In the third quarter of 2022, U.S. household debt hit $16.51 trillion, an 8.3% year-over-year increase. Debt is a regular part of most Americans’ lives. While some types of debt can be an obstacle to building financial stability and wealth, in other cases, debt is a necessary and beneficial part of a strong financial plan.
In fact, wealthy people typically hold proportionally more debt than those of lower economic standing. The Federal Reserve reports that the wealthiest 1% of the population holds 4.6% of all household debt in the U.S., while the bottom 50% holds only 36% of household debt. Individuals who have built wealth often hold larger amounts of debt because they understand how to use debt to their advantage.
It’s important to understand the difference between good and bad debt so you can improve your financial standing and begin building wealth. Keep reading to learn how to build good debt and avoid bad debt.
- Good debt is low-cost, tax-advantaged debt that increases your net worth.
- Bad debt is high-cost debt used to purchase items for consumption or depreciating assets.
- Student loans, home mortgages, and business loans are considered good debt.
- Credit card debt and payday loans are considered bad debt.
- Car loans are often considered bad debt unless they are low-cost and help you increase your earning potential.
What Is Good Debt?
Good debt is low-cost debt that is used to increase your net worth or earning potential. Good debt can be used to purchase an appreciating asset or finance an income-producing business or investment. Often, this type of debt also has tax advantages. High-income earners commonly use this type of debt to decrease their taxable income.
To determine if a type of debt is good, ask yourself these three questions:
- Will this debt increase your earning potential or net worth?
- Is the debt low-cost?
- Are there tax advantages to holding this type of debt?
If the answer is yes to these questions, the debt will likely improve your financial situation rather than be a detriment.
3 Common Types of Good Debt
Student loans are classified as good debt because they can significantly increase your earning potential. College graduates’ annual median earnings are $36,000 or 84% higher than individuals whose highest degree is a high school diploma. Student debt also has tax advantages. Borrowers can also lower their taxable income by taking a tax deduction of up to $2,500 of interest paid on student loans each year.
Student debt is typically low cost. Federal loan interest rates are currently set at 4.99% for undergraduate students and 6.54% for graduate students. However, private loan rates have greater variability. Only about 8% of student loans are private, but if you choose to take out a private loan your rate could be anywhere from 3.22% to 14.96%.
While federal student loans and low-cost private loans are prime examples of good debt, keep in mind the risk involved. Student loan borrowers who do not complete their degrees can end up repaying debts without the advantage of an increased earning potential.
Mitigate this risk by:
- Choosing a major with high employment rates: Civil engineering, education, and nursing majors all have unemployment rates below 2%.
- Pursuing a degree with a high earnings-to-debt ratio: Degrees in physical sciences, computer engineering, and engineering have the highest earnings-to-debt ratios, while education, pharmacy, and law have the lowest earnings-to-debt ratios.
- Being cautious about taking on private student loan debt: Interest rates of 10% or higher are considered high-risk.
Mortgages are the most common type of consumer debt. Homeownership is one of the key tools Americans use to build wealth as it is a low-risk, low-cost way to build equity in an appreciating asset.
In recent years, homes have rapidly appreciated, providing homeowners with a great return on their investments. According to Rocket Mortgage, homeowners who purchased their homes 7–10 years ago could now sell their homes for 46.6% more than the original purchase price. As homes appreciate, homeowners build home equity, which acts as a long-term savings fund.
The average 30-year mortgage fixed interest rate is 6.515% as of November 2022. While homeowners pay the cost of interest on their mortgages, they avoid losing money each month while paying rent, which typically rises regularly with inflation.
There are also tax benefits related to holding mortgage debt. Homeowners can deduct interest on their mortgages for the first $750,000 for married taxpayers filing jointly or $375,000 for single taxpayers.
As with all debt, there is some risk involved in taking out a home loan. In July 2022, 3% of mortgages were delinquent by at least 30 days or more. Homeowners who experience job losses or other financial emergencies are at risk of falling behind on payments and losing their homes.
To mitigate risk, diversify your income streams and build an emergency savings fund to get you through unexpected periods of unemployment. To ensure you’ll be able to build savings, avoid taking on mortgage debt that will require monthly payments of more than one-third of your income.
Small Business Loans
Low-cost business loans are considered good debt because they increase your earning potential. And just as with other types of good debt, the interest paid on a business loan is tax deductible.
There are various types of business loans, and some have lower costs than others. According to LendingTree, traditional bank loans have interest rates starting around 6.75%, while alternative business loans can start with rates lower, as low as 3.49%. They can also reach rates as high as 30.12%, so it’s critical to shop around for the lowest possible rate.
What Is Bad Debt?
Bad debt is high-cost debt that does not improve your earning potential and is used to purchase depreciating assets or products for consumption only. This type of debt can be difficult to get out of, making it more difficult to build good debt. Here are a few types of debt to avoid whenever possible:
Credit card debt is considered bad debt because it is high-cost, with the average interest rate for a new credit card in November 2022 being 22.4%. Often, credit card borrowers use credit card debt to purchase items solely for consumption or things that have rapidly depreciating value.
The high cost of credit card debt can make it very difficult to pay off. Many people who hold credit card debt have been in debt for decades. In 2021, 15% of consumers surveyed said they had been in long-term debt from credit cards for more than 15 years.
A payday loan is a small, high-interest-rate personal loan with a short payback period. Interest rates on these personal loans can be astronomically high, making it difficult for individuals to get out of debt. Many states set a maximum amount that payday loans can charge. The maximum is typically between $10 and $30 for every $100 borrowed. For a payday loan with a typical two-week payback period, a $15 fee per $100 borrowed is equal to an annual interest rate of almost 400%.
Payday loans are typically used for consumption only. Nearly 70% of borrowers use the loan to pay a recurring expense like food, rent, or a utility bill, and 16% use payday loans for emergency car repairs or unexpected medical costs. While borrowers may feel a payday loan is their only option to cover these costs, it’s best to use other methods to pay these expenses whenever possible because these loans make it more difficult to build financial stability.
Car loans are often considered bad debt because the debt goes toward a quickly depreciating asset. Cars can lose up to 20% of their value over the first year and 60% of their value over five years.
However, a car loan could be good or bad. If purchasing a car increases your earning potential and your loan is low-cost, this can be considered good debt. Many people purchase cars to expand their work opportunities to jobs that would have been difficult to commute to without a car. If a car allows you to reach a job that improves your financial standing, your car loan can be a good investment.
If you need a car loan to improve your job opportunities, look for a low-cost loan. Experian reported in the second quarter of 2022 the average car loan interest rate for a borrower with a credit score above 720 was 2.96% for a new car and 3.68% for a used car.
Rates will be higher for borrowers with lower credit scores. The average rate rises to 12.84% for a new car and 20.43% for a used car for borrowers with credit scores below 579. As rates rise, car loans become more difficult to repay and can increase your risk of defaulting.
Prioritize Staying Out of Bad Debt
Holding too much bad debt can jeopardize your financial stability and your ability to retire comfortably. A recent survey from Clever found that 67% of retirees have some credit card debt, and 43% of those surveyed struggle to pay their bills, including debt repayment and credit card bills. It goes to show, when you have a high-cost debt, it’s important to pay it off quickly or avoid taking out bad debt entirely.
Here are a few steps to take to minimize your risk of bad debt:
- Build an emergency savings fund.
- Try cash-stuffing or other budgeting tips to stay on top of regular expenses.
- Always have a plan for repayment when you take out a loan of any type.
- Work on building a good credit score.
Good Debt Keeps Cash Liquid for Other Investments
While it’s critical to avoid bad debt, you can use good debt to build your investment portfolio and accrue wealth. Good debt frees up cash for other investments. Sten Morgan, founder of Legacy Investment Planning, discourages people from paying off their low-cost debts as long as the interest rate is lower than the returns you could get by investing your cash in the market.
The average annualized return of the S&P 500 was 11.88% between 1957 and 2021. If you’re financing a business or a home with cash, you’re tying up your cash in a single investment and losing the opportunity to make money through other investments.
“If you’re under 50 and you’ve paid your house off, and there’s a bunch of locked up equity,” Morgan says, “Fast forward 15–20 years, you’re gonna look back, and you’ll get a pit in your stomach of the money you left on the table by overpaying an asset that had a low-interest rate.”
How to use good debt appropriately:
- Leverage your home’s equity to fund other reliable, high-yield investments.
- Use student loans to fund a college degree with low unemployment rates and a high earnings-to-debt ratio.
- Fund a well-planned, income-producing business venture with a low-cost loan.
To learn more about improving your personal finances, check out these articles:
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