The average American is $90,460 in debt. While that number may sound alarming, you must remember that it includes all kinds of debt—good and bad.
Some types of debt you should avoid at all costs, but others can actually put you ahead in life. The key is knowing how to tell the difference between them.
So let’s break down good debt first and then go over what constitutes bad debt so you can have a better grasp of both.
What is Good Debt?
Good debt is debt that generates future value. That’s why it’s often referred to as leverage. Think of it as a form of investment that pays for itself with time.
Here are some examples:
Business loans allow you to grow and scale a business. For example, if you get a Small Business Administration (SBA) loan for $10,000 and invest it in automation technology, you could recoup the $10,000 in operational cost savings while permanently increasing your business’s efficiency. So even though it requires you to go into debt for a time, a business loan can be well worth it in the long run.
Plus, growing your own business is one of the best ways to increase your personal wealth. That small business loan can make all the difference between a life with financial freedom and one without.
Taking out a mortgage can be another great form of debt. A mortgage allows you to own real estate, which can then generate value in many ways.
For one, real estate tends to appreciate over time. So if you ever move, you can sell the house for a nice profit. Or you can rent the property out to earn rental income and take advantage of unique tax benefits. There are tons of ways to make money with real estate.
But as with any investment, you need to do your due diligence to make sure a piece of property is worth going into debt over. The property should have a good rate of return and provide decent cash flow.
Going into debt for education can also be a good investment. People with a bachelor’s degree tend to earn $1.2 million more in their lifetime than their counterparts with only a high school degree. And having any type of degree makes it easier to find a job.
That said, you still need to ensure the amount of student debt is appropriate for the education type. The average federal student debt balance is $37,113. If you use that amount of debt to earn a degree in a high-paying field like STEM (science, technology, engineering, mathematics), then you’ll probably pay off the debt within a few years.
However, taking on that much debt to get a humanities degree is a different story. Humanities and other low-paying fields can be rewarding, but you shouldn’t go into that much debt for them since they have less earning potential.
What is Bad Debt?
Now let’s go over what constitutes bad debt. Bad debt is anything that provides no return on investment. Think material things that depreciate in value over time or that you just consume. They are things that cost money but don’t generate lasting value.
Here are some examples:
Credit card debt
Credit card debt is the most common form of bad debt. US families have an average credit card debt of $6,270, which is way too high.
Using a credit card is convenient and helps you build good credit, but you should only use one if you can pay off your credit balance on time every month. Otherwise, you’ll incur steep interest fees of up to 36% APR!
Falling behind on your payments gets expensive fast. So when it comes to unessential consumer expenses like vacations, eating out, or a new TV, you’re better off only using credit if you’re sure you can pay it off quickly.
Payday loans are like credit cards but worse. Usually, people only resort to them when they are in desperate need of money. That’s why payday loan companies often prey on low-income earners. To earn money, they set astronomically high interest rates of up to 400% (when you account for all the fees).
You should avoid payday loans at all costs. They offer zero value except a way to get quick cash. If you really need the cash, try to borrow money from a family member or a friend first.
Auto loans are another form of bad debt. That’s because a new car loses about 20% of its value as soon as you drive it off the lot. But you still end up paying premiums and interest on the original price.
It’s best to buy a car in cash or at least get an auto loan with zero to low interest. That way, you’re not stuck with a liability that only depreciates over time.
The exceptions to this rule are if you buy a collectible car (which can appreciate in value) or you need the car to commute to work. In those cases, the auto loan debt could be worth it because it helps you generate income or future value.
Ultimately, what makes debt good or bad is whether or not it helps you reach a better financial position. If the debt leaves you financially worse off than you were before, then it’s bad debt. If it leaves you better off than you were before, then it’s good debt. Simple as that.
Taking on only the right debt can help you fulfill your goals and ambitions. It allows you to escape living paycheck to paycheck and avoid financial crises like bankruptcy and instead become financially independent.
But that doesn’t mean staying out of bad debt is easy. To stay on the right track, monitor your debt-to-income (DTI) ratio by dividing your monthly expenses by your monthly pre-tax income. Anything over 43% is a red flag for lenders, so you want to stay well below that to be considered financially stable.
You can also set a budget that separates your expenses into wants and needs. Or use a balance sheet to keep track of your assets and liabilities. Whatever you do, don’t over leverage yourself and stay conservative in how much consumer debt you take on at any given time.