Good Debt vs. Bad Debt
What’s the difference?
Many of us were conditioned to believe all debt was bad. Did you know there is actually ‘good debt’? Mind-blowing huh? Did you know, people without credit cards usually have lower credit scores than people with credit cards? We often hear a lot about credit scores and in the United States, the most widely used credit scoring method is called FICO. To provide you with a credit score, FICO uses your existing debt to calculate 30% of your credit score. FICO focuses specifically on your credit utilization. While this may sound counterintuitive to some, utilizing credit has its benefits, and so does debt! So… what makes debt bad? Let’s dive in!
What is bad debt?
Like many things in life, there isn’t a one size fits all for bad debt. Bad debt comes in many variations. It can be debt on a purchase that quickly loses value or does not generate any income. Bad debt usually has high-interest rates. People who are financially savvy typically view credit card debt as bad debt, as credit card purchases typically meet most or all of these criteria. Good debt purchases aren’t normally made with credit cards like rental properties, stocks, or any other assets.
Bad debt is expensive and provides you with no true value. If you buy things you don’t need on your credit cards, like your 20th pair of shoes or sneakers, or your 15th pair of jeans or pants, those purchases are helping you accumulate bad debt. Imagine making a purchase for something you don’t need, only to fully pay it off by the time it is obsolete, out of style, or no longer functioning. That is the best way to describe bad debt. A quick example of how to identify bad debt:
If you were to buy a designer coat for $500 dollars, depending on your financial situation, you may have difficulty paying off that balance. In some instances, that coat can end up costing you over $500 in interest depending on how you pay off your debt.
How do I deal with bad debt?
Bad debt can and will hit you like a ton of bricks if you aren’t disciplined with your spending habits. Imagine not being able to pay your bills, your credit cards are maxed out, and you don’t have any way of increasing your income. Over 40 Million Americans are dealing with this situation every day, while an additional 80 million Americans live paycheck to paycheck! The key to a healthy financial life is to closely monitor all aspects of your finances and ensure your finances don’t spiral out of control.
If you’re in a situation where your credit cards are maxed out, you can barely cover your necessities, your utilities start to get cut off, and you’re unable to pay your rent, you may feel hopeless. You may be questioning “how have I dug myself so deeply into debt?” If this is your situation, you can still overcome this unfortunate situation. If this isn’t your situation, but you want to avoid this at all costs, this is also possible! Despite any poor financial decisions, you’ve made in the past, you can overcome and avoid this challenge by carefully planning your finances and practicing patience while you work your way out of your financial situation. The key is to begin immediately and stay focused! Please review our older blog posts for tips and tricks to achieve financial freedom.
Is there such a thing as good debt?
Most people like to focus on the negatives of debt and how to overcome a rough financial situation, but there’s another side to debt we often don’t hear about. While this may be a little mind-blowing, there is such a thing as good debt. What is good debt? Good debt is when money is used to make an investment or purchase that will augment or improve your net worth, financial situation, or income. In some situations, good debt can also be identified by looking at interest rates and understanding your return on investment (ROI).
To put good debt into context, the following types of debt are typically viewed as good debt: a mortgage on a home; student loans; a car loan; or a low-interest loan that will allow you to accelerate the payment of higher interest debt. In many instances, good debt will carry an interest rate under 10%. Let’s review these types of debts:
Mortgages use debt to acquire what may potentially become an asset. This type of debt typically have lower interest rates, mortgage payments are tax deductible, and historically home values have only increased over time. When considering a mortgage, we recommend you work with a real estate professional who truly understands the market. The real estate crisis of 2008 is a good enough reason to work with a real estate agent/broker who not only has your best interest in mind but also understands prudent financial purchases and the market. A quick rule of thumb, your home purchase should be 3 to 4 times your annual household income.
- For example: someone who earns $50,000 should purchase a home between $150,000 to $200,000. Anything above this purchase price will put a strain on the buyer.
Student loans receive a lot of criticism by many people. These loans are very difficult to pay-off, have only risen with college tuitions, and greatly impact people’s quality of lives after college. While all of the above is very true, student loans can also put you in a position to earn more than if you didn’t have a college degree. There are many careers that don’t require college degrees to get hired, and there are many careers that do require college degrees to get hired. We recommend you consider your unique situation, your career goals, and decide whether or not student loans can help you achieve the life you’d like to live.
Car loans allow you to purchase vehicles that may help you improve your ability to transport yourself to better jobs and opportunities. At Yofii, we do not recommend purchasing cars. We believe car leases are more beneficial than car purchases in most situations, typically depending on the person’s needs. Cars are liabilities as they do not appreciate in value, require consistent maintenance, and can generate income for very limited professions. When considering a car purchase, clearly define your expectations, needs, and stick to your goals! Car purchases are very beneficial for people who take very good care of their vehicles. Purchases are great if you are willing to keep the same vehicle for long periods of time. There are a number of vehicles that can be driven past 100,000 miles without issues and some vehicles that can be driven past 200,000 miles! Those are awesome purchases, but you do need to stay consistent with your maintenance! If you’re purchasing a car, the following article provides a few quick and easy steps on how to buy a car.
When considering the above-mentioned purchases, it’s worth noting, some people don’t consider these purchases/investments as good debts due to their level of financial literacy or their unique financial situations. While purchasing a home may positively impact your credit score, improve your living situation, and could potentially impact your net worth across a long term, many financial experts and investors view single family homes as liabilities. A liability is any purchase/investment that: does not directly generate income; requires expense to own like maintenance; and/or may appreciate in value that isn’t immediately accessible.
How do I turn bad debt into good debt?
If you want to transition your bad debt into good debt, your goal should be to find the right balance. A realistic budget is the first place to start. Operating without a budget will leave you clueless as to whether you’re on or off track. As a rule of thumb, try to keep your payments to your debt under 30% of your monthly income. You should also subscribe to stay up to date on everything Yofii. Our team is working to provide you with a simple set of answers to Frequently Asked Questions people have when it comes to managing their finances! Quick example:
How to buy a house?
When purchasing a house, you should be looking to spend three to four times your annual income. For example, if John makes $50,000 a year, John should be looking to purchase a home between $150,000 to $200,000. While John may want a house that’s worth $500,000, the mortgage payment will be higher than what he can afford. In some instances, John may be able to increase his income in the future to support a mortgage of $500,000. We don’t recommend you bet on the unknown. That is a poor financial practice that you should look to avoid.
Looking forward and freeing yourself from your financial shackles!
As your financial situation improves, you should look to stay informed and improve your financial literacy. There are many amazing books that explore accounting principles, investing principles, and how to live a healthy financial life on your terms. A few simple terms to consider: income is money you receive; an expense is money you are sending out; an asset is something that provides you income; liability is something that costs you money to own. In simpler terms: stocks can be assets as they may help you earn money or increase your net worth; loans are liabilities because you have to spend money to satisfy those loans.
The key to financial success and freedom is to own more assets than liabilities. As you learn more about personal finance, money, and wealth, ensure you take your time to analyze every financial decision. Some decisions may look great on the surface but may be a nightmare once you’ve finalized your investment.