need help eliminating credit card debt, read this post.

4. Focus on Needs vs Wants

You should try not to spend money on things you don’t need.

For example, going to restaurants is something you can cut back on, and you can also cut back on online shopping.

It will be better for your finances if you only spend money on what you need and not spend too much on what you want. This will help you from growing bad debt.

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5. Try Budgeting

A budget will help you keep track of your money, and you’ll be able to know where you’re spending too much.

For each month, determine how much you will set aside for your savings and 401(k). That will let you know how much you’ll have on your hands to spend on the essentials.

Listing your expenses will let you know which items you can cut back on if such a need arises.

6. Try not to take out a cash advance using your credit card

Using your credit card for a cash advance is a major red flag for your finances.

The interest you’ll pay will be significantly more than when you’d make a purchase. You also may be charged an additional fee while taking out a cash advance using your credit card.

7. Try not to have multiple credit cards

If you have multiple credit cards, you’d have to worry about making multiple payments. Credit cards have different interests, so that’s also a cause of concern.

If you’re not careful about using your credit cards, you’ll likely run into debt, requiring you to do debt consolidation.

With different charges accumulating on each of your cards, there’s a good chance you’ll lose track of your payments and where your money is going.

8. Keep a record of your expenses

Maintain a sheet where you record your expenses every month.

For multiple accounts or more than one credit card, keeping track of your expenditures this way would ensure that you can make payments at the right time.

9. In case of a pay increase

If your salary increases, try to utilize the amount you were paid before and keep the rest of it in savings.

10. Coupons can help you save cash

Groceries are something you can’t do without. Use coupons to buy them and other necessities. By doing so, you’ll be able to save some cash.

To avoid getting into debt, you’ll have to learn to limit your expenses. This can seem like a hard thing to do initially, but if you follow the guidelines mentioned above, you’ll get the hang of it eventually and will be able to start saving money instead of borrowing.

How do you get out of debt?

If you are already in debt and having a hard time getting out of it, then you should consider the options mentioned below:

Reaching out to your creditors

Your creditors may be able to offer you debt relief options of their own.

You may be able to modify your payment options, but you’ll have to reach out to your creditors for that. They might extend your due date, modify your payment plan, or permanently change the monthly due dates if you talk to them.

Homeowners can take advantage of mortgage modification. Those struggling with credit card debt can ask creditors to write off or reduce the late fees so they can pay it off.

Credit counseling

Nonprofit credit counseling agencies offer debt counseling.

Credit counseling will help you manage your money better and help you with your debt management. A credit counselor can help with budgeting, and you’ll also be able to prioritize which bills you should pay first with their help.

Through debt management programs, credit counselors can also contact your creditors to ask them to stop collections and stop charging fees.

Debt management programs

A debt management program is where multiple debts are combined into one installment.

You pay the monthly installment to the credit counselor you’re working with, who distributes the amount among your creditors.

A credit counselor will try to negotiate with the creditors to lower the interests, reduce your fees, or waive them entirely so that the amount becomes affordable. Typically, you’ll be able to do away with your debt within three to five years with this program.

Debt consolidation

Through debt consolidation, you’ll be able to take out a new loan to pay off your debts.

Not only will multiple debts be consolidated into one, but also you’ll be able to replace high-interest debts with a comparatively lower interest loan. Lower interest means lower costs, and you’ll also be able to pay your debt off sooner.

Debt consolidation is one of the best ways to do away with payday loan debt. Payday loans come with very high-interest rates, up to 400%, and you’ll need to pay them off within a couple of weeks.

A payday loan makes sense when you’re in dire need of money, but it can easily hurt your finances in the long term.

Payday loan consolidation works just like standard debt consolidation. You take out a low-interest loan to consolidate payday loans and then pay off your consolidation loan.

Debt consolidation also lets you choose your repayment term. In the longer term, your monthly payment amount will be low, but the overall interest you’ll be paying will be high. But, if you choose a shorter period, the monthly repayment amount will be high, but the overall interest will be low.

Debt settlement

Debt settlement is when you negotiate with your creditors to write off a part of your debt and agree to pay off the rest of the amount in one go or installments.

You can also seek the help of a debt settlement company to negotiate for you. However, you should know that your creditors might not agree to come to the negotiating table.

Bankruptcy

If you cannot pay off your debts, you can consider bankruptcy an option.

Your credit will take a huge hit. However, you’ll come out of it with a clean slate.

There are two kinds of bankruptcies, chapter 7 and chapter 13. You’ll qualify for chapter 7 bankruptcy, provided your income is very little.

Through this bankruptcy, your assets are sold off to repay what you owe, and your unsecured debts are written off.

If your income is above the limit of chapter 7 bankruptcy, you’ll have to go through chapter 13. Through chapter 13 bankruptcy, you pay your debts off within three to five years, and after your repayment is complete, your unsecured debts are written off.

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Good Debt vs Bad Debt: The Final Word

When borrowing money, ask yourself if the debt you’re getting into will give you more than what you put in. If yes, then the debt you’re getting into is good debt. Your debt should always pay you back more than what you put in; otherwise, it is bad debt.

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Good Debt vs Bad Debt – What's the Difference and Why it Matters

Author: Lyle Solomon

Lyle Solomon has extensive legal experience as well as in-depth knowledge and experience in consumer finance and writing. He has been a member of the California State Bar since 2003. He graduated from the University of the Pacific’s McGeorge School of Law in Sacramento, California, in 1998, and currently works for the Oak View Law Group in California as a Principal Attorney.

Good debt vs bad debt

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