Understanding Debt: Good Debt vs. Bad Debt

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There are certain words that are associated with negativity for so long that we fail to see the positive side to them. One of those words is debt. Growing up and acquiring limited knowledge of finance the term debt has often been connected to poverty and misfortune that we avoid. Those who have taken debts mostly use it on the wrong things which strengthen the narrative of debts being evil.

Debts are a necessary part of an adult’s financial life as it enables people to make huge purchases when they don’t have the full amount needed such as a house or a television. In this article we will focus on good debts and bad debts as a way to understand how to make better financial decisions.

Good debt

The words good debt sounds impossible but it does exist. A good debt is one that positively affects your net worth by increasing it. Your net worth refers to the number of assets you own minus the values of outstanding liabilities you owe which could be a secured debt like a mortgage or unsecured such as personal loans.

It can also be summarized as non-financial assets plus net financial assets. Items such as homes and cars are factored in your net worth and for the deceased are used to value their estate when in probate. A good debt is synonymous with the quote it takes money to make money because by getting the money and investing, you can pay it back and receive a sizable profit from it.

Some examples of good debts are:

  • Owning/ starting a small business

If there is something a majority of the world’s population wants, it’s to be rich. This dream can come true through employment but it is harder especially with a minimum wage job that does not leave you much to save.

The other way is to start your own business or company. Working on your on terms on something you value will increase your motivation and drive to work harder. However, getting small business loans is usually harder because they are a risky investment for the lender. Statistically, about 33% of small businesses die within the first two years due to the rough economic climate.

This should not deter you from your goal but motivate you to work harder; challenges make the journey more interesting.

  • Investing in education
Image: George Dolgikh

Investing in a person, even your self is a tough decision that shouldn’t be made lightly. Many have undertaken the road for either pride or passion and lived to see it all crash and burn in their faces with debts the size of Mount Everest on their back. Wanting to advance in your education is an achievable dream but colleges are expensive.

The courses you sign up for today, will decide your financial standing tomorrow which is why you should pick one that guarantees a well-paying career. Certain fields offer a better deal for your future such as careers in the STEM field. A career in music and other literary courses might sound attractive and even garner support from friends and family but your finances will not show the same.

You can also go to trade schools which are cheaper and the earnings will be worth it. There are plumbers who make up to 100k a year and teachers who make 30k.  The decision to take on student loans is left in the hands of young adults who have not experienced the world so they focus on what they love without thinking of the financial impact they will face for years.

Your passion and talents is a wonderful thing to have but financially, you should pick a course that will give you a stable life. Today you will hate the idea; tomorrow you will appreciate your sacrifice.

  • Real estate/ mortgages

A mortgage is one of the best debts to have because it serves you more than any other. First it gives you a home to live in with the eventual goal of owning it so you can simply set up and continue.

Second is that by buying a home in certain places it’s advantageous as the prices go up to a point where they double what you paid. This is a rewarding profit that simply cannot be ignored. You can buy a home and rent it out for a couple of decades or less, then as the real estate market is booming you sell.

  • Home equity loans

These are a branch of mortgages where you get a low-interest loan with your house as the collateral. They are used to make home improvements that will eventually raise the property value. While getting these loans is helpful, you have to keep up with the payments or you could lose your home.

Bad debt

With a clear understanding of good debts you could easily predict what a bad debt is. They are debts which lower your net worth by dropping in value from the moment you buy them. Bad debts are associated with wants because you can live without them or use a cheaper version but you buy them because you want to own them.

Examples of bad debts are:

Image: Karolina Grabowska

These are short-term loans with high interest rates that people often take in times of a crisis. They an unsecured type of loan because they do not need collateral and have no consideration on your ability to pay instead they are given depending on your income. Payday loans might sound attractive when you are in need but they are a debt trap that is hard to escape. It is better to look at all the other alternatives and have it as the last alternative.

  • Automobile loans

Cars are a way to gain more freedom of movement without your personal space being invaded in cramped spaces. They are a valid investment if you truly have a need for, example, to get to work or for work if you are a delivery driver or Uber.

In the case of necessity you should avoid buying a new car because their value drops as soon as they drive out of the lot. It’s better to buy a used car that is in great condition or a cheaper model. People purchase cars that they cannot afford just to boast about having an expensive car however; those around you really don’t care. You will be the topic today and forgotten tomorrow.

  • Credit cards

Credit cards are used by a large percent of the population. The idea of all your money tucked safely into one card that is easily swiped is attractive and the rewards offered seal the deal. It is all well and good until you realize you have to pay for the privilege of owning the card.

They also have high interest rates as compared to the consumer loan. You should avoid having credit card balances because the card interest offsets the value of potential rewards. It is also easy to land in credit card debt due to overspending. Don’t swipe your way to homelessness and being buried beneath debts.

  • Clothes
Clothes, shopping
Image: Gustavo Fring 

Clothes are a necessity in our day-to-day lives but we often take it to an unnecessary step. Designer branded clothes offer the same value in your life are regular clothes. As long as you present yourself neatly you shouldn’t spend so much money to buy what you don’t need.

With the recent focus on fast fashion and trends, people purchase clothes to wear once then dispose of them. Aliexpress is one of the cheapest online retailers that mass produce fast fashion clothes made with cheap fabric for a short-term wear. With the clothes being inexpensive, they are purchased faster than other long-lasting brands that cost more. The 1 dollar price tag yields hundreds of thousands in sales as long as the item is trending at the moment. Thrifting is a way you can get unique clothes that last long.

Bottom line

Taking a loan is not bad as long as you spend the money wisely. Making the right decision in how you spend the money acquired through debts will guarantee years of financial security.

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