It feels like lately all anyone can talk about is interest rates. Don’t let them scare you. Interest is a trade off that can be well worth the cost when it comes to good debt. Wait—what is good debt?
The answer isn’t so straightforward. When you borrow money to pay for something (like school, a home, or a car) that is called debt. So, can debt be good? Debt isn’t necessarily always a bad thing. Some financial gurus will tell you that debt of any kind is always bad and should be avoided at all costs. This is a pretty extreme view to hold, but we get where the sentiment comes from: Americans often take on too much debt and these debt payments can leave them in a bad spot when the economy is going through a rough period.
But when used responsibly, there are times when debt can actually be helpful and good. Debt can be used to pay for school if you don’t have the money to pay for an education upfront. It can be used to buy a home, so you don’t have to pay the entire home price in cash. Taking on debt can fuel a new business with the cash it needs until it gets up and running.
So — how do you know what is “good debt” and what is “bad debt”?
What is good debt?
In general, good debt is debt that is used to finance something that will provide a return on investment, it has a low-interest rate, and has debt payments that you are able to repay.
These following loan types are all examples of good debt that can help you invest in your future.
- Mortgage: When you borrow money to buy a home, the interest rate is generally low and you anticipate that the home will appreciate (aka will be worth more) by the time the loan is paid off.
- Business loan: If you need money to help your business get off the ground, a business loan can provide a return on investment for you.
- Student loan: If you don’t have money to pay for an education, student loans can help you finance that. You’re investing in yourself and that degree will hopefully help you earn more in the future.
- Auto loan: Auto loans that help you buy a car so you can get to work are a form of good debt. You’ve got to work and you’ve got to get there.
What is bad debt?
Any of these loans can turn from good debt into bad debt if you take out too much money and can’t afford the repayment. A word of warning — this can happen very quickly even if you’ve managed the debt well for a long time.
For example, student loans can turn into bad debt if you borrow too much money and you’ll be stuck digging yourself out of debt for years. An auto loan can become bad debt if you buy too expensive of a car or if you can’t handle the monthly payments.
Bad debt typically has high-interest rates, is used to finance something that doesn’t provide a return on investment, or comes with monthly payments that you can’t afford to make. Credit cards and other high-interest loans (including payday loans) fall on the bad debt list.
The interest rate matters a lot when determining whether debt is good or bad. The interest rate is the percentage fee you have to pay the lender for borrowing money. This is where lenders make their money. When you have a high interest rate, that means you’re spending more money just to borrow money. This is easier to understand with an example:
Let’s say you want to borrow $10,000. You think you can pay back the loan in five years. Lender ‘A’ gives you an interest rate of 15% while lender ‘B’ gives you an interest rate of 5%.
- If you take the loan from lender ‘A’, you’ll end up paying them $4,274 in interest over the course of the five years.
- If you take the loan from lender ‘B’, you’ll pay them $1,323 in interest over the course of five years.
You’ll spend nearly $3,000 more just because of interest payments! Think of what you could do with an extra $3,000 (an international vacation comes to mind).
What is a good interest rate?
If you have debt, you of course want to spend as little as possible on interest payments. There’s no universally agreed upon definition of a high or low interest rate. Credit cards are almost always considered high-interest debt because the average interest rate (as of August 2020) is 16%. Mortgages are almost always considered low-interest debt (on a 30-year fixed mortgage as of August 2020) is 3%.
A note on bad debt
If you have “bad” debt, it doesn’t mean you’re bad with money. Debt is stressful, it’s emotional, and it comes with a lot of judgment (mostly from ourselves). While we talk about bad debt and good debt, it’s not to make you feel bad about the debt you currently have. It’s to help you understand what to strive for in the future.
Because being good with money is a long game and you are here to play.
Are you looking to get out from under debt? Our Finance 101: Mastering Your Finances will walk you through everything you need to know about paying down debt!