When we hear the word ‘debt’, we often think of financial burden. But you will find that not all debts carry a burden. These are known as good debts.
So, what exactly are these good debts? Is there anything good in debt?
In simpler words, good debts are the loans that finance something to build wealth or increase your income. Mortgages and student loans are the most common examples of good debts.
Bad debts, on the other hand, are the loans that you take out for your discretionary expenses or something which doesn’t provide any return. For example, credit cards, personal loans, and payday loans are bad debts that don’t provide you with any return. Instead, you may have to shell out a hefty amount for paying off these debts. Bad debts like payday loans have high-interest rates. The average APR is above 300%. Several borrowers fail to pay such a high-interest rate and get into debt. Others consolidate payday loans to pay what they can afford and save money.
In an interview with CNBC, wealth advisor Helen Modly said, “Never use debt to acquire a depreciating asset. For a first-car-after-college sort of thing, use the least amount of debt over the shortest time frame you can afford. Cars, vacations, celebrations should rarely be financed.”
So, if you think about incurring debt in your life, focus on good debts only. Here are some tips that can help you build wealth by using good debt.
Student loans
Taking out a student loan can help you earn a degree by providing the necessary funds for it. It allows you to qualify for a better-paying job and fulfill your dreams.
According to a Bureau of Labor Statistics report, workers with at least a bachelor’s degree earned more than the $907 median weekly earnings for all workers.
You will find two types of student loans: a private student loan and a federal student loan. Federal student loans usually have better advantages than private loans as you:
- Can take out a loan with fixed interest rates
- Get flexible repayment options
- Don’t require a credit score or a cosigner.
Mortgage loans
A recent Statista report shows that 50% of Americans consider mortgage loans as good debt. David Waldrop, president of Bridgeview Capital Advisors in El Dorado Hills, California, said, “While it may be scary to have a mortgage debt of $400,000, you now have an asset worth close to the same amount. Owning a home has the potential to grow wealth over the long-term. While the interest you pay on a mortgage is significant, historical returns on real estate over the long-term can still put you way ahead.”
It can help you buy your dream home and build equity over time. Also, opting for a mortgage has certain advantages like:
- Owning a home is better than renting
- Increases your net worth
- You can reduce your taxable income through an itemized deduction of mortgage interest.
So mortgages are one of the good debts that can help you create wealth and improve your financial life.
Home equity line of credit (HELOC)
Glenn Brunker, president at Ally Home, said, “Equity provides many opportunities to homeowners, as it’s a great source for savings and for financing. For example, the equity amassed in a starter home may later provide the down payment needed to purchase a larger home as a family grows and needs more space. It’s a time-tested way to build wealth.”
A HELOC is a revolving line of credit that you can borrow against your equity in your home. In most cases, you can borrow up to 85% of the value of your home minus the amount you owe.
Your lender will set up a draw period, which is usually 10 years. During this period, you can withdraw funds whenever needed within the available credit.
After the draw period ends, you will have a repayment period, typically of about 20 years. With a HELOC, the interest rate is low, but you are keeping your home equity at stake. If you fail to repay your loan, you may lose your home.
How can you use HELOCs to build wealth?
- You can use it for home improvements and increase the value of your home. By doing so, you can deduct the interest on home equity loans of up to $750,000 when the funds are used to “buy, build or substantially improve the taxpayer’s home that secures the loan”, as stated by the IRS.
- You can consolidate your high-interest debts and get rid of them easily. In the long run, you can save a substantial amount in interest payments. It can be a small step towards building wealth.
- A HELOC can help you start a new business without tapping into your savings or taking out small business loans on high-interest rates.
- If you want to buy an investment property, you can take out a HELOC for making the down payment.
So, the bottom line is debt is not always harmful to your financial health. If you rack up bad debts, it can hurt your finances as you will have to pay a substantial amount for discretionary expenses or emergencies. You need to decide wisely and opt for good debts that can help you build wealth.
That’s why I would like to suggest you create an emergency fund so that you won’t have to rely on loans to tackle any unexpected expenses. So, the next time when you plan to buy something, ask yourself how the purchase will benefit you in the future.
What do you say?
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