In order to quickly identify whether a debt is good or bad, we need to focus on two critical questions:
Potential for long term value, and risk. That’s it!
The traditional example of this is buying a home with a mortgage. This type of debt allows you to build up value in your home over time, increasing your net worth. Mortgages are great in most cases, but there are other ways to look at long term value too.
Taking out student loans to have the benefit of a college degree or certification can lead to higher pay, and lifetime earnings. Buying a car with a car loan is another way to provide long term value. For many, cars are necessary, and as long as you are able to use it for years after you’ve paid off the loan, you’ve gained long-term value.
None of these examples are sure-fire ways to create long-term value, but are good bets as long as the risk you take on isn’t overwhelming.
So, let’s find out how to understand the risks involved with debt.
When we are talking about risk, we mean, “Does this loan/debt have the potential to hurt your financial reputation?” Your reputation (credit score) is very important and can make your life really easy or hard depending on how good it is. So we want to make sure to protect it as best we can!
The only real risk a debt has, is becoming unable to make payments on-time or not being able to pay at all. The two main questions that control this are:
Generally speaking if you can keep your interest rate below 7-9%, and ensure that the interest rate is fixed, you should be in the clear.
Here are some examples of loans that can be pretty risky:
To decide if a debt is good or bad, we have to bring everything together. Both risk and potential for long-term value need to be considered to see the complete picture. The best case is to have a loan that has low risk and lots of potential for long-term value, but it’s not always that simple.
Use the tool below to help bring everything together, and see where typical debts land.
You’ve come this far! Don’t stop now… read our next article on how to pay down your debt faster.
Knowing the difference between good and bad debts is a great step towards becoming a personal finance ninja. But when it comes to your entire personal financial picture, debt is just a piece of the puzzle. You have goals! Aspirations! Wants! Needs!
We get it… So when it comes down to making a plan that works for you, we need to consider the whole picture: Your lifestyle. We can get you there with personalized lifestyle planning. We’ll help you create meaningful goals, show you the impact of your decisions, and help put everything on autopilot so you don’t have to worry. Sound like a good deal?
Give it a shot!