Debt is the amount of money one party owes another. Money is borrowed to purchase goods or services that an individual could otherwise not afford at the moment. The loan is taken out with the promise to repay the funds with interest in the future.
This definition makes it seem like debt is neither good nor bad. A closer look at the concept of debt, however, can reveal that it can have positive or negative consequences, which depends on how the borrowed money is used.
Good debts
Good debts create value and help increase net worth. Good debts include housing loans, real estate loans, education loans and business loans. All of these have the potential to generate income over time.
- Housing loan
Not many people can afford to pay for a house with cash. With a housing loan, one can pay for a home through relatively low monthly payments over a long period. Usually, this type of debt has a lower interest rate than other loans.
In an ideal situation, the market value of the house will increase enough to cover the interest being paid on the loan. Apart from the low interest rates, the interest on housing loans is typically tax deductible.
- Real estate loan
Similar to the market value of a house, the value of a commercial property has the potential to increase over the years. Both residential and commercial real estate can also be a source of rental income. In this sense, real estate loans can be considered as investments.
- Education loan
Education boosts earning capacity. A good education results in more employment opportunities and gives an individual a better chance at taking a shot at these chances. Moreover, this type of loan typically has an easy repayment method and low interest rate.
- Business loan
Business is another income-generating endeavour. With a successful business venture, one does not have to rely on another party for a paycheque.
Being the head of one’s own business can be a motivation to work harder. However, capital is needed to jumpstart a business. Since it has the potential to build wealth, a business loan can be considered a good debt.
Bad debts
Conversely, bad debts are those that are used to purchase goods and services that have no potential to increase one’s net worth.
- Credit card and store card debts
Credit cards are usually used to purchase disposable items that easily lose value over time. The same goes for store cards.
If the balance is not paid in full, the amount being paid for the items increases due to the high interest rates, even while the market value of the items goes down.
- Car loan
Vehicles are liabilities and not assets. In general, vehicles are depreciating items. This means that they lose their value over time.
Car loans, however, may also be considered good debt if the vehicle is used for income-generating purposes such as a business.
Armed with this understanding of good and bad debts, it is time to examine one’s debt and determine which type it is in order to better manage one’s finances.
This article first appeared in The New Savvy
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