Good Debt vs Bad Debt
You may have heard the phrase: no debt is good debt. However, from a wealth planning standpoint, there are some types of debt that can be viewed as an investment in your future.
What is debt?
When we talk about debt, we mean money that you have borrowed that you will have to pay back later with interest. The interest is also referred to as your cost of borrowing. For example, you borrow $1,000 from the bank and agree to pay it back in one year with 5% interest. At the end of the year, you will pay back the $1,000 that you borrowed plus $50 interest. Basically, you paid $50 to borrow $1,000.
A purchase bought with credit that appreciates or increases in value over time or generates an income for you is good debt. Some examples of opportunities that will generate revenue or increase your net worth are:
- Student Loans
- Buying a business
These types of purchases, even though they accumulate debt in the short term, pay off in the long term and can make you money. Student loans are investments in yourself and your future. It is assumed that by putting in the time and money now, you will benefit from a higher-paying job in the long run.
Buying a house will result in a mortgage, but your net worth will increase because property is an asset. Just make sure you can make your mortgage payments and regular expenses without relying on credit cards.
Buying a business will also require some upfront debt, but it will begin to generate revenue as it grows.
Bad debt is accrued when you borrow money for anything that depreciates in value over time. For example, you buy a new smartwatch on a credit card. As soon as you start to use it, it is immediately worth less and if you try to sell it used, you will not get full price for it.
Other examples of taking on bad debt are:
- Buying a car
These items are all fun to have now, and may even be necessary, but over time they will be worth less and you’ll still have to pay back the money plus interest. Long story short: if you can’t afford these things, don’t use debt to buy them. Instead, save up for those purchases that don’t contribute to your long-term net worth. At the very least, you’ll want to choose the lowest interest borrowing option you can and set a strict schedule for paying the amount back in as short amount of time as possible to minimize the amount of interest you pay.
Make the minimum payments on all debt but focus on paying off the debt with the higher interest rate.
Pay more than the minimum monthly payment when you’re able. If you’re only making the minimum payment, you are likely only paying interest, not the principle.
In a credit card culture, it is easy to treat yourself now and ‘worry about it later’. However, sticking to your budget and monitoring non-essential expenses can prevent debt from accruing.
The bottom line
While there is “healthy” debt and “unhealthy” debt, you want to make sure you’re striking a good balance between what you owe and what you own. Talk to your Assante advisor today to discuss debt reduction strategies and for advice on striking a healthy debt balance within your budget.