5 Examples and differences between good debts and bad debts
Although there is a lot of talk about good debts and bad debts, few people know about the subject in depth.
It is common for us to use the term “indebtedness” in a generalized way, but the truth is that not all of them lead to headaches.
That is why it is so crucial to understand the differences between good debt and bad debt, and above all, to maintain a good relationship with money if your goal is to keep your finances balanced and build your wealth.
Not all debt is bad:
Not all debt is bad. In fact, in some cases, they can work as a very effective financial leverage when it comes to acquiring productive assets.
In this article you will know what good debts and bad debts consist of, you will know their differentiating elements and we will share some examples with you.
Additionally, you must stimulate your financial intelligence regularly so that you do not incur unnecessary debt or complete chaos of money.
What is good debt?
Have you ever heard the term “bad debt – good debt”? Or simply “good debt”?
Although this last concept sounds a bit ironic, you must know that this type of debt can help you earn money.
Specifically, they are generated when you borrow money for some of these purposes: acquire goods or make investments. The real background to this is to make a return within a given time frame.
In simple words, what you are looking for is for money to flow into your accounts despite incurring debt.
And although these loans will require you to pay commissions and interest, you will still receive a benefit. What is this about? The assets acquired will bring you a specific return with which you can compensate for the entire operation.
In theory, being good offers you a long-term benefit because it allows you to acquire an asset that will retain its value over time. (Even after paying the amount owed).
Know some examples of good debts:
Mortgages are a clear example of good debt, despite the belief that they were created to cause ruin.
According to a CNBC report, mortgage debt is one of the “safest forms of good debt.”
This is because their monthly payments add value to the home. However, you mustn’t mortgage it for a price that you simply cannot afford.
Suppose you borrow money to buy a house and your mortgage term is 10 years.
If you manage your money well, you could pay most of the mortgage on time, and then sell your property within a decade.
At that time you will recover the money owed and an additional benefit; considering that your asset will have appreciated considerably.
2. Vehicle loans
Since new cars depreciate when you remove them from the agency, it will be impossible for you to sell them later at the same price (to recover all your investment).
In this sense, borrowing money to buy a conventional car does not represent a good debt, because in the long term it will not offer you a greater value.
However, the situation changes when you ask for a loan to buy a collector’s car.
Simply because in this case, its value will not depreciate in the same way as that of a conventional car.
From that perspective, car loans can be categorized within this type of debt.
3. Student loans
When talking about good debts and bad debts, the need arises to mention student loans.
These are classified as favorable for people who have low or medium incomes since they allow them to finance their university studies.
But these can become a double-edged sword if they decide to ask for more financing than the total of what they will earn during their first year on the job.
For example, if you are pursuing a master’s degree in finance and the average base salary for a financial specialist is $60,000, you should not take out a student loan of more than that amount.
Characteristics of good debt
These types of debts have specific and defined characteristics, such as the ones that we will share with you below:
- They increase the flow of money into your pocket. So profitability is practically assured.
- They work as a powerful element of financial leverage to acquire assets that do not depreciate over time.
- In the long run, they help you make money.
- They allow you to borrow money without disrupting your overall budget or driving you into extreme debt.
How is bad debt defined?
The concept of good debt or bad debt always causes curiosity and suspicion, especially when people do not have much financial knowledge.
If this is your case, it is most likely that this information will help you open your mind, or that it will allow you to improve the perception you have regarding indebtedness.
And since we already told you what a good one consists of, it is time to tell you a little about its counterpart. Bad debt.
Bad debts are generated when you don’t make cash purchases, and when you don’t understand how credit works. In addition, it ties you to the payment of interest for the entire duration of the financing.
In this sense, they do not generate long-term benefits, but a small advantage derived from immediate consumption.
Here are some examples of bad debt:
1. Credit card debt
Most of the purchases you make with your credit cards are considered bad debt.
This is because their interest rates are often higher than any other type of debt.
And if you only make minimum payments on your debt, the interest charges could double, or triple, the cost of the product you purchased with these financial instruments.
As if that were not enough, purchases on credit do not usually have a long-term resale value. (This translates into an obvious lack of financial benefits.)
2. Payday loans
They are also known as short-term loans and are one of the worst debts you can take on in your life. The reason is simple: they offer no tangible value and are often used to address a financial emergency.
Additionally, its interest rate is very high and this will only dilute all the money in your budget. So that you have an idea of how dangerous they can be, we will share with you an accurate statistic:
The annual interest rate of credit cards, (on average), ranges between 16% and 18%. While the rate for short-term loans is usually 300% or even a little more.
Characteristics of bad debt
- It does not offer you any type of economic return.
- Lock down your financial freedom.
- It only serves to buy liabilities.
- Promotes over-indebtedness.
- It is generally consumer-oriented. That is, to unnecessary expenses.
- It does not generate profit or equity.
Differences between good debts and bad debts
Knowing the differences between good debt and bad debt could help you better understand both concepts. These are the most outstanding:
- They allow the acquisition of assets that generate returns. While bad debts are often used to make unnecessary purchases.
- The value of assets acquired with a good loan can increase over time. In the case of bad debts, the objects acquired are not usually resold at a higher price.
- They can function as a leverage element. While the bad ones only promote more indebtedness as a result of commissions, interest, and on debts.
- Assets purchased with good debt can be a great investment, at least in the long run. But this does not happen with the other type of debt.
- They tend to adjust to people’s ability to pay, while the bad ones tend to exceed it completely.
Important financial recommendations when acquiring a debt:
Knowing the differences between good debt and bad debt is not enough to avoid debt.
In this sense, we will share some recommendations that could prevent a good debt from becoming bad in the blink of an eye:
- Hierarchize your consumption needs.
- Calculate your expenses and income well.
- Create a budget that allows you to manage your money efficiently.
- Understand well how credit cards work, and above all, do not underestimate their interest rates.
- Feed your financial intelligence. If you don’t know how money works, or how you can use it to create wealth, it will be very difficult for you to manage yourself well.
- According to Business Insider, you should not spend more than 30% of your income on payments. If so, you would be incurring bad debts.
- Investigate in depth the concept, differences, and implications of good debt and bad debt.
Now that you know what is good debt and bad debt, you have better tools to manage your money efficiently, while avoiding debt that only impoverishes you.
Staying debt-free speaks highly of your financial intelligence, and also denotes responsibility, maturity, and commitment.