It's hard to go through life completely debt-free. There are times when a person needs to borrow money whether it's for a home, college tuition or an emergency. Debt is often necessary and, in fact, it can even be good. If you're considering borrowing or reviewing your budget, it's important to understand the difference between good debt and bad deb to set yourself up for long-term financial success.
What's considered good debt?
It may surprise you, but yes, there is good debt. Good debt happens when money owed is tied to something that can increase in value, like a home.
"Good debt is debt used to acquire appreciating assets," said Thomas E Murphy, CEO of Murphy & Sylvest Wealth Management. "These assets can be tangible like a house or intangible like an education. The expectation is that the asset will appreciate in value enough to offset the interest paid on the debt."
Here are some examples of good debt.
A home mortgage is a debt worth pursuing (so long as it makes financial sense.) Having a home mortgage shows that a bank trusted you enough to lend you a large sum of money for a purchase -- your home -- that's very likely to increase in value over time. This type of debt has the potential to increase your net worth, since the value of your home could surpass the amount you owe the bank -- that difference makes your home a very valuable asset only made possible by incurring debt.
Home equity loans/line of credit
Like a mortgage, a home equity loan or home equity line of credit confirms that a bank believes you are financially stable enough to be given a certain amount of money or credit. It also shows you have a house with significant value to borrow against while also having a manageable or paid-off mortgage. Home equities are typically used to invest in home improvement, like a remodel, increasing its value and your overall net worth.
Of course, a home equity loan could easily go from "good debt" to "bad debt" if the funds are used to purchase anything that will depreciate or has no value to begin with. For example, it's ill-advised to use home equity to pay for a vacation or a car.
The money borrowed to go to school may not be associated with a physical asset like a home, but there is a financial benefit in the future. Student loans are an investment in an individual's future that could result in a salary much higher than if that person didn't purchase an education. A 2019 Federal Reserve study showed those with bachelor's degrees earn on average $30,000 more than with a high school diploma. To be sure, not all degrees are created equal, and in the case of companies like Apple and Google, a four-year degree is no longer required from some jobs.
What's considered bad debt?
The easiest way to tell if something is bad debt is by evaluating the purchase made with the money borrowed or used to secure the loan, otherwise known as collateral. Is the debt-incurring purchase something that will hold its value over time, like a home, or will it decrease in value, like a new car? The worst kind of debt is associated with no collateral at all -- like a vacation.
"Bad debt is debt used to acquire a depreciating asset or one with no value at all," said Howard Pressman, CFP partner at Egan, Berger and Weiner. In other words, bad debt happens when money is borrowed to purchase something that will lose value or has no market value to begin with.
It's also not a good indicator of financial stability if you have to borrow money for something you can't quickly pay back such as a vacation or jewelry. Lenders that review your credit report before letting you borrow money could look at these kinds of accounts and question your creditworthiness.
Here are some examples of bad debt.
The big issue with auto or boat loans is that once the debt is acquired, these assets immediately start losing value. For example, new cars, on average, lose 10% of their value in the first month after being driven off the lot. Of course, a car is an essential purchase for most people and if you can't pay for one in cash (the preferred method), there's no way around incurring debt. When borrowing money for a car, be sure to negotiate or specifically look for an interest-free loan, which is the best way to purchase a car with borrowed money; if you're paying interest, future lenders will be critical of this debt.
Short-term loans with high interest rates are called payday loans, and they can cause more issues than they're worth. These loans are often pursued by individuals who need money fast, whether it's for an emergency or to pay for something that needs immediate attention, like rent. Avoid these loans at all costs. Not only can interest skyrocket to more than 1,000%, but some individuals who have trouble paying these loans back can find themselves in jail.
Retirement account loans
Like the payday loans, borrowing money from a 401K, or another retirement account is a way to get a sum of money without collateral, usually when an urgent need arises. The biggest drawback of these loans is that you'll find yourself investing less in your retirement while incurring fees and interest. Due to the coronavirus pandemic, the CARES Act passed in March does allow for borrowing money from a 401K, without penalty, for a financial hardship. This is a good example of when borrowing against your 401K is a viable last-resort option. Otherwise, protect your future and avoid tapping into your 401K.
A credit card can be really helpful to your credit standing -- and earn you rewards at the same time. An account with a low balance and high limit -- called "credit utilization" -- shows how responsible you are with money. Where things get bad is when you have multiple cards with high credit utilization and balances that are not paid off monthly. These credit card usage behaviors will decimate your credit score fast.
A way to keep track of how debt can affect your credit score is with a credit monitoring service. For those who want to review their credit report, the three agencies are offering free weekly reports due to the coronavirus pandemic.