Many people view debt as something to avoid, yet the average American household has about $101,915 in debt. The key is not to refrain from taking on debts entirely but to learn to differentiate between good debt and bad debt. Good debts can help you build wealth and meet your goals. They are an investment into your future. You get something valuable in return for taking on the debt. On the other hand, bad debts are high-cost and high-risk.
What Is Good Debt?
Good debt has long-term financial benefits. It provides financial returns, even if it takes time to return money to your wallet. Smart debt also carries low interest rates, making it more affordable. In short, the advantages outweigh the costs.
Home Mortgages
A typical example of good debt is your home mortgage. This type of loan is considered good because mortgages typically have low interest rates, and owning real estate is a way to build wealth. Plus, as you make payments and build some equity, you can use it as collateral to take out a home equity loan or line of credit. Homeowners can use this money to make home improvements, pay for college or a large purchase, or pay off high-interest debts. Mortgage terms vary, so know what to expect and how to choose your mortgage lender to get the best deal.
Education Loans
Education is also generally a safe investment. Despite the rising costs of higher education, those who graduate with a degree have a better chance of landing a high-paying job. Taking out student loans is a way to invest in your future and drastically increase your earning potential.
Small Business Debt
Starting a business generally requires a significant financial investment to get it going, but once established, that business can provide you with a steady source of income. Remember to explore tax deductions for qualified business expenses to save money and help you pay off your business loan faster.
What Is Bad Debt?
Bad debts are generally those acquired to make purchases that depreciate in value. They end up taking money away from you. Bad debt is also any debt that you can’t afford. If you have trouble making on-time payments, you may find yourself racking up expensive fees and penalties, which increases your debt and lowers your credit score. If you’ve already made some money mistakes, you can explore debt management options to pay down bad debts quickly.
Credit Card Debt
High-interest credit card debt is the perfect example of bad debt. Most purchases are for everyday expenses and various goods and services that don’t offer a return on investment, like real estate or education. Further, if you have a high credit utilization or fail to make your payments, your credit will take a hit.
If you plan to use a credit card, pay close attention to the interest rate. Pay off your balance quickly to avoid racking up more debt in accumulated interest. You can also get more value out of your card by choosing one that offers perks, like cashback on purchases or travel miles.
High-Interest Personal Loans
Taking out a personal loan to fund a non-essential purchase like a vacation, a new wardrobe, or a wedding can quickly become more expensive than you originally anticipated. You end up paying more than the item’s value, interest and fees.
Payday Loans
Payday loans are often expensive, with high fees and interest rates that can keep you locked in a cycle of debt that’s difficult to escape. These loans are generally for small amounts and targeted at people needing immediate emergency expense funds. Most payday loan terms use your next paycheck to repay the debt. Borrowers can choose to extend the length of the loan for a fee. The extravagant interest rates and fees can quickly balloon the debt owed to two or three times the original amount. Most states cap lender fees at $30 per $100 borrowed in an attempt to limit these predatory terms.
Auto Loans and Car Title Loans
The value of a new car begins to depreciate as soon as you leave the dealership, which is why most auto loans are considered bad debt. Even if you sell your vehicle in a few years, you won’t make nearly the amount you paid for it. That said, an auto loan is sometimes necessary and can be considered good if the terms are favorable and the access to transportation helps you secure a well-paying job.
Car title loans are another type of debt to watch out for. These loans use your car as collateral, so if you fail to repay the loan as promised, the lender can take ownership of your vehicle. As with all types, you must make sure you can afford the debt and that the risks are worthwhile before accepting any credit offered.
Before you take on any kind of new debt, consider if it will increase your net worth or detract from it. Weight the pros and cons carefully and factor in your budget and ability to repay the debt. When you have a deeper understanding of the different types of debts, you can make better financial decisions that help you grow wealth and work toward a more secure financial future.
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