The word “debt” can sometimes carry a pretty negative connotation. When most people think of debt, they think of struggles, financial hardship, foreclosures, repossessions, and more bad stuff. The truth is, there are several different kinds of debt – and they’re not all bad. In fact, there are some debts that are good and necessary depending on your desired lifestyle.
How are Some Debts Different from Others?
Debts can differ in a few ways such as payment structure, collateral, and intended purpose. These different debt types will impact the way that you are able to use the debt and how it is repaid.
There are good debts and bad debts, which is largely dependent on your financial wellbeing at the time of assuming new debts and the reason that they occur. Let’s take a look at different debt types along with some examples and how to determine whether a debt is positive or negative.
- Secured Debt
These debts include collateral, which means that the amount borrowed is backed by the value of an item. In the event of default or failure to repay the debt, the item can be repossessed by the creditor. Examples of secured debt include a car loan, mortgage, or financed appliances.
- Unsecured Debt
These debts are not backed by any sort of collateral. Examples of unsecured debt include credit cards, student loans, personal loans, and medical bills.
- Revolving Debt
These debts are open lines of credit that carry a balance which must be repaid. Revolving debts will have a credit limit, which is the maximum amount of debt that can be accumulated on the line of credit at one time. Credit cards are forms of revolving debt.
- Non-Revolving Debt
Also known as installment debts or installment credit, non-revolving debt has a set amount, which is paid down over an agreed upon term. Examples of installment debt include car loans, student loans, and mortgages.
You can think of these different debt types in two separate tracks. All debts are either secured or unsecured, as well as revolving or non-revolving. However, you can have both secured and unsecured forms of revolving and non-revolving debts.
Comparing student loans and auto loans is a good example of this. Both are non-revolving forms of debt; however, student loans are unsecured whereas an auto loan is secured with the vehicle as collateral.
Secured vs. Unsecured Debt
The difference between secured and unsecured debt is whether or not the debt is backed by a form of collateral such as a home, car, or other item. Neither form is definitively “good” or “bad”. Most people take on both forms of debt at some point.
Revolving vs. Installment Debt
Comparing revolving and non-revolving or installment debts is more about the purpose of the money being borrowed and how the credit is used. Revolving debts are open lines of credit like a credit card, whereas installment credit has a total amount financed that is paid down over time.
Both forms of debt have minimum payment amounts, due dates, and interest rates. With revolving credit, you need to spend money to build up a credit balance, which is then paid off as it is used. The balance can increase up to the credit limit as more purchases are made. Non-revolving debt, on the other hand, does not go up and down over time, but works towards paying down the full amount in installments over the life of the loan, known as the loan term.
Good Debt vs. Bad Debt
So how do you know if taking on more debt is a good idea? There are good debts and bad debts, but sometimes it’s not so straightforward. A lot of the reasons why a debt may be considered good or bad is dependent on your individual financial goals, budget, and desired lifestyle.
Types of Good Debt
From a pure financial standpoint, good debt is something that will increase your net worth. Positive debt can be anything that improves the quality of your life or has other financial benefits. Keep in mind that a debt can only be considered “good” if it makes financial sense. While it may make you happy to buy that new sports car, if it will put you in a state of financial hardship, or not increase your net worth – it’s not good debt.
Examples of good debt include:
- Investing in various income sources such as starting a business
- Purchasing a home
- Home renovations and building equity
- Furthering your education through college, online courses, or other programs
- Consolidating debts (this can be considered good depending on the state of your debts)
An example of good debt that has other financial benefits would be determining your down payment when financing a new car weighed against other options with that money.
Let’s say you are financing a new car that costs $20,000. You received a good interest rate at 3% for 60 months. You’ve saved up a lot and can afford to make a substantial down payment without cutting into your emergency funds. You want to put down somewhere between $5,000 and $9,000.
With $5,000 Down
Your monthly payment would be approximately $270 and you’ll pay about $1,170 in total interest over the loan term (5 years).
With $9,000 Down
Your monthly payment would be approximately $198 and you’ll pay about $860 in total interest over the loan term (5 years).
So, comparing your two options at the high and low end of your down payment budget, here are the advantages of each.
- $4,000 less to spend right now
- Maintain your same rates & terms
- Financing a lower amount
- Save $310 in total interest
- $72 lower monthly payments
So it looks like the larger down payment is the way to go if you can afford it, right? Well, what happens if you were to invest that extra $4,000?
Assuming you’d be comfortable with both monthly payment options, you’re only saving $310 by putting more down.
So – if you can make more than $310 over the next 5 years with that $4,000 (which is very attainable with smart investments), the lower down payment option may be better for you!
Types of Bad Debt
Of course, there are also negative forms of debt. Bad debt is put towards items that have little value or that’s value depreciates over time. While these debts to some extent can be necessary or justified, they need to be handled cautiously as they can damage your financial wellbeing such as your saving ability or credit.
One of the most common forms of “bad debt” is excessive credit card use. Struggling to make your credit card payments will prevent you from saving money, can lead to more financial struggle down the road, and potentially damage your credit.
Forms of bad debt include:
- Auto loans – while this debt can be justified, it is considered bad debt because the value of the vehicle depreciates over time and much of the money put into financing and owning the car could be considered a net loss.
- Non-essential items on credit – Purchases on credit can be a smart financial decision, but if they’re excessive or for non-essential items, this will not increase net worth or provide financial value. For this reason, they are considered to be bad debt.
Knowing How to Handle Your Debt
Everyone will encounter debt of some form within their financial journeys, and it can be a good thing! Becoming familiar with the different types of debt and weighing your options in financial decisions will help you to stay out of financial hardship.