Not all debt is created equal.
Debt is a scary concept for many people, and understandably so.
But the reality is: A little debt can actually be a good thing.
By avoiding it entirely, you could be doing more harm than good.
The key is to approach debt with a strategic mindset. You may be surprised to learn there is such a thing as "good debt".
Understanding the difference.
"Good debt" is when you borrow money to pay for things that can increase in value or help you in the long-term.
"Bad debt" is when you borrow money for things that lose their value quickly or don't help you in the long run.
Here are some of the most common good, bad, and necessary debts you're likely to encounter in your financial journey.
BAD DEBT: Cash advances
Cash advances come from withdrawing cash on your credit card, against your credit limit, and come with a cash advance fee and high APR. Both of these are extremely difficult to pay off due to the fees and high interest that come with these financial quick fixes.
Some alternatives to cash advances to consider are:
Credit rebuilder loans: These loans allow people with lower credit scores to borrow money without facing high interest rates. Louisiana FCU offers a credit rebuilder loan called the Xtend Loan, designed specifically to help individuals improve their credit while keeping interest costs manageable.
Cash out rewards: If you have a credit card that has a cash-back rewards program, like a Platinum Rewards MasterCard, you can use those rewards to redeem a large amount of cash.
Situations arise that require an immediate need for cash. Before taking out a payday loan or a cash advance on your credit card, be sure you have considered all your options to ensure your dire need for a financial quick fix won't leave you in debt for years to come.
GOOD: Home and mortgage
Some forms of debt, like home loans, can actually improve your financial health.
Builds equity: A home loan allows you to purchase a property and build equity over time. As you make your monthly mortgage payments, you're slowly paying off the loan and increasing your ownership stake in the property. This equity can be used as collateral for other loans, or as a source of savings for retirement.
Potential for appreciation: Historically, real estate has appreciated in value over the long term, which means that your home could be worth more than you paid for it if you hold onto it for a number of years. This can provide a valuable source of wealth and financial security for you and your family.
Tax benefits: Homeowners can often deduct the interest paid on their mortgage from their income taxes, which can provide significant savings. In addition, if you sell your home for a profit, you may be eligible for a capital gains exclusion that can further reduce your tax liability.
By using a home loan as a financial tool, you can set yourself up for a more secure future.
BAD DEBT: Retail credit cards
Have you ever been offered a credit card during check out at a big chain store? The cashier probably explained that by signing up for the store credit card, you would receive enticing discounts or rewards.
However, the interest rates on these cards can be astronomical, often exceeding 20%. Retail cards often come with hidden fees and penalties, such as late payment fees and annual fees, that can quickly add up and trap you in a cycle of debt.
While these cards may tempt you in the moment, they are often not worth the long-term financial strain they can cause.
GOOD DEBT: Business Loans
If you are an entrepreneur or small business owner, you may feel squeamish about taking on debt to grow your enterprise. However, taking out a business loan can be a smart move that can help your company succeed.
Capital for growth: When your business needs capital to expand or make improvements, a loan can be an effective way to access the funds you need. This can allow you to invest in new equipment, hire more staff, or open a new location, which can ultimately lead to increased revenue and profits.
Improving your credit score: By making timely payments on your business loan, you can establish a positive credit history and improve your credit score. This can make it easier to qualify for future loans or lines of credit, which can be valuable as your business continues to grow.
Tax benefits: Just like with home loans, interest paid on business loans can be tax-deductible, reducing your overall tax liability. This can be especially valuable for small businesses that are looking to minimize their expenses.
Can help manage cash flow: Business loans can be used to manage cash flow and cover short-term expenses, such as payroll or inventory. This can help ensure that your business remains financially stable during periods of slower sales or unexpected expenses.
Helps you seize opportunities: When a new opportunity arises that requires capital, such as a chance to purchase a competitor or expand into a new market, having access to a business loan can allow you to act quickly and decisively. This can help you stay ahead of your competition and capitalize on emerging trends.
BAD DEBT: High-interest loans
High-interest loans are also known as predatory loans, imposing unfair or deceptive terms to borrowers. Typically, these loans are geared towards customers who don't have a strong understanding of loan agreements, or don't have any other legitimate loan alternatives.
Taking out a high-interest loan means that your monthly payments will be significantly higher, and you will be paying more on the interest by the time the loan is paid off. To avoid incurring a high-interest loan, consider multiple lenders that are willing to help you structure your loan efficiently, and allow you to pick a repayment process that will help you accomplish your financial goals without being burdened by excessive interest. If you already have high-interest loans and are looking to pay them off faster than the term of the loan, consider:
Lowering your expenses. Look for ways you can lower your spending. This can be from cutting out smaller, monthly bills like reducing the number of subscriptions you have or cutting back on coffee and soda. Even bigger financial adjustments can help you pay off your loan faster, such as advertising for a new roommate or moving to a cheaper apartment. Every dollar you save can go towards paying off your high-interest loan(s).
Consolidating your debt. Consolidating multiple high-interest loans will give you the opportunity to refinance your debt with a loan that has a lower interest rate. Debt consolidation can decrease your monthly payments and adjust the term of the loan(s), making it easier to pay off.
Seeing a credit counselor. If you are struggling to make ends meet while paying off multiple high-interest loans, credit counselors can assist you in forming a plan to pay off your debt. Look to your financial institution for different services they provide for credit counseling.
NECESSARY DEBT: Car and Auto Loans
Auto loans can be a tricky financial decision to make, and whether they are considered "good debt", or "bad debt" can vary depending on your specific situation.
Most cars will lose value over time. If you end up needing to sell the car before the loan is paid off, you may be stuck with negative equity and owe more on the loan than you can get from the sale.
Vehicle shortages caused by supply chain issues launched auto prices to new highs in 2022. On top of that, the Federal Reserve boosted interest rates to help curb inflation. These factors have led many to pay more in interest than their car is actually worth.
However, here's where things get gray.
Cars are essential: Unless you live in a walkable city, having a car is a necessity in America. Whether you need a vehicle to commute to work, take your kids to school, or run errands, having reliable transportation is a must. If you don't have enough cash to buy a car outright, taking out a car loan can be a smart way to finance this essential purchase.
You can always refinance: If you buy a car while prices are high, refinancing to a lower interest rate can reduce your monthly payment and free up money for other expenses.
NECESSARY DEBT: Student Loans
Educational expenses can be a touchy subject. Student debt in the U.S. hit $1.75 trillion in 2022, with the average borrower taking out $28,950 in student loans to afford their education.
According to research, 28% of American college students regret taking on student debt to finance their education.
While there are certainly arguments in favor of student loans as good debt, there are many who would scoff at this idea.
For something to be considered good debt, it would need to help you in the long run. While a college or advanced degree can certainly open up opportunities for future earnings, there is no guarantee that it will lead to a high-paying job.
Highest-paying college majors
By median salary within five years of graduation
1. Computer Engineering - $74,000
2. Chemical Engineering - $70,000
3. Aerospace Engineering - $70,000
4. Electrical Engineering - $70,000
5. Industrial Engineering - $69,000
Lowest-paying college majors
By median salary within five years of graduation
1. Consumer Sciences - $32,000
2. Social Sciences- $34,000
3. Performing Arts - $34,000
4. Social Services - $35,000
5. Anthropology - $36,000Source
As you can see, the investment in education is not a guaranteed payoff.
However, there are still benefits to student loans that don't exist with other forms of debt.
Flexible repayment options: Many student loan lenders offer flexible repayment options, including income-driven repayment plans and deferment or forbearance programs. These options can help you manage your debt and avoid default if you experience financial hardship.
Potential tax benefits: Depending on your income level and other factors, you may be eligible for tax benefits related to your student loan debt. For example, you may be able to deduct the interest you pay on your loans from your taxable income.
Builds credit history: Student loans are a great tool for helping young adults qualify for other types of loans and credit products in the future.
Possible forgiveness: The issue of student loan forgiveness is a complex and controversial one, and there is currently no clear consensus on the matter. In August 2022, President Biden announced his plan to cancel student loan debt for qualifying individuals. However, there has been no widespread forgiveness of student loans to date, and it remains to be seen whether this will become a reality in the future. Currently, the federal government offers several programs that can provide loan forgiveness or cancellation for certain types of borrowers, such as those working in public service or those who have been defrauded by their school.
As with any type of borrowing, it's important to carefully consider the costs and benefits, and to borrow only what you can afford to repay.
Debt is not evil. Yes, it should be approached with caution – but don't let fear of debt hold you back from pursuing financial growth and stability. By understanding the nuances of different types of debt and approaching it with a strategic mindset, you can take control of your finances and achieve your long-term goals.
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