3.16.21

Is debt good or bad?

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Quickly learn the difference between debt as a useful tool and a financial pitfall by asking these five questions.

Borrowing is part of everyday life for most people. Credit cards can be a convenient way to make purchases. Home loans provide a path to homeownership. Auto loans help people get to the places they need to be. If you’re a borrower or thinking of borrowing, have you considered the long-term implications of debt? Debt can be a useful tool as well as a financial pitfall. Here are questions to help answer the question, “What is bad debt?”

What’s the long-term value of the thing you want to finance with debt?

An asset or venture that gains value over time or helps you earn more is often debt-worthy. Here are a few examples:

  • an education that helps you land a job and earn more than if you hadn’t invested in college or a technical degree.
  • the purchase of a home that provides a secure place to live and is likely to appreciate
  • investing in real estate that provides rental income and can be later sold for a gain
  • starting a new business that you’ll use to generate income and build wealth

There are no guarantees that education, real estate or a business venture will generate more value than what you borrow, but many times these investments do pay off. Good debt!

Some things—even if they benefit you—depreciate quickly or lose their value immediately. Clothes and furniture have low value on the resale market compared to the price of new. Things like meals and vacations have no value after they’re consumed. Borrowing for things without long-term financial value is sometimes considered bad debt.

What’s the opportunity cost of not borrowing?

In an ideal scenario, we’d all have cash on hand to pay for what we need when we need it. However, the ideal often doesn’t match reality. And sometimes, not borrowing limits our options.

Consider this situation: James needs a car to get to work (and no other transportation options are available), but he’s hesitant to get an auto loan. Without borrowing, James will miss out on the opportunity to earn income and possibly learn new skills. In his case, debt would be useful.

There are opportunity costs in housing choices, too. For example, Ashleigh decides to shift from renting to becoming a homeowner, so she gets a home mortgage. Ashleigh realizes that not buying a home would cost her the opportunity to build home equity and long-term wealth.

What’s the cost of the debt in dollars?

Many buyers who use credit overlook the true cost of their debt by focusing on a low monthly payment. This can be a costly oversight.

Sellers who promote low monthly payments use a number of tactics to make a profit. Two that dearly cost consumers are inflated base prices and high interest rates.

Payday loans always put borrowers at a disadvantage. The Office of the Michigan Attorney General explains how:

“Payday loans have high service fees and a short repayment period. For example, a customer who borrows $100 for two weeks and is charged $15 (the maximum for this loan amount), will pay a service fee equal to a triple-digit annual percentage rate (APR). The actual cost of the two-week loan is $15, which equals a 391 percent APR — and that does not include any additional fees for checking your eligibility.

“Even worse, payday loans can create a trap for a cash-strapped customer who cannot repay the loan and takes out a second payday loan to pay off the first. It’s a slippery slope. When the customer cannot pay back the second payday loan, the customer takes out a third, and so on and so on. This rollover pattern racks up service fees and puts the customer in perpetual debt.”

An APR of 391% plus fees—bad debt!

Before you take out a loan, figure out how much it will cost you over the life of the loan. Our loan calculators make it easy.

Are you getting the best rates?

Another difference between bad debt and good debt comes down to the numbers. As of this writing, the average credit card APR is 16.13%, while the rate for a 5-year HELOC at Consumers is just 3.99%. Assuming there is equity in the home, a homeowner who wants to build a new deck might be better off financing the project with a home equity loan rather than a credit card.

What’s your personal situation?
Ultimately, the factors that determine whether debt is good or bad depend on your individual situation. Your income, existing debt, and how that debt is structured must be balanced against the potential gains of borrowing.

If you have questions about any kind of loans—home, auto, personal, credit card or business—our team is here to help. Give us a call at 800-991-2221.

Consumers provides banking services for more than 100,000 members. If you have banking questions, call us at 800-991-2221. We make it easy to bank how you want, when you want.

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