To many people the term “good
debt” may seem like an oxymoron. Being in debt can be a burden, but there
are types of debt that are beneficial because of the opportunities that come
out of them. Avoiding debt completely isn’t always the best option. Paying for
everything in cash can often deplete your savings, and leave you without having
anything to fall back on. Knowing when it’s necessary to borrow money, and
managing your debt well is part of what becomes good debt.
A lot of what makes certain debt “good” can
be associated with what is known as “opportunity cost”. Opportunity cost is the
sacrifice a person makes of income in the short-run with the intention of
making more than they would have in the long term. Furthermore, good debt
should be for things you need but can’t afford to pay for out of your own
pocket. As the saying goes: “it takes money to make money”. Here are three
examples of what can be considered good debt.
Education
Tuition for schools is notoriously high,
and there’s pretty much no way you can get a good education without gaining
some debt. It’s true that certain careers are obtainable without getting a
college degree, but they are scarce and don’t pay as well. For example, you may
get a job where you make $30,000 a year without going to school. However, you
may never go above that amount and have a greater opportunity to maketwo times
as much if you go to college. This is where good debt and opportunity cost come
in. By sacrificing the $30,000 over four years (a total of $120,000) you are
investing in the long term, and the idea that you will make vastly more than
what you lost. Since the debt you are acquiring is for the purpose of something
you need to become more successful, it is considered a good debt.
Homeownership
Buying a home can be pretty costly, and if
we’ve learned anything from the last decade—it’s pretty volatile too. Chances
are you won’t be able to pay for a house upfront, and even if you could it
isn’t wise to spend all your capital in one shot like that. A mortgage loan is
a good form of debt because of the equity that comes out of it. Once you’ve
paid off your loan you now have a new asset. Down the road the opportunity cost
will most likely be positive too, since you may end up paying less in property
taxes and home maintenance than you would have in rent every month.
Small
Business
Taking out a loan in order to start your
own business is another form of good debt. Again, in the long-run the
opportunity cost of having your own business can end up being a bigger
financial windfall for yourself than if you worked for another company. Of
course the risk associated with starting your own business is much higher than
getting an education or owning a home. Although this is good debt, since you
are doing something to further your financial success, it is important to do
research and know if it’s right for you.
As stated with the small business example,
it’s imperative to realize that taking on debt in any form can be a risk, and
you should do your research before making any costly decisions. When taking on
debt of any kind keep your debt to income ratio in mind. A good rule of thumb
is your monthly debt payments should never exceed 36% of your gross monthly
income. Be aware of how much debt you’re taking on at any one time. What all
three of these examples, and any type of good debt, have in common are that
they are investments in your future with the intention of capital growth.
Remembering that when deciding to borrow money can help you avoid bad debt
situations.
Angie
Picardo is a staff writer for NerdWallet, a personal finance website dedicated
to helping consumers find the best credit cards.
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