- It may make sense to take on debt in some cases.
- When you take on debt, you need to make sure you take on good debt and not bad debt.
- In all cases, you have to be able to derive more value from your debt than the amount you take on for it to be a wise decision.
Financial advisors, books, and websites tell you to stay out of debt. If you are already indebted, they advise you to focus your financial energies on getting out of debt and avoiding it in the future.
Some types of debt can rob you of your freedom, future, and financial options. On the other hand, under some circumstances, some types of debt may actually end up helping you in the long run.
Good Debt vs. Bad Debt
Not all debt is bad. Debt, used wisely, can be a tool. Think of playing with debt to make financial headway as being a bit like playing with fire.
Skilled craftsmen can use fire to forge things of beauty and great utility without burning themselves. In the same way, financially skilled people can use debt to improve their financial situation.
If you treat debt properly and approach it with care and thought, you can “tame” it, turning it into “good debt.” If you allow it to run amok and control you, you make “bad debt” of it.
When Taking on Debt Makes Sense
There are a few situations in which it makes sense to take on debt. Here are some of the most common reasons for “good debt.”
Mortgages are generally “good debt.” Through such a secured loan, you can get a roof over your head. You also acquire an asset that retains its value well against inflation or may even increase in real value over the years.
The good: A fixed-rate mortgage is a good option for buying a property that is likely to appreciate over time. You can usually deduct property tax and mortgage interest on your federal tax form.
The bad: Variable-interest mortgages may end up being bad debt, landing you in a financially untenable situation, unable to make the payments.
Investing in your education and the improvement of your skills is the equivalent of investing in your future. Student loans tend to make sense for those with enough foresight to determine how much they will likely be able to repay once they find a job.
The good: A college degree will give you access to a higher-paying job. With more income, there is a higher likelihood that you will attain financial freedom sometime in the future. It is important to weigh the cost of the loan against the income your future job will give you. If your future income justifies the costs, your debt may be a good one.
The bad: Accepting every penny a student loan offers can be tempting for many. Some people also overestimate the productivity of their future job, ending up with more debt than they can handle.
Some things in life are inevitable. To hold down a job, you will have to be able to get from point A to point B relatively quickly and efficiently. For that, you may need a vehicle. Early in your career, you will likely lack the financial means to pay cash for a car. To get the transportation you need, you may have to go into debt.
The good: Putting down around 20 percent and paying off the balance in four years at most usually makes your car loan a “good” one. It is also important to keep your payments below the 10 percent income mark of your household.
The bad: Some people are prone to see their car as an investment. It is not: it is an expense. The value of your car does not appreciate over time.
For businesses, profit opportunities requiring additional investments abound. If you think your business can turn a profit from an investment you currently cannot finance, it may make sense to take on debt.
Taking on “good” debt requires foresight, however, and a thorough understanding of the opportunity that justifies the debt. As a business owner, you probably know what works and how you make your profit. Focus on amplifying the already profitable aspects of your organization through new investments.
Shop around for loans. If you take on debt to increase your profits and expand your operation, make sure it comes with reasonable costs.
The good: If you use debt to fund the right ventures, you can improve your organization’s cash flow and reap a tidy windfall.
The bad: There is no room for risky and haphazard expansion attempts using debt. Investments that fail to pay for themselves can spell the end of your business.
How to Get Out of Bad Debt
Due to its high costs, it seldom makes sense to take on significant amounts of consumer debt. Credit card debt can be the most expensive form of debt, putting your finances on hold for years. Seek debt relief if you find yourself stuck in credit card debt.
The information provided is for informational purposes only and is not intended to provide credit counseling or lending advice. Please consult a certified financial advisor for individual credit and lending advice.