Most consumers spend nights awake worrying about the debt they have or might have to take on. "Debt" is a bit of a dirty word and consumers are more averse to it than ever before because of the impact the recession had on finances and the way people think about their money. However, debt is often necessary function as a modern consumer. Taking on debt helps facilitate large-ticket purchases you need to make, or can help pay for everyday items.
But not all kinds of debt are bad. In fact, when it comes to your credit score, there are actually types of debt that will reflect well on you.
How to Identify Good vs. Bad Debt
There's a simple litmus test for determining whether the debt you are about to accumulate could be classified as good or bad. Namely, if going into debt demonstrates an investment in your personal or business's future, builds wealth and is taken out in a responsible manner, it can be considered a good kind of debt.
On the other hand, both using debt to make a purchase for luxury goods that aren't totally needed and leaning too much on borrowed money can be seen as bad kinds of debt.
The amount of the loan also matters. While large sums may need to be taken out for large purchases, any amount you take out that lowers your credit score automatically or severely restricts your finances and ability to make payments (even if it is for a good debt like a mortgage) will likely be typified as bad debt.
It also depends on from whom you borrow. Recognizable banks and financial institutions that lend are usually nonsuspect debtors, but as Debt.org notes, borrowers who take out from payday loan providers, for example, may be more exposed to bad types of debt.
Kinds of Good Debt
Having set the criteria for what constitutes a good debt, here are a couple common examples that consumers usually engage in:
- Buying a home: The most noted example of good debt is taking out a loan to buy a home. Obtaining a mortgage to become a homeowner represents a sizable financial commitment, but if payments are made on time, the equity created by homeownership is often a benefit for consumers. The same positives also carryover for real estate investors – not just regular homeowners. Getting a home is a good kind of debt because a house is often a consumer's biggest asset. If home values rise and consumers have made value-adding renovations, the debt taken out to own a home will look better and better. An Equifax blog notes using home equity to add another bathroom is a better investment than using credit card debt to pay for dinners and vacations.
- Secondary education: Whether this is pursuing a traditional undergraduate degree or enrolling at a trade or technical school, taking out money to enhance one's education is normally looked upon as a good investment. Getting a degree or certifications can help improve a consumer's earning potential and attractiveness in the job market and is an investment likely to pay for itself in the long haul.
- Borrowing for your business: Small-business ownership is increasingly thriving in a better U.S. economy, and making investments into the company for expansion is viewed as a good kind of debt. Owners often have to obtain capital or loans to finance operations and grow, and this is good debt in itself. However, owners should take measures to protect their own credit scores from potential business failure by incorporating the business and legally separating business and personal finances.