When you take on debt, a lender gives you an amount of money, and you agree that you’ll pay it back, usually with interest. Having debt can impact your financial life in many ways from needing to make monthly payments to affecting your credit score, which raises the question – is all debt created equal?
The answer is no. Some debt is commonly considered “good” while others is looked upon less favorably. One way to distinguish between these two types is to look at what the debt does for you. Some forms of debt let you achieve your goals. Others keep you stuck in the past or create patterns of harmful financial behavior. Some debt isn’t as clear and, in some cases, a type of debt that many people consider “good” can turn“bad” if it keeps you from moving forward from a negative pattern or event in your life.
Learn more about good debt and bad debt and what you can do to help make sure you’re continually making progress toward your financial goals.
What is Good Debt?
Good debt is any debt that will put you one or more steps closer to achieving a goal, both in the short and long term. Usually, good debt allows you to purchase something that will increase in value over time or will produce revenue or income. Good debt can help you live a better life.
Two notable examples of good debt include student loans and mortgages.
During the 2017-2018 school year, the average annual cost to attend a four-year college ranged from $20,050 to $43,139, depending on whether a school was public or private, for-profit or non-profit. Even after saving up for years, many people don’t have $20,000 or more available to pay for a college education in cash each year.
The rising cost of a college education, combined with an increase in the number of students enrolling in post-secondary programs, has led to a rise in student loan debt in recent years. In 2019, the total student loan debt owed by households in the U.S. was $1.5 trillion, more than triple the amount of student loan debt in 2001.
How Much Does Student Loan Debt Cost?
Typically, the interest rates charged on student loans are lower than the interest rates you see on other forms of debt. In the case of federal student loans, the interest rate is fixed and will stay the same for the life of the loan. For federal student loans distributed after July 2019 and before July 2020, interest rates range from 4.53% to 7.08%.
What are the Advantages of Student Loans?
Student loans can help you get a leg up in life by allowing you to finish your degree. Although there are other financial aid sources available, such as scholarships, grants, and work-study, those sources are often not enough to cover the full cost of college.
The competition for scholarships can often be fierce, and grants may have certain restrictions based on family income levels and fields of study.
Work-study amounts are also usually limited and require you to work part-time while in school. Depending on the type of program you’re in, finding time to work while juggling your courseload can be challenging.
While student loan debt can be a financial burden, there are some advantages to different types of loans if you need to take them.
In the case of federal loans, there are annual limits on the amount you can borrow, which can help you avoid borrowing more than you can comfortably pay back later. Annual borrowing maximums range from $5,500 to $12,500, depending on how far along you are in school and whether you’re someone’s dependent or not.
Another advantage of student loans and one of the factors that makes them “good debt” is that they can help increase your earnings potential over time. The median weekly salary of a person with a high school diploma was $712 in 2017. The median weekly pay of a person with a bachelor’s (four-year) degree was $1,173 in 2017. Those with a master’s degree had median weekly salaries of $1,401.
Earning a college degree or higher can do more than lead to a higher income. It can also help you avoid unemployment. The unemployment rate for those with a high school diploma and no college degree was 4.06% in 2017. The unemployment rate for those with a bachelor’s degree was 2.5%, and the rate for those with a master’s degree was 2.2%.
There may also be tax benefits associated with paying down student loan debt that can help ease the financial burden. A qualified tax professional can answer questions you may have on this topic.
Keeping these factors in mind, especially if taking out student loans leads to higher income and better employment opportunities, you can see why student loan debt is usually considered a form of “good debt.”
In the U.S., the median sale price of a home in 2018 was $326,400. In the Northeastern part of the U.S., the median sale price was $484,600. The median price of homes makes it difficult, if not impossible, for the average person to save up and pay for a property using cash. Mortgages make homeownership an achievable goal for many people.
Since you use a mortgage to purchase property, and because property values tend to increase over time, people typically consider a mortgage a type of “good debt.” A few other factors make a home loan or mortgage a type of beneficial debt, such as the typically low cost of the loan and the advantages it offers.
How Much Do Mortgages Cost?
Like any other type of debt, you’ll pay interest when you take out a mortgage. But, the interest rates typically charged on home loans are often much lower than rates charged on other types of debt, such as credit card debt or personal loans.
The interest rate you pay on a mortgage depends on a variety of factors. Some of those factors are beyond the control of the borrower. Factors that are out of your control include inflation, the strength of the economy, and the Federal Reserve. What you do have some control over are your credit history and score, the length of the mortgage, the size of your down payment, and where you’re buying a home.
Another cost to consider when applying for a mortgage is private mortgage insurance (PMI). Putting less than 20% down up front usually means you need to pay PMI. The amount of PMI is based on the size of your down payment. The less you put down, the higher the insurance amount.
What are the Advantages of a Mortgage?
The biggest advantage of a mortgage is that it makes homeownership possible. Although homeownership isn’t for everyone, it can be the right option for many. Some of the benefits of using a mortgage to buy a house include the following.
- Predictable monthly payments. If you take out a mortgage with a fixed interest rate, the amount of your mortgage will stay the same for the entire term. This allows you to plan ahead for payments throughout the life of your loan in a way you can’t with rent payments. Your monthly rent is likely to increase every year or at the end of each lease. You might have to move more often, in search of more affordable rent, which can get expensive.
- You can build equity over time. Each mortgage payment you make builds equity in your home. If you find yourself needing to relocate, complete a large project, or move to a different home, you can tap into this equity. Additionally, when you’re ready, you can sell the home and the money you receive (less paying off your mortgage and associated home sale fees) is yours to use as you need.
- Some costs are tax-deductible. Like the interest you pay on student loans, mortgage interest may be tax-deductible, which can reduce the amount of tax you need to pay.
- You can prepay. You often have the option of paying more than you owe each month on a mortgage. If you prepay, you can shorten the term of your home loan and pay less interest over time.
What is “Bad Debt?”
While your student loans and mortgage can help you reach goals, such as getting a higher paying job, having more stable employment, and enjoying a home, bad debts might make you swerve off course financially. Typically, obligations that fall into the “bad debt” category have higher interest rates. The things you buy with bad debt might not increase in value or might be disposable. Credit card debt and payday loans are two notable examples of bad debts.
Credit Card Debt
Credit cards make it easy to pay for things — in some cases a little too easy. Paying with plastic is practically painless until the bill comes around, and you realize that you have to pay back thousands of dollars.
If you pay your balance in full before the due date, you usually don’t have to pay interest or other fees. If you pay any amount other than the full balance, you’ll carry the remaining balance over to the next month. When you carry a balance, you’ll be charged interest on the remaining amount. Since interest rates on credit cards are usually in the area of 20% Annual Percentage Rate (APR), it can take you years to pay off even a relatively small amount, if you make only the minimum payment.
Cost of Credit Card Debt
Looking at an example can help you see the cost of credit card debt. You have a credit card with a 19% APR. You charge $1,500 worth of purchases to the card and pay the minimum payment of $60 per month. To pay off the full $1,500, plus interest, you would make 106 payments. It would take nearly nine years to pay off the debt, and you’d end up paying almost $900, more than half the principal amount, in interest.
High interest isn’t the only factor that can make credit card debt expensive. Many cards also have fees, such as late fees and over-the-limit fees. If you use a card when traveling or when paying in a currency that isn’t U.S. dollars, you might have to pay a foreign transaction fee. Some cards also charge an annual fee.
Is it Always a Bad Idea to Use a Credit Card?
Although it is possible to get in over your head when it comes to credit card debt, credit cards themselves aren’t necessarily bad. Some types of credit cards have lower interest rates than others, and some allow you to earn rewards or cash back. Some cards also have fewer fees than others or no fees at all.
One way to look at a credit card is as a tool. The type of results you can get from a tool depend on how you use it. If you always pay your credit card off at the end of the month and stick to your budget when making purchases, you can avoid getting in over your head with credit card debt and build good credit along the way.
Payday loans might be the Big Bad of all bad debts. The premise behind payday loans is that you borrow a small amount to help you make it to your next payday. When you take out a payday loan, you typically have to write a post-dated check to the lender for the amount you’re borrowing, plus a fee.
The lender takes your check and gives you the principal amount in cash. The lender might also deposit the amount into your bank account or put it onto a debit card. Then, once your payday comes around, they cash the check and receive back the money they lent you in addition to the fee or accumulated interest.
Usually, payday loans are for small amounts, such as $500 or less. The small amount can make payday loans seem innocent. You’re “only” borrowing a few hundred dollars, after all.
The Cost of Payday Loans
What makes payday loans one of the worst types of bad debt is their high cost. Usually, the loans have fees attached to them. You might pay $15 to borrow $100, for example. That $15 might not seem like much, but it is 15% of the $100. Through compounding, the annual percentage rate of a $15 fee on a $100 loan is 391%.
The cost of a payday loan skyrockets if you can’t pay the amount back by your next payday. You might get your next paycheck and realize you need to use the money to pay for other necessities, such as rent or food. The payday lender might agree to rollover your debt until your next payday for another fee. Suddenly, the cost to borrow $100 isn’t $15, but $30.
If you have trouble paying the balance when the second payday comes around, you might have to roll the debt over again, for another $15 fee. Now, the cost of the loan is nearly half as much as the amount you’ve borrowed.
Are Payday Loans Ever a Good Idea?
Unlike credit cards, payday loans usually don’t offer you any advantages. They can seem like a quick way to get cash when you need it, but the cost is often too high for them to make sense. Depending on the amount you borrow and how long it takes you to repay it, you could easily spend more on fees than the principal.
If you feel that you need to take out a payday loan, it helps to know that there are other options. A personal loan will typically have a lower interest rate and better repayment terms compared to a payday loan. A credit card can also be a more affordable option. If you don’t have good enough credit to qualify for a traditional credit card, you might also consider a secured credit card, which works similarly to a credit card and can help you build up your credit over time.
Can “Good Debt” Turn Into “Bad Debt?”
One thing to remember when you are considering taking out student loans or applying for a mortgage is that it is possible to have too much of a good thing. Borrowing what you need to achieve a particular goal is helpful, but going overboard can create financial difficulty.
In the case of student loans, it helps to think about how much you’re borrowing and how much you can potentially earn in a particular career. Some careers have higher earnings potential than others. A doctor or lawyer is likely to make a lot more money over their lifetime compared to someone who is a teacher or artist. It makes more sense to borrow more to go to law school or medical school than it does to borrow a lot to go to art or theater school.
You don’t have to give up your dreams to avoid taking on too much debt, though. If you want to find work in a field that doesn’t pay the highest salary, it helps to consider your school choices carefully. You might decide not to attend the school with the higher price tag to avoid having to take out six figures worth of loans. You can get an excellent education from a public, lower-priced school and not incur excess debt.
In the case of a mortgage, it’s sometimes possible to borrow more than you can comfortably afford. There are a few reasons why that can happen.
If you make a small down payment on your home and the housing market turns, you can end up owing more on the house than it is worth. You might not be able to sell the property because the proceeds of the sale wouldn’t cover the remaining balance on the mortgage.
A change in your circumstances can also make a mortgage a bad debt. If you experience a job loss or decrease in your income, you might struggle to make mortgage payments and end up falling behind.
You might also get caught up in the excitement of home buying and buy more than you can afford. Your lender might approve you for an amount that looks good on paper, but the amount you need to put toward your mortgage and other housing related costs each month might make it difficult to reach your other goals, such as saving for retirement or your children’s college educations.
How to Avoid Bad Debt
Knowing the difference between debt that benefits you and debt that gets in the way can help you plan your finances and set goals. Knowing what you can do to avoid bad debt can also help you as you work toward financial success.
Here’s what to pay attention to and do to keep bad debt out of your life:
- Create a budget. The first step to avoiding bad debt is knowing what you can and can’t afford each month. Calculate how much you earn monthly, then subtract your fixed expenses from it to see if you have any discretionary income.
- Build up an emergency fund. Payday lenders promise that they’ll help you out in a pinch. But their “help” is super expensive and can make a tough situation even more challenging. If you can save up an emergency fund, even just a few hundred dollars, you have something to fall back on when money is tight.
- Be cautious of interest rates. How much you pay in interest can make a good debt bad or a bad debt even worse. Shop around when looking for loans or credit cards to get the lowest rate possible.
- Consider the value the loan provides. Before you borrow money, consider the long-term value of the loan. With a mortgage, you’re spending hundreds of thousands of dollars, but you end up with a forever home. In terms of student debt, you might not be able to pursue your desired career without borrowing money. With credit card debt, not being able to pay off the entire amount you borrow right away can end up costing you even more without any real benefits for you.
- Try to keep your overall debt low. Lenders often talk about the debt-to-income ratio. It’s how much you pay each month compared to your income. The lower your debt-to-income ratio, the more financially comfortable you can be. If you have a lot of debt already, whether it’s good debt or bad debt, it’s a good idea to consider how taking on an additional loan would add to your debt-to-income ratio. If your ratio is over 43%, it can be challenging to pay off debt.
Make the Most of Your Money and Achieve Your Financial Goals
Remember, not all debt is created equal. As long as a debt is helping you achieve something, isn’t difficult to make payments on, and has long-term value, it’s usually a healthy, good debt. But if you’re struggling to make payments or are paying for your past, you might want to consider getting help. Options such as a debt management plan can consolidate your loans and make payments more manageable.
PSECU offers a variety of loan options to help you reach your goals, from mortgages to student loans and from personal loans to low-interest credit cards. Learn more about our offerings and visit our WalletWorks page for more tips and advice on responsibly borrowing money.