Good Debt vs. Bad Debt
“I thought all debt was bad?” - a very common misconception. There is a difference between “good debt” and “bad debt”. Debt is often used as a financial tool that allows individuals and businesses to borrow money to achieve financial goals. Let’s uncover the differences between good and bad debt because understanding where they differ can help you make better financial decisions and avoid unnecessary financial stress.
Put simply, good debt is debt that will increase in value or has the potential to generate income. For example, a student loan, a mortgage, or a business loan could be seen as examples of good debt. That is because these types of debt are seen as an investment into your financial future.
Why are student loans a good form of debt? Obtaining a post-secondary education of some sort will increase your earning potential and the probability of acquiring a high paying job. Although it may seem like a large investment, the long-term benefits of earning a degree or specializing in a trade will often outweigh the cost of borrowing.
Similarly, a mortgage is considered good debt because it allows you to invest in a home, which is likely to increase in value over time. Homeownership can also provide a stable living environment and the ability to build equity. While a mortgage may involve a large initial investment, it can lead to significant long-term financial benefits. Think about it this way, over the course of twenty years, your options are to spend your rent money and never see it again or you could be putting that money toward owning the property that will likely increase in value. It’s a no-brainer right?
Business loans are another type of good debt. By borrowing money to start or expand a business, entrepreneurs can create new opportunities for income and growth. While there are always risks associated with starting a business, taking out a loan can provide the financial support needed to achieve long-term success. The ultimate point of starting a business is to make a profit and that is seen as an investment.
In contrast, bad debt is any debt that is used to finance purchases that will most likely decrease in value or will not generate an income or profit. Examples of bad debt include credit card debt, car loans, and payday loans. These types of debt are often associated with high-interest rates and can quickly spiral out of control, leading to financial distress.
Credit card debt is one of the most common types of bad debt. Credit cards often come with high-interest rates, and many individuals use them to finance non-essential purchases, such as vacations or shopping sprees. While
it may be convenient to use a credit card for these types of purchases, it can quickly lead to a cycle of debt that is difficult to break.
Car loans are another form of bad debt. While it may be necessary to borrow money to purchase a vehicle, cars typically decrease in value over time, making it difficult to recoup the initial investment. Additionally, car loans often come with high-interest rates & payments, which can add up over time and lead to financial stress. It’s a good idea to buy a car that is within your budget.
Payday loans are perhaps the most dangerous type of bad debt. These loans often come with exorbitant interest rates and are designed to prey on individuals who are in desperate need of cash. While payday loans may provide a short-term solution to a financial problem, the repayment plans make it hard to get ahead & pay off your initial borrowings.
How is my debt considered when looking to qualify for a mortgage?
When applying for a mortgage, the lender will always look at your credit history & debts. Your debt balances are added to your application and are calculated differently depending on the type of debt. The calculation rules also vary between lenders, but here are some general guidelines:
Credit Cards = 3% of balance
Unsecured Personal Line of Credits = 3% of balance
Personal Loans & Vehicle Loans = Total monthly payment
Student Loans not in repayment = 1 to 3% of balance
Student Loans in repayment = Total monthly payment
Secured Line of Credit (HELOC) = Balance amortized over a 25 year period
Other mortgages = Total Principal & Interest payment
In general, it is important to avoid bad debt whenever possible. Credit cards can be a slippery slope, especially in this day and age where consumerism is glorified. Instead, focus on building good debt that can help you achieve long-term financial goals and improve your overall financial health. One of the keys to managing debt effectively is to create a budget and stick to it. By tracking your expenses and prioritizing your financial goals, you can make informed decisions about when and how to borrow money.
Additionally, it is important to educate yourself about the terms and conditions of any loans or credit cards you are considering, and to avoid borrowing more than you can realistically afford to repay.
Good debt and bad debt are two very different financial tools that can have a significant impact on your overall financial health. While good debt can help you achieve long-term financial goals and improve your overall financial health, bad debt can quickly lead to financial stress and hardship. It's important to carefully consider the purpose of any debt, the interest rates, and your ability to repay the debt before taking on any financial obligations. By focusing on building good debt and avoiding bad debt, individuals and businesses can work towards a more secure financial future. Remember, debt can be a tool, but it's important to use it wisely.
Regardless of your debt history, there are different mortgage strategies we can explore in order to still get you pre-approved for a mortgage at a reasonable rate. Book a call with me today and let's see what we can do.