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Good and Bad Debt: Understanding the Difference

good and bad debt

If you’re considering taking on debt, there’s a lot to think about. When will I be able to start paying this loan/credit card off? Can I afford this debt? Will my income or assets change in the future? How will it impact my credit?What will I gain if I put off paying until later? What will I gain if I pay early?

The decision to take on any debt can be complex. To further complicate things, you may have heard the terms good and bad debt. What does that even mean?

Understanding the Difference

If you’ve ever been in the position of owing money, you know it can be stressful. Especially if you’re not able to pay them quickly. But what if you entered a loan knowing that while you made the minimum monthly payments, that debt might actually work for you, enhancing your future income? The stress may lessen, and while you know you’re ultimately responsible for paying the debt, you also know that it could benefit you.

Some Debt Can Serve a Purpose

A “good debt” can typically be defined as money owed for things that can help build wealth or increase your income over time. Examples may include (but not always) student loans, a viable business startup loan, or a property that’s likely to appreciate in value.

“Bad debt,” as you may already have experienced, is debt that doesn’t benefit you or improve your financial outcome. From impulse buys to automobile loans we can’t afford or spending too much on entertainment. The results of bad debt typically leave us with more bills than income to pay them with.

Of course, there are not always black and white answers when it comes to debt. Some debts fall into a bit of a grey area. For example, a vehicle that gets you to a well-paying job is definitely an asset worth going into debt for, but not if you’re opting for an expensive car with all the bells and whistles and a price tag to match. Since vehicles very rarely gain value, a high monthly car payment can be bad debt, even if the car addresses the necessity of having transportation to and from your job.

Be Honest With Yourself

It can be easy convince yourself that a bad debt is actually good. It’s much easier to look at someone else’s set of circumstances and determine whether the debt is wise. So when it comes to your own decisions it can be a good idea to run financial decisions past someone you trust if debt is an ongoing struggle.

It’s a good rule of thumb to never accrue more debt than you can pay back comfortably in a short period of time, and to keep your total debt of no more than 38% of your income for a healthy debt to income ratio.

At the end of the day, it’s important to recognize that you don’t have to fear debt, but you do need to be careful with it. Whether it’s borrowing for your education, a home, or starting a new business, determining good and bad debt is an important part of a healthy financial future.

The team at CESI is committed to helping you make wise financial decisions and to helping you understand how to get out, and stay out of debt.  For a free debt analysis, contact us and find out how we can help.

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