Bad debt is the kind that’s usually taken primarily to pay for something that you can’t afford out of your income and savings. We might even think of it as being convenience related debt. You want to purchase something, but you’re not willing to save the money, so you turn to credit to make it happen.
Here are examples of both good debt and bad debt.
Examples of good debt
It’s important to understand that even good debt has its limits. Loans taken for any of these purposes in excess can actually turn into bad debt. But let’s go with the assumption that you incur the following debts in the right measure.
Student loans are generally considered to be good debt because they’re taken to enable you to enter a career that will provide you with an income for life. The basic idea is borrowing $100,000 to pay for an education that will provide you with a career that will generate several million dollars in income over the next 40 years. That’s the dream, anyway.
It’s good debt if the monthly payment will be a comfortable fit with the expected income after graduation. But as a lot of graduates (and non-graduates) know, it can quickly turn into bad debt if the desired career is insufficient to support the loan payment.
Taking a mortgage accomplishes two purposes that will help you to move forward in life. The first is that it will provide shelter for you and your family. The second is that it will enable you to build equity in your home, that will represent a very real wealth creation plan.
For example, since mortgages are self-amortizing, the loan will be repaid in no more than 30 years. At that point, you will have 100 percent equity in your home. You can then choose either live in the home mortgage-free, or sell it to help you with your retirement.
But mortgage debt can also turn into bad debt if not properly managed. Serial refinancing, especially to take cash out, is what is known as equity stripping. It can leave you with rising monthly payments, and very little equity even after living in the property for decades.
These are loans that you take to build or expand a business. Much like student loans, they have the potential to either create or increase your income. In that way, business loans tend to “pay for themselves”. They’re paid out of the (extra) income they generate.
An example would be taking a business loan with a monthly payment of $500, that will enable you to expand your business and generate an extra $1,000 per month in revenue. That’s one of the very best kinds of good debt.
We often think of cars as being consumer goods—like TVs and recreational vehicles—but they actually have a critical economic purpose. At a minimum, you need your car to get to work and back every day. That means that your car is a vital tool in the production of your income. That fact alone makes car loans good debt.
But perhaps more so than any other good debt on this list, car loans can easily turn into bad debt. That happens either when you can’t really afford the monthly payment (people are routinely approved for car loans they really can’t afford), or when you borrow more on a car than it’s actually worth. The term for that situation is being upside down, and it’s a real thing.
In certain situations, borrowing for medical purposes is absolutely necessary. The cost of healthcare is out in orbit, and even if you have health insurance, deductibles and coinsurance provisions can result in substantial out-of-pocket costs.
If you’re borrowing for a medically necessary procedure, particularly of the lifesaving variety, going into debt will be an absolute necessity.
Examples of bad debt
Bad debt is pretty easy to spot, but here are the most common examples:
These are everyone’s favorite whipping boy in the bad debt category, but it’s easy to see why. Credit cards are most often used as an extension of the paycheck. Whatever you can’t afford to pay out of your salary, is paid with the swipe of a plastic card.
Complicating credit card debt is the way the loans are structured. They are revolving debt, which makes it very easy to continue borrowing, even after making monthly payments. They also come with variable interest rates. That very affordable 9.9 percent APR you’re paying is probably an introductory offer. After that, the rate can go as high as 29.99 percent. At that point, it will be almost impossible to repay the loan.
As the saying goes, Once a Visa, always a Visa.
Related: How To Get Out Of Debt On Your Own: A DIY Guide
These loans are quite deceptive. Most people think of them as good debt, if only because they are secured by your retirement plan. But there’s more to 401(k) loans than most people assume. Here are some of the potential problems:
- 401(k) loans reduce the investment earnings on your plan.
- It’s a process of using your retirement plan for purposes other than retirement.
- If you leave your employer, you must repay the loan amount within 60 days. If not, the entire unpaid balance of the loan is considered an early distribution, subject to ordinary income tax and a 10 percent early withdrawal penalty if you are under age 59 ½.
- Like credit cards, repeated use of 401(k) loans has the potential to turn it into a revolving debt arrangement. You may have loans outstanding in your plan even once you reach retirement.
Payday loans are probably the best example of bad debt. They’re short-term loans with extremely high interest rates. They’re generally taken for no more than two weeks—your next payday—when they have to be repaid. Because of the interest rate structure, you may pay up to $30 on every $100 borrowed on each loan. On an annual basis, the interest rate on payday loans runs well into triple digits.
Because of the cycle of payday loans, being collected each payday, it’s very easy for the borrower to get caught in a borrowing cycle with no end. You’re unable to repay the loan out of salary alone, for all the same reasons you needed to borrow in the first place. Solution: another payday loan. It’s a no-win situation of the worst kind.
It’s often easy to spot good debts and bad debts. But always be aware of the reality that good debts can turn in the bad debts, if they’re taken for the wrong reasons or in excessive amounts.
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