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There is a common misconception that borrowing money means sacrificing one’s financial freedom. But good debt is actually one of the best ways to gain fiscal freedom and reach long-term goals. Thus, understanding the difference between good and bad debt is a must for anyone looking to make informed financial decisions.
Borrowing money and taking on debt (both good and bad) is often the only way many people can afford important big-ticket items like a home. Obviously, home loans, college tuition, or having the financial backing to start your own business are justifiable and provide value. As a result, debt for a house, education, or a startup company are all seen as good debt.
That said, there is another end of the spectrum; however, that involves debt that is taken on haphazardly or debt that can hinder your long-term financial goals. Of course, differentiating between these two extremes might seem pretty straightforward, but it is not always as cut and dry as you might think.
As briefly suggested, any low-interest debt that helps you increase your income or net worth qualifies as good debt. Better still, good debt is debt that improves or builds your credit history and that you can write off on your taxes. Nevertheless, it is important to keep in mind that too much of any debt is typically classified as bad debt.
A prime example of good debt is student loan debt. In general, student loans are often regarded as an investment in one’s future, especially if these particular loans have lower interest rates. Plus, you can deduct student loan interest on your taxes. Usually, student loans will continue to be classified as good debt if you are diligent about staying on top of your payments.
Yet another example of good debt is a home loan or mortgage. In this instance, a mortgage is a path to homeownership. Moreover, homeownership and investing in real estate are ways to build wealth and increase your net worth. Mortgage interest rates are generally lower than other debt types and amortize longer as well, which helps you maintain a stable financial situation.
Thus, any debt that has the potential to bring financial gains should not be considered bad debt. You can also tap into the equity you build in a home over time with home equity lines of credit or home equity loans. These home equity loans can help fund home improvements, pay part of your children’s college education or pay off higher-interest-rate credit-card debt.
Note, you can deduct the interest on mortgage debt on your taxes, which is generally regarded as one of the many perks of homeownership. Interest may also be tax-deductible for both these equity home loan products as long as you use the funds for its intended purpose: to buy, build or renovate said home.
Nevertheless, to ensure that your mortgage, equity loans, or lines of credit stay good debt, keeping up with your monthly payments is crucial. That said, if you are having trouble managing your mortgage in general, there are a few solutions—including downsizing, refinancing, or moving to a lower-cost area to make housing costs more manageable. Note, these are just a few common examples of good debt.
On the other hand, expensive debts (with high or variable interest rates) are seen as bad debt that can negatively impact your financial situation. This is especially true when debt is incurred for discretionary expenses or things that lose value. To put it another way, if the item or purchase will not go up in value or generate income, then this kind of debt is not viewed favorably.
Bad debt can also be good debts gone awry, as alluded to earlier. In fact, good debt gone bad is all too common with credit cards that have a high interest rate. Of course, if you can pay off your high-interest credit card each month, then the issue is mute. But if high-interest credit card debt builds up, that’s a different story.
Along those same lines, high-interest loans such as payday or certain personal loans are considered bad debt. A few other items that can lead to you incurring bad debt include clothes, cars, and consumables.
Clearly, clothes, food, furniture, transportation, and all kinds of other things are usually necessities. But borrowing to buy them by using a high-interest credit card—without paying off the full balance at the end of the month—is not a good use of debt.
Borrowing money to purchase a vehicle is not necessarily the best move from a financial perspective, especially since most cars depreciate in value. But be that as it may, auto loans can be good debt if you can get a reasonable APR and the vehicle you purchase maintains its value after loan repayment. So, it is important to choose wisely and if you do need to borrow to buy a car, then do yourself a favor—look for a loan with low or no interest.
Similarly, there are a few instances where debt cannot be classified as good or bad. For example, borrowing to pay off debt (debt consolidation) and borrowing to invest are both types of debt that can be good or beneficial for some, yet not for others. Here, whether a debt is good or bad depends on what you can realistically afford and how it will affect your financial health.
Overall, it is important to know the difference as a prospective home buyer in order to be in the best financial situation when applying for a home loan. In general, good debt has the potential to increase your net worth or significantly enhance your life. In contrast, bad debts are costly short-term fixes and do not improve your financial future. Therefore, knowing what constitutes as good or bad debt is definitely in your best interest.
That said, the easiest way to focus on good debt and avoid accumulating bad debt might be as simple as asking yourself, when making a purchase that increases your debt, how will this purchase benefit you – not just today, but long term. Is the debt you will incur going to provide you a lasting benefit, or is it something that will satisfy an immediate desire that you cannot afford? These questions will help you make wise choices.
You should also have an emergency fund for unexpected expenses, so you do not have to use credit cards to pay them. Focusing on paying off the debt you have, restricting new or large purchases, being mindful of how much you borrow, and paying your bills on time every time are all vital as well.
Lastly, when it comes to your mortgage, remember a home is an asset, and having a mortgage debt of $300,000+ means that you now have an asset worth close to the same amount. Ultimately, owning a home has the potential to grow wealth over time, and returns on real estate can still put you way ahead. Thus, by properly managing your good debt and keeping your bad debt low as possible, you can be in the best position financially and can make purchases that benefit you in the long term.
Do you have questions about home loans or need assistance securing financing for a home purchase? If so, Sammamish Mortgage can help. We are a local mortgage company from Bellevue, Washington, serving the entire state, as well as Oregon, Idaho, and Colorado. We offer many mortgage programs to buyers all over the Pacific Northwest and have been doing so since 1992. Contact us today with any questions you have about mortgages.