What is Healthy Debt? Understanding Good vs. Bad Debt for a Stronger Financial Future

Debt may be a word that almost no one likes, but its one many know well. The average American adult owes nearly $102,000, according to a recent Experian consumer debt study. 1.

That number may give you sticker shock. But remember that debt isnt always high interest or fast multiplying or what people classify as “bad debt. ” In fact, certain kinds of loans are recognized by some as “good debt. When it comes to mortgages, good debt is viewed as a means of securing your financial future and realizing a portion of the American dream.

Here’s how to identify bad debt from good debt and how to reduce any bad debt you may already have.

Debt. It’s a four-letter word that sends shivers down the spines of many, conjuring images of financial hardship and endless payments. But not all debt is created equal. In the realm of personal finance, there exists a fascinating dichotomy: good debt vs. bad debt. Understanding this distinction is crucial for navigating the complex world of borrowing and building a healthy financial future.

Good Debt: Your Ally on the Path to Prosperity

Good debt, in essence, is debt that works for you. It’s the kind of borrowing that helps you increase your net worth, generate future income, or invest in assets that appreciate over time. Think of it as a strategic tool that, when used wisely, can propel you towards your financial goals.

Here are some examples of good debt:

Education loans: While student loans may seem like a burden in the short term, they can be considered good debt because they invest in your future earning potential. A college degree can open doors to higher-paying jobs and increased career opportunities, leading to a significant return on your investment.
Mortgages: Homeownership is often seen as a cornerstone of the American dream, and mortgages play a key role in making it a reality. By borrowing money to purchase a home, you’re not only acquiring a valuable asset but also building equity over time. As the value of your home appreciates, you’re essentially paying down the loan with an appreciating asset.
Small business loans: For aspiring entrepreneurs, small business loans can be the fuel that ignites their dreams. By leveraging borrowed funds, you can invest in your business, expand operations, and potentially generate significant income.
Investing in appreciating assets: Borrowing money to invest in assets like stocks, bonds, or real estate can be considered good debt, provided you do your research and make informed investment decisions. The potential for growth and appreciation of these assets can outweigh the cost of borrowing.

Key characteristics of good debt:

Low interest rates: Good debt typically comes with lower interest rates, making it easier to manage repayments and maximize your financial gains.
Investing in assets: The borrowed funds are used to acquire assets that have the potential to increase in value or generate future income.
Long repayment terms: Good debt often comes with longer repayment periods, allowing you to spread out the cost and make manageable monthly payments.

Bad Debt: The Silent Drain on Your Financial Well-being

Bad debt, on the other hand, is the kind that weighs you down. It’s debt that weighs down your budget and general financial well-being because it doesn’t advance your finances and frequently has exorbitant interest rates.

Here are some examples of bad debt:

Credit card debt: Credit cards offer convenience and rewards, but they can also be a slippery slope to high-interest debt. Carrying a balance on your credit card can lead to significant interest charges, trapping you in a cycle of debt.
Payday loans: These short-term, high-interest loans are designed to tide you over until your next paycheck, but they often come with exorbitant fees and interest rates that can quickly spiral out of control.
Title loans: Similar to payday loans, title loans offer quick cash in exchange for the title to your car. However, the high interest rates and short repayment terms can lead to losing your vehicle if you’re unable to repay the loan.
Cash advances: Cash advances from credit cards or other lenders may seem like a quick fix, but they come with high fees and interest rates that can make them an expensive way to borrow money.

Key characteristics of bad debt:

High interest rates: Bad debt typically carries high interest rates, making it difficult to pay off and significantly increasing the overall cost of borrowing.
No asset accumulation: The borrowed funds are used for consumption or non-appreciating assets, offering no long-term financial benefit.
Short repayment terms: Bad debt often comes with short repayment periods, making it difficult to manage monthly payments and potentially leading to late fees and penalties.

Making Wise Choices: Navigating the Debt Landscape

Understanding the difference between good and bad debt is the first step towards making smart borrowing decisions. By carefully analyzing your financial goals and needs you can determine whether debt is a viable option and choose the type of debt that aligns with your long-term financial well-being.

Here are some tips for managing debt wisely:

Create a budget and track your spending: Before taking on any debt, it’s crucial to have a clear understanding of your income and expenses. Creating a budget and tracking your spending can help you identify areas where you can cut back and free up funds for debt repayment.
Prioritize high-interest debt: If you have multiple debts, focus on paying off those with the highest interest rates first. This will save you money in the long run and help you get out of debt faster.
Consider debt consolidation: If you’re struggling to manage multiple debts, consolidating them into one loan with a lower interest rate can simplify your payments and potentially save you money.
Seek professional advice: If you’re unsure about your debt situation or need help creating a repayment plan, consider seeking guidance from a financial advisor or credit counselor.

Debt, when used responsibly, can be a powerful tool for building wealth and achieving your financial goals. By understanding the difference between good and bad debt, making informed borrowing decisions, and managing your debt effectively, you can transform debt from a burden into an ally on your path to financial success Remember, the key is to be strategic, responsible, and always keep your long-term financial well-being in mind

Examples of good debt

Education Taking on debt to pay for education is typically regarded as “good debt” because more education can increase your future income, even though student loans can be a financial burden. The average college graduate makes $30,000 a year, or $579 more per week, than a high school graduate. 2 College grads also have a lower rate of unemployment, according to the US Bureau of Labor Statistics. 3 That leads to almost double average lifetime earnings, according to the Brookings Institute. 4 Thats why some consider student loans an investment in your future.

It’s crucial to remember that in order for student loan debt to be deemed “good,” it needs to fulfill a few requirements:

Low interest rates. Reduced interest rates on student loans facilitate their future repayment. These types of interest rates are common on federal student loans, but they are not on all private student loans. Make sure you thoroughly consider the terms of any student loan debt you incur.
Helps your short-term and long-term career prospects. It can be helpful to consider your student debt in the context of your future financial situation to have even a ballpark idea of what your income might be after graduation and throughout your career. For example, it might not be wise to take on large, higher-interest student loans to pay for a degree that might only result in a salary that is comparable to what you could already make. In some situations, knowing if you could be eligible for government or employer-sponsored loan repayment programs can help you make an informed choice.

Have student loans and wondering how to pay them off? Visit Fidelitys student debt tool.

Home or real estate Mortgages are a type of loan used to buy a house or real estate. They have historically been regarded as one of the safest types of debt since they often have lower interest rates and can assist you in gradually accumulating equity—imagine gradually becoming the owner of your home.

The equity Americans can build in their home is important for a few reasons:

Home equity is the biggest asset most Americans have. According to the US Census Bureau, nearly two-thirds of Americans own equity in a home, with the median value of that equity being $174,000. 5.
Homes may appreciate, or gain, in value. Since 2019 January, home prices have increased by an average of 298 percent or 204%. 4% annually, according to the Federal Housing Finance Agency. 6 However, just like with any investment, past performance does not guarantee future results, and the value of your house could drop to less than what you owe on a mortgage.
You can take out a home equity loan or home equity line of credit (HELOC) to borrow against the equity you’ve built if necessary.

Before signing anything, make sure you’ve done your research, especially if it’s a mortgage, which can have a lot of moving parts. For example, you may be able to choose if your mortgage has a fixed or variable rate. There are significant trade-offs between fixed-rate and variable-rate mortgages. Variable-rate mortgages are more complicated and frequently have lower initial rates, but there is a chance that rates will rise. If you’re in the market, take a look at these six factors that every buyer should take into account when looking for a mortgage.

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“Good debt” can help you create income in the future or gradually raise your net worth.
“Bad debt” can have a high interest rate and does not contribute to an increase in net worth or future income.

Debt may be a word that almost no one likes, but its one many know well. The average American adult owes nearly $102,000, according to a recent Experian consumer debt study. 1.

Here’s how to identify bad debt from good debt and how to reduce any bad debt you may already have.

Feed your brain. Fund your future.

Is There Such a Thing as Good Debt?

FAQ

How much debt is healthy?

Ideally, financial experts like to see a DTI of no more than 15 to 20 percent of your net income. For example, a family with a $250 car payment and $100 of monthly credit card payments, and $2,500 net income per month would have a DTI of 14 percent ($350/$2,500 = 0.14 or 14%).

What are examples of good debt?

Examples of good debt are taking out a mortgage, buying things that save you time and money, buying essential items, investing in yourself by borrowing for more education or to consolidate debt. Each may put you in a hole initially, but you’ll be better off in the long run for having borrowed the money.

What is a good debt to?

Your debt-to-income (DTI) ratio is how much money you earn versus what you spend. It’s calculated by dividing your monthly debts by your gross monthly income. Generally, it’s a good idea to keep your DTI ratio below 43%, though 35% or less is considered “good.”

How much debt is acceptable?

Debt-to-income ratio is your monthly debt obligations compared to your gross monthly income (before taxes), expressed as a percentage. A good debt-to-income ratio is less than or equal to 36%.

What is a healthy debt-to-income ratio?

A debt-to-income ratio under 35% is considered healthy. Keeping your debt-to-income ratio in this range ensures your monthly income can meet your debts. If your debt-to-income ratio is higher than that, then now’s a good time to plan repayment. Here are some generally healthy habits and best practices to establish with your debt:

Is medical debt a good or bad debt?

But too much of any kind of debt — no matter the opportunity it might create — can turn it into bad debt. Medical debt, for example, doesn’t neatly fall into the “good” or “bad” debt category. It’s an expense that’s largely uncontrollable and often doesn’t have an interest rate. You have a few ways to pay off medical bills.

Is debt good or bad?

If the debt you take on helps you generate income or build your net worth, then that can be considered “good.” Going into debt may be beneficial to your overall financial health in several types of scenarios, such as paying for an education, funding a business, or buying a home:

Is a debt ratio good or bad?

Understanding the debt ratio within a specific context can help analysts and investors determine a good investment from a bad one. While investors like debt ratios of .3 to .6, whether or not a ratio is good depends on contextual factors: a firm’s industry or current interest rates.