Woman Checking Good Vs Bad Debt

What Is Considered Good Debt And Why Is A Mortgage The Best Debt Of All?

Carla Ayers4-Minute Read
August 26, 2021

Debt is a four-letter word but it’s not always a bad word. Some debt is unavoidable. Most Americans don’t pay for a home or the family car with cash – they need lenders to let them borrow the funds to make large purchases.

Here we’ll cover what good debt is and why a mortgage is the best type of debt to have.

What Is Good Debt?

Good debt is a loan used to finance an investment that offers a good return on the investment. An example of a good debt would be a mortgage to purchase a home. You borrow money from the bank to pay for a home that will hopefully increase in value over time.

How Much Debt Is Good To Have?

This question has a few layers to it. Good debt is about the qualitative nature of the debt in question. Taking on the responsibility of a mortgage to buy a home is a very different debt than buying the latest fashion in a boutique. A mortgage will appreciate in value, most pieces of clothing do not.

The quantitative question of “How much debt is good” is based on your circumstances. Most lenders will calculate a borrower's debt-to-income ratio (DTI) to evaluate the risk of lending to the borrower. This ratio weighs your total amount of debt against what you bring in as income.

What Are Some Examples Of Good Debts?

Good debt is a debt the borrower has planned for and can afford. Big ticket items like vehicles, work equipment and housing are needs that will likely require some level of debt. These purchases usually fill a vital need for your lifestyle or career choice.

Mortgages

Most adults will spend most of their income on their home. Mortgage, utilities, renovations, general maintenance are all a part of the cost of living. Unlike student loans, mortgages pay for shelter that could appreciate in value over time and the homeowner would have housing expenses regardless.

If you purchased a home with a 15-year, fixed-rate mortgage for $250,000 after 5 years, with a conservative 3% appreciation rate, your home would be worth $289,818.52. Once paid off in 15 years, your home would be worth more than $139,000 over your original purchase price.

The graph below shows the continual appreciation over the course of a 15-year loan at 3%.

Year

Rate of Increase

Home Value

Year 1

3%

$250,000

Year 5

3%

$289,818.52

Year 10

3%

$335,979.09

Year 15

3%

$389,491.85

Total Appreciation

$139,491.85

 

Student Loans

Taking out student loans to attend trade school or college to attain the skills and experience to get a higher paying job could be considered a good debt to some. A study by The Georgetown University Center on Education And The Workforce found that over a lifetime, individuals with a Bachelor’s degree make 84% more than those with only a high school diploma.

Business Loans

Taking out a business loan to finance your entrepreneurial dreams could be considered another form of good debt. If you’ve done the research and developed a solid business plan, it could be the infusion of cash to launch your business and financial future to new heights.

If you’re looking to start a business or you need help flushing out ideas, contact your local Service Corps of Retired Executives (SCORE) by searching your local area for a volunteer at www.score.org. SCORE is the nation’s largest network of volunteer, expert business mentors across the country who provide free consultation services and advice to business owners and aspiring entrepreneurs.

What Is Bad Debt?

Bad debt is debt used to buy noninvestment goods and services. These items usually don’t appreciate in value. Bad debt often accumulates on credit cards. Typically bad debt is used to buy goods for consumption, so consumers are often paying interest on the purchase price while the item itself loses whatever value it had.

Is There A Worst Type Of Debt?

Payday loans and other short-term debts are considered the very worst type of debt because of the exorbitantly high interest rates and fees charged. While a payday loan may get you money when you need it, it could hurt you in the long run.

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Pop Quiz: Are These Good, Bad Or Neutral Debts?

Let's discuss the good, the bad and the neutral debt types below. Hint: They’re all trick questions.

Debt Consolidation Loans

In conjunction with a budget and a resolve to stop using credit cards, a debt consolidation loan is a neutral debt. While it makes financial sense, it does not appreciate in value. In some cases, this could become a bad debt quickly because freeing up a credit card for new purchases can push borrowers deeper into debt.

Cash-Out Refinances, Home Equity Loans And HELOCs

Cash-out refis, home equity loans or home equity lines of credit (HELOCS) used to finance renovations that will likely increase a home value, makes these options a good debt. If the borrower plans to use the proceeds for other purposes that create more debt, then these options would be considered bad debt.

Auto Loans

Reliable transportation is essential to many careers and businesses, so to the extent that the car or truck is necessary, an auto loan can be a good, or at least an unavoidable, debt. Anything beyond reliable transportation (like a luxury car or sports car) could be considered a bad debt.

Buying Investments On Margin

Many stock brokerage accounts allow investors to buy on margin, or credit. This is technically a good debt but a very risky way to invest. Inexperienced investors should avoid margin buys. Before buying on margin speak with a financial investment professional, as there can be an incredible amount of risk involved.

Is No Debt Best Of All?

Debt is necessary to build your credit. Having no debt makes it impossible to show your credit worthiness. Lenders might be hesitant to lend to someone with no credit score when they apply for a mortgage or business loan. If you don’t have enough credit history, qualifying for an auto loan or mortgage can be difficult.

Does Good Debt Improve My Credit Score?

Lenders are primarily concerned with the amount of overall debt a borrower has. As we discussed early, learning more about your debt-to-income ratio is a great place to start when evaluating your financial health. Good debt can be problematic if the borrower can’t comfortably make their payments.

The Bottom Line: It’s How You Use Debt That Determines Whether It’s Good Or Bad

Debt can be good if the borrower manages the debt correctly and invests in assets that will appreciate in value. When investing in yourself, your business or your shelter, you are in control of your financial future. Reaching out to a professional financial advisor or real estate professional can provide insight now that can maximize your credit score today.

 

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Carla Ayers

Carla is a freelance writer and Realtor with a background in marketing, communications and property management. She attended Eastern Michigan University where she received a Bachelors in Arts Marketing and a Masters in Integrated Marketing & Communications.