It’s not often that people talk about debt as something good to have. Most of the time when people mention debt, they refer to credit card balances, student loans that feel stifling, or a car payment that might be eating up too much of the household budget.
Each of those types of debts does create a drag on your finances, thanks to the fact that it ties up cash that you need to use each month to slowly chip away at your balance. Worse, debt comes with interest you need to pay, too.
Interest is what can kill your finances and it’s what makes debt so “bad” to have.
The Cost of Carrying Debt
The interest rate on your debt is the fee you pay for the privilege of borrowing money (if you took out a loan) or financing a purchase (if you charged something to your credit card).
If you didn’t need to pay interest, debt wouldn’t be such a bad thing at all. You’d just need to pay back the same amount you borrowed.
Of course, that’s not how it works as anyone who’s ever carried a balance on their credit card can tell you. The interest that gets charged costs you more than what you borrowed or financed. The higher the interest rate, the more that debt will cost you.
Take a look at this example to see how different interest rates dramatically impact what you would pay to borrow the same amount of money from a lender (assuming a loan term of 60 months, the average length of a car loan):
|Money Borrowed||Interest Rate||Total Amount Owed|
There’s a $4,277 difference between borrowing that money at 5 percent versus 10 percent.
Now just imagine we’re talking about borrowing hundreds of thousands of dollars — which is exactly what most people do when they buy a home and get a mortgage. With that kind of money, the interest rate you get on your home loan becomes really important.
Even a point of interest (paying 4 percent versus 5 percent, for example) can make the difference between tens of thousands of dollars owed in interest fees alone.
(As a side note, this is why it’s important to maintain a great credit score. The better your score, the more likely you are to receive the best interest rates from lenders and financiers.)
Are Certain Types of Debt Worse Than Others?
All debt comes with interest, and interest costs you money. So why is some debt considered good debt? Isn’t it all bad?
Here’s how we explain the difference:
Bad debt is debt you end up with when you borrow money to purchase a depreciating asset. Cars are a prime example, which is why a car loan is considered bad debt. They depreciate the minute you drive off the lot — but you’ll be paying interest on that loan for the next 5 years.
Credit card debt is also bad debt thanks to sky-high interest rates that can make what you owe fast outpace the value of the things you actually obtained.
If it’s not going to generate money for you or increase in value, it’s probably bad debt. So what’s good debt?
Good debt is debt that you use in hopes of obtaining an appreciating asset. That’s why student loans are often considered “good debt.” You borrow money to pay for an education that will hopefully provide you with a better-paying job than one you could have gotten without a degree.
Your higher education can serve as an investment into yourself and your future earning potential. The old saying “it takes money to make money” could apply here. The idea is that you need to invest first, and that either means spending money you have or borrowing it if you don’t.
Of course, even good debt is still debt and that presents a risk — as anyone who took out more student loans than their post-college job allows them to reasonably repay can attest.
3 Ways Millennials Might Leverage Good Debt
Good debt can help you earn more income or obtain something that will increase in value. There are a few ways you can use good debt to your advantage if you’re in your 20s or 30s:
- Invest in yourself. This could mean student loans, as mentioned above — or it could mean other types of education, like special training programs, certification courses, or licenses and designations. These are all ways to invest in yourself professionally, which could translate into more earnings in the future. But you could also consider investing in yourself personally, through something like a personal development program. There’s no one straight line to success, and using resources for self-improvement could pay off in ways you can only imagine right now.
- Buy a home. This is not a hard-and-fast rule nor a guarantee. Buying property is not always better than renting, but it still provides a good opportunity for millennials looking to add to their assets — especially if you consider investing in a rental property. Again, it’s an option but not necessarily the best course of action for everyone. You need to carefully analyze your own financial situation, cash flow, and goals before you buy a home. (This calculator can help you determine if renting or buying is better based on your situation and location.)
- Start a business. Taking out a small loan in order to start your own business could pay off in a big way if your entrepreneurial venture is successful. When you work for someone else, your earning potential is always limited (by the size of your paycheck and what your company chooses to pay you). When you run your own business, your earning potential could be unlimited.
It’s important to understand that none of this should be interpreted as a green light to go out and borrow thousands with no strategy, risk assessment, or plan. You always face the risk of incurring costs that you can’t recover.
Just because you could use a debt as leverage to purchase appreciating assets doesn’t mean the asset you end up with is guaranteed to increase in value. Again, make sure you carefully analyze your financial situation and explore all your options before choosing to take on debt.
At the end of the day, debt is a liability. Make sure your finances can handle the risk that even good debt carries.