Good debt is an essential tool for creating financial freedom. Whether you’re trying to reduce your monthly expenses or build wealth, leveraging good debt can be the difference between success and failure.
But how does borrowing money help improve finances, and how can one avoid the "bad debts" that wreak havoc on their wallets? Here's everything you need to know about the strategic use of debt.
What Is Good Debt?
Think of good debt as money you borrow to achieve a goal. This type of debt can also help you build wealth or otherwise improve your financial situation in the long term.
It helps you invest in your future. While you'll still have to make regular monthly payments to repay it, these "good debts" will work to your advantage.
That doesn't mean those good debts are risk-free. As with any financial undertaking, it's important to understand the terms and conditions beforehand.
Looking for low-interest rates and negotiating a payment plan can help you lower any associated risks.
Examples of Good Debt
Student Loan Debt
Education-related debts invest in your future by giving you access to knowledge, skills, and training that can boost your employment opportunities and improve your financial future.
help you create, run, or grow a business venture.
Depending on your needs, a small business loan
can help by increasing your cash flow, making it easier to buy new equipment, allowing you to invest in new property, and other strategies to build your brand's value.
helps you afford a new home. These loans tend to come with relatively low-interest rates. Unlike renting, owning a home helps you build long-term equity and even comes with certain tax benefits.
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What Is Bad Debt?
Where good debt helps to improve your finances, bad debt often hurts your bottom line in the long run.
Bad debts generally include consumer debt you can't afford and loans with unfavorable repayment terms, especially those with high-interest rates.
Sometimes, we take out bad debts to purchase items that decline in value or unimportant things we don't truly need.
Examples of Bad Debt
It can become a form of bad debt, depending on how you use them. Because normally a high-interest credit card can damage your history, with no set repayment period, unpaid credit card balances can grow larger fast.
If you fail to pay off your personal or business credit cards regularly, they become bad debt.
It can sometimes be valuable, especially when you need a car to expand your options for employment or running your own business.
However, it's crucial to remember that cars depreciate in value the second you drive them off the lot, meaning that you won't build any wealth with this investment.
These products may seem helpful in theory, but they have high-interest rates and hefty late fees. In other words, they can be predatory, and your debt will spike fast if you miss payments, making these loans a risky bet.
Good debt vs. bad debt
As we've hinted above, many types only become good vs. bad debt based on your financial habits.
Few financial options are completely black and white; what works as a "good debt" option for one person may become a "bad debt" option for someone else.
Take personal loans as an example.
A house flipper who uses a personal loan to renovate a property for resale has "good debt," as they're investing in a project with a clear return on investment.
However, someone using a personal loan to fund an extravagant honeymoon (that they can't actually afford) may have "bad debt," something that they'll be paying off long after the trip is over.
What Should I Consider to Avoid Bad Debt?
In general, avoiding bad debt means doing your due diligence before
you take on any new debt. Here are a few things to consider:
- Don't borrow more than you can repay. This is especially true if you're already in debt. You can't solve a problem by taking on more of that problem, with the only exception being debt consolidation.
- Don't borrow for spending if your discretionary income doesn't cover costs. If you're taking out a loan for something you don't need or won't help your finances, think twice about it.
- Make sure the debt will offer you a good ROI. Returning to the goal of debt that helps you grow, seek debts that help you achieve one of your financial goals.
- Shop around for the best rates and repayment terms. Look for a favorable interest rate and terms, as these are often impossible to modify after the fact. In addition, debts with fixed interest rates are often a better bet than variable rates.
How Can I Protect My Finances if I Have Bad Debt?
You aren't out of luck if you already have bad debt. Getting out of it can feel overwhelming and time-consuming, but it's possible to manage your finances and even pay off your debts faster with a few tips.
First, plan to begin paying off your debts with every free dollar you have.
This may mean downsizing your personal or business spending habits in the short term.
You can use various strategies here
- When paying off bad debts, some experts advise using the "Snowball" strategy or paying off smaller debts first.
- Others advise using an "Avalanche" strategy, focusing on high-interest debts while making minimum payments on other debts.
- Consolidate your debts into a single loan and reach out to your lender to see if they're willing to offer a different payment plan.
- If you need additional help or resources, consider getting advice from a credit counselor.
There is no single right or wrong strategy, as each has its pros and cons. What matters is finding a tactic that works for you and sticking with it.
Debt Do and Don'ts
- Start by getting organized. If you haven't done so, list every debt, including everything from credit card debt to student loans to medical bills. Take note of the minimum payments and interest rates associated with each.
- Make a payment plan. Prioritizing your debts will depend on your personal preferences, but focusing on either the Snowball or Avalanche methods mentioned above will always be a safe bet.
- Consider setting up automatic payments as part of your plan, as this makes it easier to avoid missing a bill and paying fees or interest.
- Do lower your interest rates if you can. While this isn't always possible, you may be able to switch credit cards or consolidate debt in a way that allows low-interest payments. This can help you save money in the long term.
- Don't continue taking on new debt. If you're already worried about your current debts, focus on paying them before shopping for new ones. Note that this might also mean avoiding using your credit cards.
- Don't only make the minimum payment each month. Though this strategy might save you money, it ensures you'll rack up interest fees and stay in debt for longer.
- Don't avoid getting help if you need it. If you're struggling to stay organized or if you're in over your head, reach out to a friend or a professional. Money management is a learned skill, and there's no shame in admitting that you need to work on it.
How to Use Debt to Build Wealth
It's worth noting that mortgage loans are one of the safest and most risk-free ways of building wealth.
These low-interest loans allow you to build personal equity over time.
If you already own a home and wish to invest in a second property, you can finance it through a loan. This can be a smart option for those hoping to invest in real estate.
It's important to keep an eye on how you're using the funds and ensure they're going where they're meant to go.
Regular monitoring will help ensure that you make sound investments and get the most out of your capital.
Get an Education
Student loans are another way to build long-term wealth.
Though these loans can take many years to pay off, the idea is that you'll be able to do so faster by earning more money through a higher-paid job, often one you might not have gotten without the proper schooling.
Even for business owners, going to school or returning
to school can open doors to greater opportunities.
Consolidate Your Current Loans
Loan consolidation can be helpful for both personal and commercial use.
Debt consolidation loans allow you to bundle several debts into a single loan, often with lower interest.
This can make it easier to organize your monthly payments and avoid missing a bill.
These loans may also offer better repayment options and terms. Though you'll still need to pay off your current debts in full, you'll often save money, allowing you to put that cash toward something else you need.
Create a Budget
A budget will help you keep track of how much money is coming in and going out so you can manage your cash flow more efficiently and ensure that you can repay your loan on time.
Get a Commercial Loan
If you own a small business, taking out an unsecured business loan is a fast way to grow your brand.
Whether you're struggling to expand to a new location, purchase new tools, or market yourself online, a commercial loan can help you get started.
We are one of your best options if you are ready to obtain a commercial loan, turn it into good debt, and grow your wealth.
At Camino Financial, we are ready to help you.
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How do I know if I have too much debt?
The easiest way to figure this out is by calculating your debt-to-income ratio. This means taking your total monthly debt and dividing it by your monthly income. Most experts advise keeping this ratio below 35-40%, and lower is always better.
Is a mortgage considered debt?
Yes, a mortgage is a type of debt. However, these safe loans are a type of "good debt," as they can help you build equity in your home.
What is the difference between debt and credit?
Credit is your ability to borrow money, often up to a certain financial limit. Debt is money you've already borrowed, whether you've borrowed it with credit or through a loan.
What is the definition of debt in economics?
In economics, debt is money that one party borrows from another. These debts often help the borrower make purchases they would otherwise be unable to afford.
What is considered debt?
Any amount of money someone borrows from someone else is a form of debt. Some of the most common debts include a mortgage, an auto loan, medical debt, a home equity loan, student loans, and credit card debt.
What does investing in debt mean?
This happens when someone "owns" a debt, expecting the borrower to pay them back with interest.
The most popular example of this is banks, which loan out money and make a profit off of the interest. However, consumers can also invest in debt through bonds, treasury securities, and similar strategies.