We’ve all heard of good debt vs bad debt. But what really is the difference and how can homeowners put themselves on good financial footing and make sure they have enough good debt and less bad debt?
All debts have one thing in common – people wanted or needed things that they couldn’t buy outright, so they bought those things on credit or took out a loan to make the purchase.
Because that money has to be repaid, usually with interest, debt is something that people try to avoid. But not all debts are created equal.
Good Debt vs Bad Debt
As counterintuitive as it may seem, there is good debt and bad debt. The good ones actually improve your financial situation in the long run.
What Is a Good Debt?
When it comes to good debt vs bad debt, it’s important to understand what good debt means. Good debt is one that improves your earning potential, raises your net worth, or is likely to have value in the future. One common example is a student loan that qualifies someone for a higher-paying job. If the lifetime salary difference is more than the student paid to attend school, it is officially a good debt.
Mortgages and Their Benefits
A home might be the most expensive purchase that you ever make, but that big mortgage isn’t as scary as it seems. If you keep making payments on time, it can give you a major financial boost and can be good debt for homeowners vs bad debt if you’re behind on payments.
Home equity is the portion of your home’s value that you own outright or the total value of your home minus the percentage that is mortgaged. Because that portion counts as collateral for your mortgage, you can’t use it as a financial asset.
Your equity is the part that is working for you. If you decide to sell, you can use your equity to buy your next home. As long as you stay, however, you can turn it into cash in the form of a home equity loan or “second mortgage.”
Under the Tax Cuts and Jobs Act, you can deduct up to $750,000 of the mortgage debt that lets you buy or renovate a home. You may be able to deduct more if you took out your mortgage and closed on the home before mid-December of 2017.
Mortgage interest tax deductions can be valuable to any homeowner, but it tends to be most valuable to holders of newer mortgages. In the early months of a mortgage’s lifetime, the percentage of interest in each payment is very high.
If you eventually pay off your mortgage completely, you may find that it increases in value far beyond what you paid for it. You can then sell it at a profit or pass it on to your heirs.
No financial benefit of a mortgage is ever guaranteed, but even holding one can help you improve your financial standing. If you apply for a different kind of loan, such as a car loan, a mortgage with a history of on-time payments can position you as a desirable borrower.
The Flip Side – Bad Debts
On the other end of the debt value spectrum lie credit cards, payday loans, and other bad debts. These offer no benefit but can make your financial situation much worse. How do we figure out what’s a bad debt when measuring good debt vs bad debt?
The things that people buy with credit cards usually don’t increase in value over time. In fact, you usually have the debt longer than the purchase is doing you any good financially. Vacations end, clothes go out of style, and holiday gifts are forgotten, but credit card debt sticks around until it’s paid off.
Interest – Growing Your Debt
Credit cards: good debt vs bad debt? Credit card debt would be considered bad debt because it doesn’t just stick around, it grows. This is due to the interest rate involved, which averages more than 15 percent.
In the long run, you can add a lot to your bill by not paying your balances in full, and the total you end up paying ends up being much higher than any item’s initial purchase price.
Payday loans are even worse for you than credit cards. They take advantage of your need for emergency cash by charging you up to $30 for every $100 you borrow. If you don’t pay it off right away, your annual interest rate ends up totaling 400 percent.
Why Bad Debt Is So Bad – Your Credit Score
Debt is inherently bad in our minds, so how can you measure good debt vs bad debt? Well, debt is bad in the short term because interest is more than worthless; you lose money but get nothing in return. However, debt can also have a more serious long-term impact on your finances by damaging your credit score.
Your credit utilization, or the amount of debt that you carry in comparison to your credit limit, equals 30 percent of your credit score. The closer you creep to that credit limit, the worse your score will get.
If you make late payments, your credit score will drop even further. Even good debt mortgages can turn into bad debt mortgages if you default.
Fixing Bad Debt With Good Debt
So, is mortgage debt good vs bad if you’re having trouble paying bills?
Not necessarily. If you’re able to use your home equity to get cash to pay off your high-interest debts, your mortgage is still working for you. Current credit card interest rates average 17.5 percent while mortgage rates range from approximately 4.4 percent for a 15-year mortgage to 5.01 percent for a 30-year mortgage. Even if you trade one for the other, you still save more than 10 percent overall.
Any time you have equity in your home, you can turn that equity into cash. The amount you borrowed effectively becomes re-mortgaged.
If you go this route, you want to make sure that your loan-to-value ratio after refinancing is no more than 80 percent. To check, add the amount you will borrow to the current amount that you owe on your mortgage. You want to make sure that you understand good debt vs bad debt when refinancing for your financial situation.
If you don’t like the idea of owing more on your mortgage but don’t want to sell and move, a sale-leaseback program offers a solution. The program enables you to sell your home and receive all of the equity.
Unlike a traditional sale, however, you get to stay in your home as a tenant. You pay rent until you are ready to buy your home back or relocate. The choice is yours. You get the money to pay off bills, whether they be good vs. bad debt.
If you have debt as a homeowner, it can be confusing to understand good debt vs. bad debt. Make sure you’re working on your finances to ensure you have more good debt than bad. Talk to a financial advisor today.