Within many finance circles, there is a common and unfortunately 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 and 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. In this article, we will be discussing 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 that people who are trying to avoid debt tend to shy away from is applying for a credit card. This is because credit cards are some of the most common loans used, and therefore, many people have been exposed to the risks of them at some point or another. However, effective credit card usage can be extremely beneficial to 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, if you use your credit card on things you were going to 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, try to avoid a credit card utilization rate of over 30% a month, as this 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 of this, 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. When this occurs, your credit score may be negatively impacted, especially if you are unable to pay off the monthly minimum.
A low credit score (usually below 600) can ultimately cause you to have limited options when it comes to things 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 are able to 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:
- The cost of a mortgage is often less than rent costs in certain locations.
- Once you pay off your mortgage, you effectively have to 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.
In order 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 do find that you will save money in the long run, you can start saving for a down payment right away. It is recommended that you chose 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 good of home buying, there are also some negatives as well. Many home buyers deal with buyer’s remorse, as they are up to their heads in mortgage expenses that they are struggling 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 allows them to have enough money to spend on food and other expenses and also save for retirement. If you find that you are struggling 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 during the time 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 the freedom that comes from being your own boss. However, starting a business is not cheap, and therefore, business loans may need to be utilized in order to afford the costs of startup. This is not necessarily a bad thing, however, as it means you are able to leverage debt to generate positive cash flow.
Let’s say you want to start a small business. You estimate that it will cost you $100,000 to start and will 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. Now 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 that 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’s allowing you to earn more money than the debt itself costs.
However, there is a caveat to this: if your business is not able to succeed, you may find yourself with debt that you are unable to pay off. This puts your business at risk of bankruptcy, and if you aren’t properly protected, your personal assets could be at risk as well. To avoid this risk, there are a few actions you should take.
The first is that 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 that you won’t need to worry about losing your home, your car, or more 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 you need to file for bankruptcy so that you won’t need to worry about losing your business assets.
At the end of the day, debt can be effectively utilized to build your wealth and build your credit. However, like most things in life, it requires moderation and careful strategy to be effectively utilized. Therefore, the best way to approach debt is with research and planning, in order to maximize the benefits and take on more good debt than bad debt.