Understanding the difference between good debt and bad debt

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What’s considered good debt

There are certain things in life worth going into debt for — and they usually aren’t the latest clothing trends or fastest cars (no matter how much we love them). Good debt helps you generate income, manage your finances effectively, and increase your net worth. Think of good debt as investing in your future. Here are some examples:

Getting a student loan ?‍?

Furthering your education can help provide you with better career opportunities and a higher salary. In fact, a study done in 2016 by Georgetown University found that on average college graduates made nearly $1 million more in earnings over their lifetime than individuals who only graduated from high school. Thus, taking out student loans can be good debt if you approach them wisely. Be sure to supplement student loans with scholarships and choose a degree that will lead to a lucrative career.

Taking out a mortgage on a home ?

One of the best examples of good debt is taking out a mortgage on real estate. That’s because mortgages come with relatively low interest rates, and tax breaks, like writing off interest and property taxes. Also, a home’s value tends to increase over time. In fact, the price of housing increased on average 5.4% per year from 1968 to 2009 according to the National Association of Realtors. That’s some serious financial gains for many Americans.

Starting a small business ?‍?

Owning a small business is tough — almost one-third of small business fail to survive their first two years, according to the Small Business Administration. However, with enough ambition (and luck) borrowing money to get your business up and running could be the best investment you ever make. Start small, research all of your options to get the best loan terms possible, and be sure to have a backup plan in case things go sour.

What’s considered bad debt

Bad debt is anything you purchase using credit that loses value the minute it’s in your possession. Unfortunately, that describes many of life’s guilty pleasures, like clothes, cars, and electronics. When purchasing these things, use cash if possible and search for the best deal — which may mean bargain-bin hunting. Check out these examples of bad debt:

Purchasing a new car with an auto loan ?

Automobiles depreciate rather quickly (the minute you drive off the lot in most cases), and automobile loans tend to have fairly high interest rates. Thus, using credit to purchase a new car is often considered bad debt. In much of the US owning a car isn’t an option, but a necessity due to the lack of public transportation. If you do need to purchase a vehicle, limit your loan amount by paying what you can in cash and purchasing a used car.

Using credit cards recklessly ?

Credit cards are a great tool when used correctly. However, they tend to be the most expensive form of debt you can take on — with APRs usually around 20% or more. Always try to limit the amount of debt you put on your credit cards, and when possible, pay off your entire balance before you incur any interest charges.

Borrowing money from your 401k ?

Many employers allow you to borrow money from your own 401k plan. However, you must pay back the borrowed money within five years, or you could get hit with early withdrawal penalties by the IRS. Plus, the interest you’ll pay on the loan will effectively get taxed twice – first when you pay it, and again when you withdraw it during retirement. Who wants to pay the taxman twice?

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