Generally speaking, debt is something you want to avoid when it comes to your financial life. Debt can take a toll on your finances because you are forced to divert some of your cash to pay the interest and principal on that debt.
However, not all debt is created equal. Used well, some debt can act as positive leverage to help you earn more than what you pay on debt. Here is a brief overview of the different types of debt and which are considered “good” versus “bad”.
Last updated: October 12, 2021
Best: Mortgage Debt
The general rule of thumb when it comes to debt is that the “best” types are those used to buy appreciating assets, such as houses. So while it can be alarming to borrow hundreds of thousands of dollars to buy your primary residence, you shouldn’t necessarily be stressed out with massive debt. Theoretically, the value of your home will appreciate over time, so borrowing to buy a home actually leverages the investment in your favor.
Worse: credit card debt
One of the worst types of debt you can have is credit card debt. Typically, people with credit card debt simply spend too much, often on consumer goods. Regularly going over budget not only burdens you with unnecessary debt, but also prevents you from spending that money on savings and investments. Worse yet, most credit cards charge double-digit interest rates, which means your debt can quickly spiral out of control even if you stop overspending. High debt levels also hurt your credit score, making it harder to qualify for low rates on everything from mortgages to auto loans.
To start: 25 ways to save yourself from debt
Best: Student loan
This topic has become controversial in recent years, but the fact remains that those with a college or university degree earn significantly more over the course of their lives than those with only a high school diploma. Taking out a student loan for this degree will create financial hardship as you are just starting out in life, but over time you will likely end up earning more than enough to pay off that loan. This is especially true if you are using this loan to earn a degree in a high paying field, such as engineering, medicine, or law.
To verify: How much debt Americans have at each age
Worse: payday loans
A payday loan is one of the worst types of loans you can get. While these loans are easy to obtain and can be tempting in times of need, the interest rates are sky-high. It is not uncommon for a payday lender to charge triple-digit rates of 100% or more. Using the power of compounding, that means your debt will be multiplied by a factor of about 2.6 in one year and 6.8 in two years. In other words, if you borrow $ 1,000 at 100% interest, you will owe over $ 6,800 in just two years if you don’t make any payments. This is an extreme example, but it aims to highlight how bad a payday loan is.
Best: Investment Debt
Investment debt, when properly used, can be a good thing. Even though you still have to pay interest, if you use the amount you borrow to buy good investments that exceed your interest costs, you will be on the positive side. An example would be purchasing a rental property that earns more income than the cost of your interest and principal. While there are risks with any investment, borrowing money to buy assets that may rise in value can be a smart use of debt.
Worse: vacation debt
If you take on debt to fund things you should be saving for, like a vacation, it’s a path to financial ruin. Everyone wants to take a vacation, but you should save for that vacation first and pay for it in cash rather than borrowing. This is the type of consumer debt that is extremely difficult to get rid of, and more often than not it ends up costing your vacation twice as much as if you had just saved up for it rather than borrowing for it. finance.