All debt is not created equal. In the most simplest of breakdowns, there are essentially two forms of debt – good debt and bad debt. Most all individuals carry some form of debt during their lifetime, but the differences between the two will determine whether a person ends up financially OK or buried under excessive financial obligations.
Good debt is essentially debt that can either lead to (a) future wealth or valuable assets or (b) decrease current expenditures as a way to save money. Examples of good debt are mortgages, loans to purchase real estate, education loans, business loans, and sometimes, investments such as stocks.
Mortgage and real estate loans are considered to be good debt because they generally lead to ownership of a tangible asset. Homes and property typically increase in value over the course of time and can be resold for a profit. Education loans offer a tangible financial benefit because a college degree can lead to higher earnings potential in terms of salary. Business loans can lead to a valuable business and the investments which are considered to be smart, can lead to wealth growth.
Car loans, on the other hand, are not considered to be good debt because they depreciate as soon as the vehicle leaves the lot and, in most instances, does not regain value. Same with purchases made with credit or store cards; these goods typically do not provide any long-term value.
According to CNN Money, “Ideally, experts say, your total monthly long-term debt payments, including your mortgage and credit cards, should not exceed 36 percent of your gross monthly income.” Anything beyond this may lead to financial difficulty down the road. Lenders often consider this metric when they assess whether or not they will agree to a loan to a hopeful borrower.
Good debt is not a bad thing, however on the other hand, carrying too much bad debt can quickly spiral out of control and lead to being in a financial hole which can be difficult to escape from.
Unfortunately in today’s quick-spend society, many individuals buy now and worry about payments later. This makes for a dangerous financial situation because of high interest rates which, if the debt is not paid off rapidly, can lead to increased debt, unlike good debt which leads to something of value.
In order to avoid falling into this pitfall, consumers are wise to spend with the future in mind. If a large purchase is a concrete asset in which value can be recouped, this is smart spending. Amassing large credit card bills is not. In the case of the latter, consumers are wise to stick to the rule if the debt cannot be paid upon monthly statement to avoid interest charges, or at least shortly thereafter, than the purchase is not a good one. Basically if one does not have the cash to pay, the purchase is not good debt.
Good debt, in its most basic form is debt that leads to something of value and does not deplete your resources or will hinder your ability to pay.