Unfortunately, many finance circles have a common, overused sentiment: “All debt is bad debt.” While it is true that, in many cases, debt can be a drain on many people’s lives, the issue is a bit more nuanced than this statement presents, as, in many situations, there are instances where debt can be effectively utilized helpful.
The important distinction between good and bad debt is this: bad debt constantly decreases one’s income and makes life more difficult to manage. Good debt is debt that can create a positive cash flow or save you money in the long run. This article will discuss both types of debt, how you can properly utilize good debt to earn more money, and how to reduce bad debt.
Good Debt: Effective Credit Card Usage
The first thing people trying to avoid debt tends to shy away from is applying for a credit card. This is because credit cards are some of the most common loans used; therefore, many people have been exposed to their risks at some point or another. However, effective credit card usage can benefit one’s financial life.
First, credit cards provide points and cashback rewards, something that paying with cash cannot. While those who shy away from credit cards point out that this incentivizes unnecessary spending, using your credit card on things you would buy anyway, such as food and gas, you can effectively gain more points without overspending. Another benefit of credit cards is that paying them off on time is a surefire way to boost your credit score.
To properly use a credit card, treat it like a debit card. Don’t spend more than you’re budgeting for a month, and immediately pay it back in full when the bill comes around. Also, avoid a credit card utilization rate of over 30% a month, which can negatively impact your credit score. When you start using your credit card this way, you won’t be overspending, you’ll be able to get rewards, and you’ll increase your credit score.
Bad Debt: Letting the Bills Pile Up
On the flip side, credit card debt can negatively affect many people’s lives. Spending over one’s budget can rack up debt incredibly quickly, and the high-interest rate associated with many credit cards can often cause this debt to grow even faster. Your credit score may be negatively impacted when this occurs, especially if you cannot pay off the monthly minimum.
A low credit score (usually below 600) can ultimately cause you to have limited options, like taking out a home loan and starting a bank account. Thankfully, there are actions to take if your credit is poor. Some banks offer second chances for people with bad credit, allowing you to open an account and have a place to maintain your finances while you pay off debt and rebuild your credit score. You can also look into debt consolidation loans that combine all of your credit card debt into one loan that is easier to manage.
Good Debt: Smart Home Buying
When you buy a home, chances are you’ll take on a mortgage unless you can pay cash in full upfront. Depending on the cost of the home, and the location you’re in, a mortgage will range from hundreds of thousands to millions of dollars. However, despite the staggering cost of a mortgage, in many cases, it can save you money in the long run. There are a few reasons for this:
- A mortgage is often less than rent costs in certain locations.
- Once you pay off your mortgage, you must pay $0 in monthly housing costs aside from property taxes.
- Housing values go up over time, meaning that if you ever want to sell, you could be leaving your home with more cash in hand than when you first started.
To explore this idea more in-depth, check out realtor.com’s renting vs buying calculator to compare how much you will be saving by buying a home and effectively utilizing your mortgage to save you money. If you find that you will save money in the long run, you can start saving for a down payment immediately. You should choose a down payment of 20% or higher, as this can drastically reduce the monthly mortgage payment.
Bad Debt: Excessive House Debt
Unfortunately, with all the goods of home buying, there are also some negatives. Many home buyers deal with buyer’s remorse, as they are up to their heads in mortgage expenses that they struggle to pay. This is often the case when people buy a home before they are ready, causing them to need to make payments far more expensive than they can handle.
The recommended amount that one should be spending on housing is 1/3rd of their income. This gives them enough money to spend on food and other expenses and save for retirement. If you struggle to make your mortgage payments each month, it might be a good idea to look into refinancing your home. If your home’s value has gone up when you’ve owned it, you can take out a new loan leveraging the increased value of the property and use the new loan to pay off the old mortgage.
The reason for doing this? While it does mean that you will spend more time paying off your mortgage, a refinance often has a lower interest rate, allowing you to reduce your monthly payment and breathe easier as your home becomes more affordable.
Good Debt: Business Loans
Starting a business can be a great way to achieve financial success and give you freedom from being your boss. However, starting a business is not cheap; therefore, business loans may need to be utilized to afford the costs of a startup. This is not necessarily bad, however, as it means you can leverage debt to generate positive cash flow.
Let’s say you want to start a small business. You estimate it will cost you $100,000 to start and earn $3,000 a month upon completion. If you were to pay the full $100,000 in cash, it would take around 2-3 years to earn back your initial investment. Taking a different approach, if you were to put $20,000 down towards your business and take out a loan of $80,000 with a 6% APY, you would incur monthly expenses of $1,500. This means you would have a positive incoming cash flow of $1,500 that you could reinvest into the business or keep as profit. This is an example of good debt because it allows you to earn more money than the debt itself costs.
However, there is a caveat to this: if your business cannot succeed, you may find yourself with debt that you cannot pay off. This puts your business at risk of bankruptcy, and if you aren’t properly protected, your personal assets could also be at risk. To avoid this risk, there are a few actions you should take.
First, you should claim your business as an LLC, allowing you to separate your personal assets from your business assets in the case of liquidation and bankruptcy. This means you won’t need to worry about losing your home, car, or personal property if you can’t pay off your debt. You can also look into debt relief companies like National Debt Relief that will help negotiate your debt before filing for bankruptcy. You won’t need to worry about losing your business assets.
At the end of the day, debt can be effectively utilized to build wealth and credit. However, like most things in life, it requires moderation and careful strategy to utilize effectively. Therefore, the best way to approach debt is with research and planning to maximize the benefits and take on more good debt than bad debt.