Good debt and bad debt
Published 10/13/2022 | Last updated on October 13, 2022
Although debts often have a negative connotation in people's imagination, the truth is that they are not always bad. The important thing is to know how to use credit to our advantage and thus have a peaceful life.
Knowing how to use credit correctly will allow us to achieve our goals and dreams. In addition, from financial institutions, teaching will enable us to transform lives and bring people closer to their objectives more efficiently.
Bad debt vs. good debt: how to identify them?
Getting into debt is not always bad, but not knowing how to choose your debts can lead you down paths that jeopardize your financial, personal, and emotional stability.
Personal or family finances are more similar than we think to a company's finances. At the household level, we have income and expenses, assets or resources that can generate future value, and debt. However, no matter how much fear this word may instill, the truth is that not all debt is negative. In fact, if well planned, it can even be beneficial.
Good debt and bad debt, the differences
Faced with the choice of whether to go into debt, most families would choose not to. Debt is generally seen as something negative, something to run away from if we can afford it. Debt is nothing more than the obligation of a person (natural or legal) to meet the payment commitments acquired during their economic activity. In other words, the debt is what we must pay back to the person who has lent us money. In addition, the repayment is almost always made with interest, which means we end up paying more than we initially received.
This definition makes it understandable that debt is understood as something negative. However, there are different types of debt, which are not always detrimental to the family economy. One of the most common classifications is to divide debt into good and bad debt.
What is bad debt?
Under the denomination of bad debt are grouped all those debts that cause stress to personal or family finances or worsen the economic situation of the person who contracts it. Generally, they are those debts acquired to buy something we want (although we do not always need it) but we cannot pay in cash. That is to say, the mortgage of a first home, a new car, a vacation, or the expenses of the credit card.
Bad debts, also called bad debts, are linked to the lifestyle of the person who incurs them and can end up generating severe financial problems. Except in specific cases (such as purchasing a first home that later appreciates), bad debts impoverish us. They do not report more benefit than the enjoyment of the acquired good and force us to return the money plus interest in installments.
In other words, bad debts allow us to have cash that we did not have before but that we use to buy liabilities, usually without long-term economic profitability. Even so, within bad debts, there are also levels. It is not the same as contracting debt to buy a house and pay it in installments with an amount like rent as to contract debt to travel to destinations we could not afford or to acquire a luxury vehicle far from our reach.
The most dangerous debts are those with a very high annual percentage rate of equivalence, such as, for example, many of those incurred when financing purchases with a credit card or directly in the business in which we acquire a product. If the amount borrowed is very high, it may even become necessary to acquire new debt to pay the previous ones, entering a spiral of the destruction of wealth that is difficult to stop.
What is good debt?
The opposite case to the previous one is good debt, a term under which all obligations that help the borrower to improve his economic situation are grouped. This type of debt also called expansively, is used to invest or acquire assets that will provide short, medium, and long-term profitability. That is to say, they are those debts that will make us earn more money than we must pay back to the lender, including interest.
The clearest example of good debt is acquired for purchasing a property that will later be rented or refurbished and sold again once it has been revalued.
Any indebtedness that allows a sustained profit to be obtained over time is considered good debt. Another classic example, although it involves more risk, is taking on debt to set up a business. If the project goes ahead and is successful, in the long run, we will have turned the debt into an asset that will yield significant profits.
Although there are bad and good debts, getting into debt is always risky. For that reason, it is necessary to consider the economic situation of the moment the debt is assumed to be invested. Buying a property to rent at a market price peak or before the bursting of a bubble (as happened in 2008) or taking on debt to acquire highly volatile assets at a specific moment (such as shares or cryptocurrencies) is never advisable.
Three main expansive debts
According to some specialists, there are three types of expansive debts that help you grow:
- Debt for business: if you buy raw materials on credit and sell the product, you will have a profit to pay the debt and have a profit.
- Debt for investment: if you are going to invest money and you borrow at a much lower interest rate than the return on the investment (assuming all assets have risk).
- Debt for education: if you are going to pay for your education on credit, and with what you are going to learn, you will generate more money to pay the credit and have an additional profit afterward.
The first thing to know is that a "good debt" "allows you to generate money with it. On the other hand, a "debt is not so good" when it generates expenses, such as buying a cell phone with too many installments, which will exceed its useful life, or going into debt to go on vacation.
At El Paisa Multiservices, we want to help you with your finances in Hartford, CT. You can contact us if you have questions about our services.
By Ingenuity & Solutions
