Banking insights: The difference between good and bad debt
Do you know the difference between good debt and bad debt? Borrowing is part of banking, along with saving and money management. And while there is nothing wrong with coming to your banking institution for a loan, it’s important to know how debt fits into your overall financial situation.
Good debt comes from borrowing money to buy or invest in something that will be more valuable over time. Depending on your situation, these might include a mortgage on a house, a student loan to cover tuition and other educational costs, or a business loan to launch a new business or finance new equipment or expansion. A banking professional can help you navigate these types of debt based on your objectives and your financial position.
Loans for remodeling and additions to homes can also be called good debt because they tend to increase the resale value of the home over time, also increasing net wealth.
Bad debt comes from borrowing to buy something that decreases in value, or taking out a loan for which you cannot afford the regular payments, resulting in your total debt load continuing to grow. Examples include charges on a store credit card with a high interest rate; payday loans to cover regular, recurring expenses; or any money borrowed to purchase something that is not useful or that you don’t really need.
How to tell the difference
With good debt, the value of the asset purchased with the loan increases over time, while the amount owed decreases as you make regular payments. In the end, you have more net wealth than you started with.
With bad debt, the value of the item purchased declines or disappears very quickly, and your net wealth decreases.
A good example of bad debt is a payday loan. These are loans taken out to pay for regular monthly expenses such as rent or a car payment in advance of your paycheck. Banking professionals point out that if you’re borrowing money to meet such recurring expenses, you probably won’t have enough money to repay the loan plus interest and meet the next month’s expenses, even after you receive your paycheck. You end up borrowing money again, or worse, rolling over your debt so you end up owing even more money.
Unlike lines of credit and other credit tools at banks, payday loans also usually have very high interest rates, often higher than the rates on credit cards. In addition, many payday lenders add special administration fees and other charges that drive the cost of the loan extremely high.
Sometimes, a debt can be either good or bad, depending on the circumstances. Although a home mortgage is usually considered good debt, it can be bad if you cannot afford the monthly payments. Financial experts agree that your consumer debt payments—all the loan payments you have to make such as car payments, line of credit and other loans, other than your mortgage—should not be more than 15 to 20 percent of your before-tax monthly income. Your total debt payments, including mortgage, should be no more than 40 percent of your before-tax income.
Talk to your banking professionals
The friendly banking consultants at First Utah Bank are always happy to talk to you about home lending, construction loans, refinancing and a full range of loan and credit options for established and new businesses.
Call First Utah Bank at your convenience, or use one of the contact methods listed on the Contact page of our website to set up a time to talk about how banking can meet all your credit, savings and money management needs for banking in Salt Lake City Utah.