Smart Debt vs. Bad Debt: 7 Reasons to Borrow (and 8 to Avoid)

Debt tends to have a negative stigma, and rightfully so. The wrong kind of debt can wreak havoc on people's lives.

But there are some instances when taking out a line of credit is an effective strategy. Whether you want to buy a home, open a business, or fund your education, debt may help you reach financial goals.

Healthy debt will help you build wealth, while bad debt often comes with high interest payments.

Here are some sensible reasons to go into debt (and totally useless ones).

Credit card debt for benefits (Good debt)

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As long as you pay off your statement balance every month, charging expenses to credit cards can be beneficial.

Making purchases with the right credit cards can help you earn cash back or travel rewards. It may also improve your credit score because it shows the credit bureaus that you're using your credit cards responsibly.

Mortgage (Good debt)

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According to data from Redfin, the median price of a home in the U.S. was $421,714 in 2023. But most people don't have that kind of money lying around, so mortgages are necessary for most homebuyers.

As you pay off your debt, you build equity. Once you have your house paid off, you own it, and it has the potential to increase in value.

Second mortgage (Good debt)

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Taking out a second mortgage is a decision you shouldn't take lightly because you're putting your house up as collateral.

However, the terms are usually reasonable, so it can be an effective debt tool under the right circumstances.

For example, you can use the money for necessary home remodels, funding a small business, or paying off credit card debt.

Student loan (Good debt)

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Investing in higher education could help you advance your career and earn more money.

Therefore, a student loan may be a healthy debt because it can bring you more earning potential. You can use your increased income to pay off your student loan debt.

Make sure you choose a major you're passionate about with many employment and salary opportunities.

Debt consolidation loans (Good debt)

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If you're already struggling with debt, a debt consolidation loan may offer some relief. It could condense multiple debts into one loan and offer a lower interest rate than you currently pay. 

However, lower rates may not be a better deal if it's over a longer duration. You should also watch out for "teaser rates" that only last a limited time.

Small business loan (Good debt)

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Whether you want to open your dream business or expand your existing one, a small business loan can help.

You can use the money to cover upfront costs like hiring employees, buying equipment, or remodeling real estate.

However, if your venture fails, you'll just be in debt, so have a clear plan for your business beforehand.

Personal loan for emergency repairs (Good debt)

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If you need emergency repairs on your car or home, consider taking out a personal loan to cover the expense.

While many people put these types of expenses on credit cards, it ends up costing them more in the long run due to high interest rates. If you can get a better rate for a personal loan (which you likely will), it could be a better alternative. 

Ideally, you should have three to six months of expenses as an emergency fund for these instances. However, a personal loan may be a good alternative if you don't have enough to cover the repairs.

Personal loan for travel (Bad debt)

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Traveling is an excellent way to enjoy new experiences and broaden your horizons. However, you shouldn't go into debt to travel.

Instead of applying for a personal loan, set aside a portion of each paycheck for a vacation. This way, you can enjoy your trip thoroughly, knowing you didn't go into debt to pay for it.

Personal loan for unnecessary remodels (Bad debt)

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Comparing yourself to other people can be detrimental to your finances.

For example, some people take out personal loans to remodel their homes to keep up with their neighbors. While remodeling can increase your home's market value, you should be careful of taking on debt for the wrong reasons.

Consider the potential return on investment before applying for a personal loan to renovate.

Auto loan (Bad debt)

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You may need a car loan to travel to and from work or school, depending on your situation.

However, auto loans are typically considered bad debt since cars quickly depreciate, so try to keep your car payment as low as possible.

According to Equifax data, you may save an average of $209 by opting for a used car over a new one.

Tax debt (Bad debt)

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It's crucial to correctly file your taxes on time and pay any balances to avoid tax debt.

Tax debt accrues costly interest charges that are compounded daily, and you can face penalties for paying late.

The IRS may take extreme measures to collect payment, such as garnishing wages, putting a lien on your home, or taking your tax refund.

Medical debt (Bad debt)

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Even if you have health insurance, it won't necessarily cover all medical costs, so you may have to pay some expenses yourself.

You can build an emergency fund to prevent medical debt and keep up with your health plan premiums.

If you find yourself in medical debt, you may be able to negotiate a payment plan with your healthcare provider to avoid the bills going to collections.

Credit card debt past the statement cycle (Bad debt)

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Credit card debt can be considered bad if you don't pay off your balance in full every month and carry it over from month to month. Not only will you face high interest charges, but it can also harm your credit score.

If you're already in credit card debt, stop using your cards and start paying more than the minimum balance due. Aim to pay off the cards with the highest interest first.

You might also consider opening a card with 0% APR on balance transfers.

Payday loans (Bad debt)

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Payday loans are known for their exorbitant interest rates and predatory practices. They're unsecured and have short repayment terms.

Although many states cap fees, a typical payday loan can have around 400.00% APR, according to the Consumer Financial Protection Bureau. Compare this to credit card interest rates, usually around 25.00% APR.

You should avoid payday loans at all costs.

Borrowing to invest (Bad debt)

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People often take out a line of credit, such as a personal loan, and invest the money in stocks, CDs, or bonds.

While it can sometimes pay off, you shouldn't try this strategy if you're an inexperienced investor. It's a risky move because if your investment fails, your loss will be much more significant since you'll have to pay that money back with interest.

Bottom line

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While there tends to be a negative stigma around debt, it can be an effective way to manage your finances.

It's important to note that bad debt is sometimes necessary, and taking on good debt isn't always a wise choice. Before opening a line of credit, ensure you're doing it for the right reasons.

With a clear goal and plan, you can use debt to your advantage to help you achieve meaningful milestones and get ahead financially.

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