Debt, for many, is synonymous with life. By the time an individual turns eighteen, they will have likely been introduced to the world of debt through credit card and personal loan offers in which the lure of ‘access to excess’ overrides personal responsibility.
Merriam-Webster defines debt as “a state of being under obligation to pay or repay someone or something in return for something received.” For many, this means educational debt, automobile debt, or homeowner debt. As younger folks welcome debt into their lives, it is important to recognize and understand good debt vs. bad debt.
Good debt
Good debt is incurred where the resulting benefit will outweigh the cost (cost of debt outweighed by earnings generated from the use of the loan proceeds). For example, a college education may be financed through student loans. According to www.usnews.com, the average 2016 graduating student will incur $37,172 in debt. While this may sound alarming, consider the statistic that college graduates earned 56% more than high school graduates in 2015. (Source: Economic Policy Institute.) As a college education is an investment to one’s career, this becomes worthwhile debt.
For the entrepreneurial type, incurring debt to own a business can be considered a form of good debt. Securing financing to begin a business can be advantageous. While a business can be profitable without generating a positive cash flow, the initial year or two may leave net income in the red. Low initial earnings should be a planned-for occurrence (meeting with a financial advisor or business strategist before launching a business is always recommended). However, over time, the goal is to build and create a profitable business.
Finally, another ‘good debt’ example is an investment in real estate. For many real estate investors, good debt derives from building equity in the home and from generating a positive cash flow from the operation of the property. Equity is what allows the homeowner to recognize a gain on sale of their home. For others, investing in real estate offers the opportunity to create rental income or a tax shelter through residential or commercial rental activities.
Bad debt
Bad debt, simply stated, is when the cost of repayment outweighs the benefit derived from incurring the debt. The easiest example is automobile debt. Unless one purchases a collector’s item, a vehicle is a depreciating asset. This means that the asset will not gain in value and therefore will generally lead to a loss on the sale of the asset. While owning a car is often essential for transportation, the vehicle itself, typically, will not provide any cash flow to the vehicle owner. The workaround? Pay cash for a used car where the depreciation has already occurred.
Another example of bad debt is paying for wants instead of needs. Typically, store credit cards carry very high interest rates and oftentimes, as most folks do not pay the card off by the due date, the interest continues to accrue and the payoff falls further and further from reach. In particular, high-end electronics such as computers or a T.V. also offer ‘same as cash’ financing. However, if payments or the payoff is not made according the due date schedule, consumers may find themselves faced with a staggering balance from the initial purchase and the accrued interest.
Credit card interest rates are not federally mandated. According to Bankrate.com, the average credit card interest rate is 29.99 percent. If you do not pay off your credit card debt each month, the monthly cost will always outweigh the benefit.
As you have read, these are just a few examples of good debt versus bad debt. I am happy to meet with you to discuss how we can get good debt working for you and put strategies in place that will help reduce bad debt.
Contact us at info@zinnerco.com or any of the professionals on staff at 216.831.0733. We are happy to help and ready to start the conversation.