Understanding different types of loans: Good vs Bad debt

Posted On October 31, 2023

Disclaimer: All the below options and views I gave are my individual opinions and you should definitely consult with a financial expert before proceeding with any of them. Please do your research and check what suits your financial situation.

How to figure out if you are getting into a good debt or a bad debt. It helps to be debt free soon and live a free human? As we all know, half of us are stuck in jobs that we are not interested just because they pay for our high expectations or debts that bind us to the job.

Good debt:

Good debt is described as something that helps you secure an asset, it can help you grow or pay for your retirement(early if you wish to) or gets you closer to the promotion or a higher income. A good debt as per financial experts is also something that charges less than 6% as interest.

Some of the examples of good debt are:

Home Loan:

Mortgage on a home is considered good as you can accumulate equity on it, pay off and have a shelter when you are retired. Also rental homes are considered a good investment as long as you have emergency savings based on your debts and can pay for your expenses for 6 months.

Education loan:

This is also considered a good debt if it is used to attain a degree that pays you a higher income and gives a competitive edge over your contemporaries. In a study it was found that usually people with a degree are paid more than high school pass outs. But you need to make sure that the degree is fetching enough in future.

Business Loan:

If you are interested and know a skill that you can make money out of, then you should put that to work. It can initially be your side hustle and you can fund it with your steady income job but eventually when it grows big and starts earning you well, you can quit your day job and take a loan that can help your business grow further. This is what makes it good debt, it helps you grow.

Debts that fall in grey area:

There are some debts that are good basing on the situation that are usually considered not a good choice:

Car Loan:

This loan comes under grey area of good vs bad because if you live in an area that has a good public transport with all essential stores nearby then you should definitely take that as a win and avoid buying a car or buy a second hand car for cash. But if it helps you to commute to work, drop off & bring back your kids and helps you in your business as it can be claimed as business expense then it can be a good investment to buy a car. This helps you buy back your time.

401k loan:

This is a loan you can take on your accumulated retirement savings basing on how your employer set the rules for borrowing. You can also withdraw from it directly but you have to pay a penalty of 10% for early withdrawal(before 59.5 years) and it is taxed as ordinary income. The good thing about the loan is that both principal and interest are going to your retirement account instead of a financial institution which will replenish it back quickly but the interest is usually high(around 8% as of now). Also as far as I checked last time, you can only take 50% of what you accumulated up to $50,000 max and pay it back within 5 years.

Peer-to-peer loans:

There are certain apps(like Prosper, Lending club etc.) from where you can take loans from peers who pool up the money and lend to people but they usually check your credit history and stuff. You must be careful and read all the terms and conditions while opting for these kind of loans incase there might be a catch. The interest rates can start from 7% but may go higher.

All the above loans can save you from falling down much farther into bad debt or can help you once in a while if you are in a position to pay back.

Bad debt:

Bad debt is something that doesn’t give any long-term benefits or accumulate assets. They are higher in interest rate(starts from 24%), usually unsecured and very difficult to pay off if you are too deep in them. It hurts your credit history which will make it difficult for you to get any kind of loan in future.

Examples of bad debt are:

Credit card loans:

Credit cards can be good if you are using them to get bonuses, interest free initial periods, miles and avoiding international charges etc. But if they aren’t paid in full every month then you get into deep debt. Usually these loans charge very high interest rate and can be variable meaning, they can go high with market fluctuations. If you are just doing minimum payments every month then it gets worse and keeps pooling up. This causes more trouble. So it is suggested to pay the credit card in full each month before the billing cycle and divide your spending into 50-30-20 rule to keep it in check. It helps you get rid of unwanted debt soon.

Pay day loans:

These are the loans that are most hurtful. They are usually hand loans that are given to people who don’t have access to other forms of credit and need to be paid back within 2 weeks of disbursement. They charge super high-interest rates even more than credit cards. Those people who take this kind of loan fall back into the same cycles of debt again.

Loans on existing equity of a mortgaged asset:

These are the loans that are given on the equity you accumulated on an already mortgaged asset like your home or any rental property. This will become a bad idea if the interest rates are high which they usually are like HELOC(Home Equity Line of Credit) loans. You are taking a loan on the equity you accumulated on an appreciating asset which will diminish the value you are getting out of it.

Irrespective of whatever loan you take, check all the terms and conditions as there may be hidden charges you might not know and let me know if you know about any other kinds of loans or if I missed anything in the comments below!!

Resources:

Good debt vs Bad debt: Understanding the difference