An amount of money borrowed by one party from another – the basic definition of debt sounds neither good nor bad and leaves many wondering – how do I determine if taking on debt is worth the risk? Although the answer is not always crystal clear, most debts can be defined as either positive or negative for your overall financial situation.
The word “debt” carries a negative connotation and although largely justified, not all debt is bad, when used wisely it can actually be a catalyst for building wealth. Here are a few examples where taking on debt, with careful planning and in moderation, may be advantageous:
- Taking Out a Home Mortgage – the goal here is to build ownership in an appreciating asset that one day may provide a source of retirement money. A mortgage may also be the single biggest tax break available to you in the form of interest deduction.
- Funding Higher Education – in most cases, investing in your future through education is a good decision. Those with college or technical degrees tend to earn higher incomes than those without. Also, the interest paid on student loans is often tax-deductible.
- Small Business Loan – while potentially the riskiest of the “good debt” examples, a small business loan can provide the necessary capital to start or expand a business. For example, a business may need to expand its physical location, buy new equipment, or purchase more inventory; a small business loan can help fill these funding needs.
Even “good debts” can get out of hand if not used judiciously, but there are other debts that are just simply bad for your financial well-being. While good debt is considered an investment that will grow in value or generate long-term income, bad debt is just the opposite, a debt that is accrued to purchase things that generally depreciate in value and do not generate long-term income. Let’s take a look at some examples of debts that are potentially harmful to your financial goals:
- Credit Card Debt – when used for convenience or to earn rewards and not for borrowing, credit cards, when paid off each month, can be beneficial. However, two thirds of Americans are known as “revolvers”, meaning they don’t pay off their bills in full so the debt revolves. With the national average APR just north of 16%, it’s easy to see how outstanding credit card debt can lead to trouble.
- Luxury Items – these are things that we want rather than things we need, (jewelry, expensive clothes, vacations, etc.) thus resulting in bad debt. The rule of thumb here is, if you can’t pay cash for it, don’t buy it.
- Car Loans – the ultimate example of a depreciating asset, vehicles begin losing value as soon as they are purchased. While the majority of people need an automobile for everyday life, the way people go about it (buying more car than they need) is what creates the problem.
If you are having trouble differentiating between good and bad debt, try to think like an investor before increasing any debts. Will this purchase return a profit or help my long-term financial well-being? Waiting until you have adequate cash may be the solution if the answer is no.
Everyone’s financial situation is different and each individual views debt differently. Like many disciplines in financial planning, the topic of debt analysis cannot be tackled with a one size fits all approach, yet it should be handled on a personalized level.