Navigating the maze of debt can be a stumbling block on the path to wealth. While becoming debt-free is an important goal, some personal financial situations rarely allow someone to be entirely debt-free.
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Soaring housing costs and stagnant wages make it imperative to understand and prioritize different kinds of debt make up the current economic landscape In other words, it’s vital to differentiate between “good” debt and “bad” debt. Before taking on any debt, an individual or family should review their finances and make a personal finance plan.
Good Debt
Generally, “good” debt is when someone is investing in themselves for the future and/or when the debt is either at a lower interest rate or tax deductible. Good debt may increase an individual’s earnings potential or net worth. It can also increase an individual’s earnings potential or net worth. Examples include student loans (low-interest and tax-deductible), mortgage loans, and some equity loans or second mortgages. Entrepreneurship and investment loans are other types of good debt. These include business loans for budding entrepreneurs and strategic borrowing to invest in stocks or real estate.
Investing in Education
The COVID-19-related federal moratorium on student loan repayment is over. Still, investing in higher education typically falls under the category of good debt. Most people need substantial loans for college or graduate school. However, the degree earned can increase a person’s earning potential and may even be necessary for career advancement in fields like business, political science, and law. Thus, prospective students and their families often evaluate factors like a school’s reputation and the professions specific degrees lead to.
Homeownership
Owning a home is often a route to financial stability. Benefits hinge on the type of loan a person qualifies for and the ever-changing housing market, which includes location and timing factors. Potential homeowners should anticipate maintenance costs, property taxes, and unexpected expenses, such as plumbing or electrical issues. Still, a mortgage provides an avenue to secure an appreciating asset, and often the interest paid on mortgage loans offers tax benefits.
All of the above examples are subject to the question of affordability within your budget. No debt is worth taking if you cannot afford it.
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Navigating Good Debt
Any investment in yourself–whether it’s education, starting a business, or buying a home–requires careful planning. This includes borrowing within your means, understanding loan repayment terms, and establishing a repayment strategy. Financial planners, accountants, and user-friendly sites like Investopedia or Mint are widely recognized by those looking for reviews and comparisons of financial products or for budgeting and tracking finances. Additionally, discussions with family and friends a bit further along in their financial journey can offer valuable (and free) insights.
Bad Debt
Examples of bad debt are high-interest loans: Pay Day or Buy Now, Pay Later Loans, credit card debt, most car loans, and loans taken out for discretionary items such as vacations or luxury goods.
Credit Cards
A high-interest credit card can snowball if balances are not cleared promptly. Making the minimum monthly payments can mislead consumers into thinking they are managing their debt, while interest continues to accrue. Interest on credit cards is not tax-deductible. This kind of debt is a major problem in America. According to the Consumer Protection Financial Bureau, Americans paid $120 billion in credit card interest and fees a year before the pandemic, during which people borrowed less and paid down debt. Now, debt from interest and fees is on the rise again. A good rule of thumb is to pay credit card balances off in full every month if possible.
A silver lining is that, when used responsibly, credit cards establish your credit history and offer purchase protection. Understanding the credit card companies’ terms, especially interest rates, is critical.
Car Loans
A car is often essential for commuting. Yet cars depreciate the minute they’re driven off the lot. If financed with unfavorable loan terms, this essential expense can turn into a burdensome debt. Car loan interest is not tax deductible unless you are self-employed and need your car for business. It might be painful in the short term, but paying off a car loan as quickly as possible saves you money.
Payday Loans
These short-term loan solutions often carry exorbitant interest rates. Borrowers might find themselves trapped in a cycle of debt, making it challenging to pursue long-term financial aspirations. Payday loans should be avoided.
Consumer Loans
People resort to these loans for a variety of reasons, including discretionary expenses. While they offer fast cash and are easy to qualify for, their cost can be steep in the long run. Think carefully about an expensive item or trip to determine if it can wait. The cost of taking out a consumer loan usually does not outweigh the benefit, except in instances like necessary medical procedures or emergency car repairs.
By understanding the pros and cons of different kinds of debt, an individual can make decisions with their eyes wide open and stay on the path of financial freedom. Debts and interest accrued on those debts can put a damper on moving forward into a healthy wealth journey. However, staying consistent, knowledgeable, and aware of debt can help give an individual a clear view of what needs to be done in their personal finance journey.
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This article originally appeared on GOBankingRates.com: Wealth Drain: How Your Debts Can Determine Your Financial Failure
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