Good Debt vs. Bad Debt: Understanding the Difference and Making Informed Financial Choices
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By Bromwich+Smith Staff | 1400 words | Reading Time: 7 minutes | Last Update: 2024/03/06
Debt. Is it a good thing or a bad thing? So often it is frowned upon and we’re told to avoid it, however when used wisely, it can be a powerful tool for achieving financial goals and building wealth. In this blog post, we'll explore the concepts of good debt and bad debt and how they can impact your financial well-being. We'll also discuss how good debt can be used to your advantage and offer guidance on recognizing and managing bad debt effectively.
What Is Good Debt?
Good debt is typically associated with investments that have the potential to increase in value (appreciate) or generate income over time. Here are some examples of good debt:
Mortgage: Taking out a mortgage to buy a home is a common example of good debt. Homes often appreciate over time, and a mortgage can allow you to build equity in your property while providing a place to live.
Student Loans: Education is an investment in your future earning potential. Student loans are good debt when they enable you to acquire valuable skills and qualifications that lead to higher-paying job opportunities.
Small Business Loans: Starting or expanding a business often requires capital. Taking out a small business loan can be a strategic move, as it may lead to increased profits and long-term financial stability.
Real Estate Investments: Purchasing real estate properties, such as rental properties or commercial buildings, can generate rental income and appreciate. Loans used for real estate investments are typically considered good debt.
Why Is Good Debt Good?
Good debt is considered good for several reasons:
Asset Appreciation: Many forms of good debt are linked to assets that have the potential to increase in value over time. This means that your net worth (the value of everything you own minus how much you owe) can increase as the asset grows in value.
Income Generation: Some good debts, like business loans or real estate investments, can generate income, helping you cover your loan payments and generating you a profit.
Tax Deductions: Interest on certain types of good debt, such as mortgage and student loan interest, may be tax-deductible, reducing your overall tax liability.
Investment in Your Future: Good debt often represents an investment in your personal or professional growth, potentially leading to higher income and improved financial prospects.
How Can Good Debt Help Me?
Good debt can provide several advantages that can help you achieve your financial goals. By using good debt to invest you can increase your net worth over time. For example, a student loan and the additional schooling that comes with it provide the potential for career growth, which is expected to lead to higher earning potential. Real estate investments add variety to your investment portfolio and should reduce risk and increase your return. Good debt also showcases to potential credit lenders that you are able to pay back your debt and increases your creditworthiness.
Can Good Debt Go Bad?
All debt must be paid back, and one of the keys to keeping good debt good is to make sure it’s being paid off as agreed. Mortgages, student loans, or small business loans can turn into bad debt if you are not up to date on your payments.
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What is the risk of bad debt?
Bad debt, on the other hand, is generally associated with consumer debt, often acquired for non-essential purchases. In general, purchases made with bad debt will either have no or decreasing value. Bad debt can significantly impact your financial well-being, and understanding the consequences is crucial for making informed financial decisions. Here are the three most important things to know about bad debt:
1. Definition of Bad Debt:
Bad debt refers to borrowed money that doesn’t increase your net worth, without the resources to repay it. The higher the cost of borrowing, the worse the debt is.
Here are some common examples of bad debt:
Credit Card Debt: Credit cards are meant to be paid off every month, so they generally carry very high interest rates on their balances. This is a classic example of bad debt. Often, they are used to purchase non-essential items like frequent restaurant meals or extravagant gifts. However, even essential purchases like groceries and utilities could be subject to very high interest rates when paid by credit card.
Payday Loans: These short-term, high-interest loans carry even higher interest rates than credit cards. They often lead to a cycle of debt that is difficult to escape.
Personal Loans for Non-Essential Items: Borrowing money for vacations, entertainment, or other non-essential items can be bad debt.
Unmanageable Consumer Debt
Accumulating multiple loans and credit card debts that you struggle to repay is a sign that bad debt may be overwhelming you.
Bad debt becomes a problem when it hinders your ability to meet your financial obligations, leads to financial stress, or prevents you from achieving important financial goals. Bad debt will have a significant consequence on your credit score and your overall financial situation.
Consider the following:
Credit score. Missed payments on loans or bills will be reported to the credit bureaus and will make it more challenging to qualify for new credit. A lower credit score may put you at risk for higher interest rates.
Debt collection Your lenders may seek out collection agencies to pursue legal action to recover outstanding debt. This can result in additional stress, legal consequences and affect your financial situation further.
Long term consequences Outstanding bad debt can have longer lasting effects making it difficult to secure future credit, rent or own property, or even potentially obtain certain jobs.
It's important to address bad debt to avoid these consequences. Communicate early with your creditors if you are facing difficulties repaying your debt. Lenders may be willing to work with you to establish a payment plan or reduce interest for you to get back on track. Prioritize debt and seek advice from a professional if needed. If bad debt becomes overwhelming, consider seeking a Licensed Insolvency Trustee to learn more about your debt relief options .
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How do I Deal With Overwhelming Debt?
Recognizing and addressing overwhelming debt is an important step toward achieving financial stability. Here are some steps you can take to help with bad debt:
Create a Budget: Start by assessing your financial situation and creating a budget. This will help you understand your income, expenses, and how much you can allocate toward paying off debt. It is important to prioritize debt repayment if you are overwhelmed with debt.
Debt Repayment Plan: Develop a debt repayment plan that focuses on paying off your debt. You can use strategies like the debt snowball (start making extra payments on the smallest debt first and work up to the largest amounts) or debt avalanche (start making extra payments on the highest interest debt first) method.
Debt Consolidation Loan: A debt consolidation loan can help you combine multiple debts into one loan with a lower interest rate, making it easier to manage and pay off your debt. Qualification will depend on your current credit score, and your income to debt ratio.
Debt Relief Programs: You may want to consult with a Licensed Insolvency Trustee to explore options for managing overwhelming debt, including Consumer Proposal or Bankruptcy. A Consumer Proposal is often a strong option for those who are looking for debt relief. Through this program your Licensed Insolvency Trustee will negotiate your debt directly with your creditors, often reducing by up to 80% the total debt owed. You will then make monthly payments based on what you can afford to pay, not what your creditors are asking. You can take up to five years to repay, and once you have completed all the requirements the remainder of the debt will be forgiven. Bankruptcy is typically considered as a last resort and for some it is the best fresh financial start.
Financial Education: Invest in your financial education to make informed decisions about managing your money and avoiding bad debt in the future.
Understanding the difference between good debt and bad debt is a fundamental aspect of financial literacy. Good debt can be a valuable tool for building wealth and achieving your financial goals, while bad debt can lead to financial hardship and stress. By making informed decisions, managing your debt wisely, and seeking help when needed, you can maintain a healthy financial future and make debt work for you, rather than against you.
Bromwich+Smith has a number of debt relief strategies to help you regain control of your finances and get your life back on track. Reach out today for a free, confidential, no obligation consultation. Bromwich+Smith’s Debt Relief Specialists are available by phone at 1.855.884.9243, Live Chat or you can request a call back at contact us page. We want to see you flourish!