In this blog post, we will delve into the differences between these two types of debt and shed light on how they can impact your financial well-being.
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The total amount of money that you owe is only one aspect of debt.
When it comes to debt, many people often associate it with negative connotations. However, not all debt is created equal. In fact, there are two distinct categories of debt: good debt and bad debt. In this blog post, we will delve into the differences between these two types of debt and shed light on how they can impact your financial well-being.
First and foremost, you've probably heard it from financial gurus *cough Dave Ramsey cough*, but there's a lot more to debt than Ramsey portrays. Some debts can actually be beneficial. This may seem strange to you, but bear with me while I explain. When a lender examines your credit report to discover what types of accounts you have, some debts will be treated more positively than others. If you want to get out of debt, you should first learn which debts are considered bad and which are considered beneficial. That way, you may prioritize your bills and pay off the most serious ones first.
Some of the money you owe could be seen as an investment. You might be wondering, "How can something as bad as debt be an investment?" It's possible that the debt you took on was a good one if you used it to buy something that will increase in value and help your overall financial health, for example, to increase your credit score. When you use debt to pay for things you can use up, you are getting into bad debt. This is the kind of debt that makes a person's finances bad.
With a mortgage, you build equity in your home, and the money you pay toward it can be seen as an investment. Many people think that renting an apartment is a waste of money, but when you buy a home, you build equity. But even this can be a bad way to handle debt. If you take out too much mortgage debt or use your home's equity to buy things right away, this is not good debt.
If you want to build your wealth, you have a much better chance of doing so if you start your own business and work for yourself. Entrepreneurship is very popular right now, and there are many ideas for small businesses that have already been successful. But have a plan and maybe a few people who will support you. Because they are riskier for the lender, small business loans are harder to get. But if you have enough drive, business sense, and luck, taking out a loan to start your own business could be the best money you ever spend.
Since this debt helped you get a better job, you can say that it was worth it to borrow the money. The Department of Education says that people with a bachelor's degree make about $1 million more over the course of their lives than those who don't go to college. But you still want to borrow as little money as possible. You can sometimes use a student loan to pay off bad debt. Don't borrow more than you need just to have more money to spend.
Note: Even if you do not itemize deductions on your taxes, you can deduct the interest that you pay on your student loan from the total amount that you owe in taxes. This may cause you to put paying off this debt lower on your list of priorities for paying off your debts.
Because of how credit cards are used to buy things, this is often thought of as bad debt. You should never use debt to buy things like clothes or food that you need every day. If you use a credit card for these kinds of purchases, it should be on purpose, like if you want to get rewards or if you know you'll pay off the whole balance by the due date. You might be tempted to put a vacation on your credit card if you think that taking a break will make you more productive when you get back. But a vacation doesn't have much value, even if it does have real benefits.
In cases like these (taking a vacation), it would be a better idea to start a sinking fund than to use a credit card.
Read more: How to Start a Sinking Fund?
Note: Your credit scores won't suffer if you don't carry any balances on your credit cards, but you will need to keep open and active credit accounts in order to achieve the best possible results. You can acquire an excellent credit score if you make regular use of your credit cards and then pay off the amounts on those cards each month (so that you do not have any outstanding debt). The most important thing is to have good activity on your credit report, which may be accomplished even if you are not carrying any debt.
The interest rates on high-interest loans can be extremely high for specific personal loans and payday loans. Payday loans are 10 to 15 times worse than credit cards in terms of convenience. To get you through a crisis, you receive short-term cash. In exchange, you postdate a check with the intention of paying the remaining sum when your next paycheck is received (typically two weeks). Although it's quick and simple, there are loan fees of between $15 and $30 for every $100 borrowed. A typical two-week payday loan with a cost of $15 per $100 results in an APR of 400%. You should see a psychologist instead of a gastroenterologist if that doesn't make you queasy (they can use the business).
Read more: 10 Tips to Starting An Emergency Fund
Car loans can sometimes be considered bad debt because the value of a car drops 20% in less than half a mile after it leaves the lot. On the other hand, car loans can be a good way to borrow money if you can get a good annual percentage rate and the car you buy keeps its value after you pay off the loan. Some car interest rates are relatively low (1.4% to 2.5% for new with good credit; 2.5% and up for used), and if you need a car to get to work, it will have a lot of return on investment in this way.
Here are the Best Car Loan Rates of 2023.
It takes time and a mental adjustment to develop the habit of taking on good debt and avoiding bad debt. Good debt is acquired by sensible financial planning, not just for the sake of having good debt. You might decide to get a degree, for instance, in order to boost your earning potential. If you don't have any other options for paying for your education, taking out a student loan may be a justifiable course of action.
To learn more about sensible financial planning suited to your goals, speak to an advisor at Vincere Wealth.
Be smart in how you approach your debt repayment plan. Generally speaking, it's a good idea to prioritize paying off your poor debts first as they may incur more fees and interest rates than your good debts and have significantly lower values. Prior to taking on mortgages or student loans, you should pay off your credit cards and auto loans. Think about using the debt snowball method to pay off your debt.
Your decisions about how to spend your money ultimately determine whether a debt is good or bad. Always keep in mind that you should probably avoid taking on excessive debt or using it to pay for whims rather than necessities. Furthermore, just because a loan is favorable rather than harmful does not mean you should borrow all of the available funds. Exercise good judgment when you make decisions to borrow money. If you wind up becoming house poor as a result of buying a property, you could regret doing so. Maintaining a debt-to-income ratio under 35% of your income is advised.
- In a year or five years, will I have something to show for this money?
- Is it something I need right away, like paying for an emergency car repair or a medical problem? Can I instead save up for it using a sinking fund?
- Is there another way I could pay for this?
Even if the debt is good debt, you should still try to pay it off as soon as you can. It will help you start making money and building your wealth. You also won't have to rely as much on your monthly paycheck. Getting out of debt is important for many reasons. If you really want to get out of debt, you'll need to make a budget and a plan for paying off your loans that lets you pay more each month. If you know how to handle your money well, you can pay off your debts faster than you think. It might require you to take on an extra job for a short time or cut back on your spending, but the sacrifices will be worth it.
Use our FREE budget spreadsheet to make your budgeting easy!
The snowball approach and the avalanche method are two common strategies for paying off debt:
Works like this: With the Snowball method, you put any extra money you have each month toward the debt with the smallest balance. At the same time, you pay the minimum on your other debts. Once that debt is paid off, move on to the next smallest debt.
Works like this: Put any extra money you have each month toward the balance with the highest interest rate. Make minimum payments on your other balances. When it's paid off, move on to the next highest-interest debt. It might make sense to pay off high-interest credit card balances first, but it's important to find a way out of debt that fits your budget, lifestyle, and financial goals. You can use an existing way to pay off debt or combine a few to make your own plan to get out of debt.
- Set a budget. This will prevent you from accidentally overspending. You want to make sure your costs stay below your income, otherwise you may end up owing more money in the form of credit card interest or overdraft fees.
- Pay your bills on time to save money. Late payments usually trigger fees or service charges that can make it harder to reduce your spending.
- Where possible, automate your payments to come from your checking account.
- When you receive your bills and statements, make sure they are accurate and your rates remain the same. If there are errors or your rates increased without any explanation, call your lender to fix accordingly.
- Set up sinking funds for your vacations and big purchases so that you do not have to take out loans to afford them. Saving is key #nointerestrates.
Eliminating debt takes time, but if you put in a lot of effort, you'll get there in the end. When developing and implementing a strategy to repay your debt, the following additional suggestions may prove useful:
- Lowering your spending as much as possible and taking control of your finances with a budget will allow you to put almost all your extra money toward paying off your debt.
- Before you put all of your extra money toward paying off your debt, you should make sure you have an emergency fund set up.
-Start making payments toward other obligations at the same time you are paying off accounts.
- Once you start chipping away at your debt, don't forget to keep an eye on your credit score. Keeping track of how far you've come may be a very motivating experience.
-If your income changes during your debt repayment plan, be sure to re-evaluate your budget.
-After you have paid off all of your debt, you should continue to stick to your budget in order to assist you in remaining debt-free.
Distinguishing between good debt and bad debt is crucial for making informed financial decisions. While good debt can provide opportunities for growth and wealth accumulation, bad debt can trap you in a cycle of financial stress and hinder your long-term goals. By understanding the differences between these two types of debt, you can work towards minimizing bad debt and leveraging good debt to create a more secure financial future. Remember, responsible borrowing and wise financial management are key to maintaining a healthy financial life.
With the help of a fiduciary financial advisor to help guide your decisions, you stand a much better chance of retiring comfortably—and maximizing your sources of income so you can live the life you want.
Contact Vincere Wealth to start today.
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