The Difference Between Good Debt and Bad Debt (and What You Should Do About It)

What do you think of, when you hear the word debt?

Does it make the hair on the back of your neck stand up straight? Do you love using leverage to get ahead?

Or, if you looked at it truthfully, are you swimming in an ocean of it?

Depending on where you are in your journey, you may not be so excited to think about it. However, it’s a vitally important part of what I like to call financial wellness, and I’d love to cover it with you today.

The first thing I’d like to address is an age-old question:

Is There Really Such Thing As “Good” or “Bad” Debt?

For me, this is a no-brainer.

There absolutely is such a thing as helpful and harmful debt, and I’d like to explain the differences to you today.

Good Debt Is:

Generally, debt that’s used to acquire an asset. 

The technical term for this is “secured debt”. 

This type of debt is “secured” by the asset. For instance, if you buy a car or a house, that debt is backed by the actual asset you purchased. If that’s good debt, better debt would not only be secured by an asset, but the asset would either provide you income, appreciate in value, or both. For example, a rental property.

Typically, with any type of secured debt, you won’t have to pay as high an interest rate on your loan when debt is secured by some asset.

Why? Simply because there’s less risk for the lender. 

Worst case scenario, if you can’t make your payments anymore, the lender still has a claim on your asset. They’ll likely be able to recoup some or all of their losses this way.

Debt works on two sides, borrowing, and lending, leading us to our next point.

Bad Debt Is:

Typically debt that is NOT backed by anything. In other words, it’s “unsecured” debt. 

There is no security in this type of debt, so the lending institution will generally charge a lot higher interest rate, as they’re taking a larger risk on their loaned capital.

It’s not always true, but a memorable mnemonic for this is:

Higher risk = higher required return.

In this case, it’s “bad” debt because it doesn’t work in your favor. For the lender, it’s not bad unless you default! Then, it really becomes a risk for them.

YOU are the one paying lenders higher rates, and this is typically on things like credit card purchases, consumer loans, and the like.

When you run up your credit card bill on a new TV, don’t pay the full balance at the end of the month, and end up compounding 18%+ in interest each month?

That is bad debt. Eventually, you wind up paying more for the TV than you ever imagined.

One thing both types of debt have in common is the requirement of a strong credit score. In both scenarios, having good credit helps you tremendously.

What If You Find Yourself In A Bit (Or A Lot) Of Bad Debt – What Should You Do?

The first action step to take is to look at all of your debts – mortgage, loans, credit cards, etc. 

List all of it and take a good hard look at it.

Most people don’t want to (and therefore won’t) do this.

But to get a handle on it, you must get clear on where things stand today! What are your balances, interest rates, and to whom do you owe money? Start thinking about how you can actually get it squared away for good.

A common strategy is putting all of your focus on say, one credit card at first (ideally the one with the highest interest rate) and paying it off consistently until you hit a big, satisfying zero.

Then, move on to your next highest interest rate balance, to “snowball” some of your momentum, and get a handle on it for good. Oftentimes, it’s beneficial to seek some outside assistance on this.

Credit Card Consolidation, Best Practices & Zero Interest

There are many helpful ways to consolidate your credit, like taking a home-equity loan, or a no-interest credit card…

However, this takes an enormous amount of personal discipline.

Plus, if you consolidate all your balances into one loan, and your other cards are at zero, it’s simply too easy (and tempting) to fall back into the trap of using them again.

This pattern leaves you in a worse off financial position than before you consolidated! With credit cards, you need both habitual discipline and a keen awareness of how they really work against you.

Ideally, you only want to charge what you can actually pay off in that month! 

There’s absolutely no reason to be carrying a balance, racking up extra interest on your card (which compounds into more debt).

You should treat your credit cards like debit cards.

I love credit cards myself, especially when I can earn points, miles, rewards, and much more! But the key is to never carry a balance, and only charge things you can actually afford to cover with your cash flow each month. Otherwise, you’re paying high interest costs for the rewards, making them much less rewarding!

Your credit card, any debt you may be carrying, and the available options are not the problem. In fact, they can be very beneficial.

The problem is the discipline and financial intelligence needed, in order to use these tools wisely and always know where you stand.

The Conclusion to Getting A Handle On Your Debt

Credit can be leveraged to build your independent credit score, secure more favorable interest rates and higher limits, and reap all types of other rewards and bonuses.

Keep in mind, this isn’t something that comes naturally to people, and it can be very uncomfortable getting a handle on it at first.

But it’s absolutely necessary.

And most of the time? After you’ve looked it all over (and even if your picture isn’t perfect) you feel an empowering sense of clarity and control.

I want you to be able to feel this sense of clarity, control, and confidence over your finances.

I invite you to click this link to get in touch with me now! I’m happy to answer any questions you’ve got about your unique financial situation.

There Is One More Kind of Debt

There is another kind of debt which falls into a unique category and it’s is one of the largest types of debts held in our country. It’s an unsecured loan through either the Federal Government or a Private Institution. Yes, I’m talking about Student Debt. There are so many aspects to this special kind of debt though, I’ll save it for another post. 

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