The Difference Between Good Debt and Bad Debt
Updated: Jun 29, 2021
The word “debt” on its own can feel intimidating, it is often associated with fear. According to the American Psychological Association, 64% of Americans cite money as a significant source of stress; they call this debt stress syndrome. It can be argued that no debt is good debt, but for the average person there are purchases that wouldn’t be possible without taking on debt, like a home. Borrowing money does not mean sacrificing financial freedom, debt could actually be one way to gain that financial freedom you desire. It is important to understand the difference between good debt and bad debt so that you can make educated financial decisions.
What is the difference between good and bad debt? Good debt can be described as debt that is used for things that appreciate in value or generate income. While bad debt is a consumable that depreciates in value.
Common Examples of Good Debt
It may sound cliché but we have all heard the phrase “It takes money to make money.” Loans taken out to support the growth of your business that can increase your revenues, whether it is updating your systems or hiring more personnel for improved customer experience, is considered good debt. It is debt that you are able to pay back and is helping you generate more business and/or remain competitive.
Probably the largest debt for most Americans is a mortgage. Purchasing a home that is within your financial means and you can afford its payments and maintenance is debt that can help you increase your net worth. Typically, homes are appreciating assets and can provide tax benefits that renting/leasing does not. We must note that purchasing a home that you cannot afford or overpaid for is not good debt.
It is not easy to borrow money for a mortgage or a business if you do not have strong credit history. Today, it is rare to even find an apartment for rent that does not require a credit check. Credit card debt can be good if you use it to build credit and you pay off its debt each month. A positive credit history can have considerable benefits for your financial future. Furthermore, some business owners use their credit card as a competitive advantage by providing lower estimates when taking into consideration the rewards they will receive on purchases. To illustrate, a contractor purchasing $10,000 in supplies for a remodel may provide a discount knowing he/she will receive 2% cash-back from their credit card provider.
Benefits of good debt include potential tax breaks, credit building, building equity and/or a return on investment (ROI).
Common Examples of Bad Debt
High Interest Credit Cards
We mentioned credit-building debt under good debt, however carrying excessive debt month-over-month can add up over time and when the interest fees are high it can be increasingly difficult to reduce your credit card balance; this is considered bad debt. Correspondingly, making the minimum payments or paying after the due date may result in a poor score on your credit report.
Payday loans are incredibly expensive. According to the Center for Responsible Lending as of February 2021 the typical payday loan interest rate in Florida is 304%; Texas has the highest payday loan rates at an APR of 664%. These types of loans can easily make a borrower fall into a bad-debt cycle.
Clothes, electronics, furniture, vacations, and/or personal items that you borrow money to purchase and do not add value to your financial wellness, is debt that is likely to have high interest rates. Ask yourself how the purchase benefits you in the future, if the benefits are not long-lasting it is likely a bad debt. Know what you can afford.
Bad debt generally lasts longer than the things you acquired by taking it on. For example, taking out a personal loan to celebrate your birthday in Ibiza can be bad debt if you are still paying it years later.
Every situation is different, we must consider your personal circumstances and financial abilities to tell if a certain type of debt is good or bad for your needs. Not all debt is easy to categorize. It is worth mentioning that even good debt has the potential of becoming bad debt. Part of our job as your accountant at CPA by Choice is to provide you with objective advice on the best ways to grow your business. We are available to answer your questions, feel free to call us or send us a message.