Generally speaking, debt is something you want to avoid when it comes to your financial life. Debt can act as a drag on your finances because you’re forced to divert some of your cash flow to paying interest and principal on that debt.
However, not all debt is created equal. Properly used, some debt can act as positive leverage to help you earn more than you’re paying on the debt. Here’s a quick overview of the varying types of debt and which ones are considered “good” vs. “bad.”
Best: Mortgage Debt
The general rule when it comes to debt is that the “best” types are those used to buy appreciating assets, like homes. So, although it can be alarming to borrow hundreds of thousands of dollars to buy your primary residence, you shouldn’t necessarily stress out about it in terms of having massive debt. Theoretically, the value of your home over time will appreciate, so borrowing to buy a home actually leverages the investment in your favor.
Worst: Credit Card Debt
One of the worst types of debt you can have is credit card debt. Typically, people with credit card debt are simply overspending, oftentimes on consumer goods. Exceeding your budget on a regular basis not only burdens you with unnecessary debt but also prevents you from spending that money on savings and investments. Even worse, most credit cards charge interest rates in the high double-digits, meaning your debt can rapidly 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.
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Best: Student Loan
This topic has become controversial in recent years, but the fact remains that those with a college or graduate school degree earn significantly more in their lifetimes than those with simply a high school diploma. Taking out a student loan to get that degree will create some financial hardship as you’re just starting out in life, but over time, you’ll likely end up earning more than enough to pay that loan back. This is particularly true if you use that loan to get a diploma in a high-earning field, such as engineering, medicine or law.
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Worst: Payday Loans
A payday loan is one of the worst types of loans you can get. Although these loans are easy to get and can be tempting in a time of need, the interest rates are beyond exorbitant. It’s not uncommon for a payday lender to charge triple-digit rates of 100% or more. With the power of compounding, this means your debt will multiply by a factor of about 2.6 in a single year and 6.8 in two years. In other words, if you borrow $1,000 at 100% interest, you’ll owe over $6,800 in just two years if you don’t make any payments. This is an extreme example, but it’s meant to point out just what a bad idea a payday loan is.
Best: Investment Debt
Investment debt, when properly used, can be a good thing. Although you still have to pay interest, if you use the amount you borrow to buy good investments that outearn your interest costs, you’ll be on the plus side. One example would be buying a rental property that pays more income than the cost of your interest and principal. Although there are risks with any investment, borrowing money to buy assets that can grow in value can be a smart use of debt.
Worst: Vacation Debt
If you’re going into debt to finance things you should be saving for instead, such as a vacation, that’s a path to financial ruin. Everyone wants to take a vacation, but you should save up for that vacation first and pay for it with cash rather than borrowing. This is the type of consumer debt that’s extremely hard to get rid of, and more often than not it ends up making your vacation cost twice as much than if you had simply saved up for it rather than borrowed to finance it.