You might be under the impression that all debt is bad. That simply isn’t the case. While no one likes to owe money, some loans can help you become more financially secure and provide you with opportunities to improve your current financial situation further.
The important thing to understand is that not all debts are the same. Good debts present less of a risk for lenders and typically come with lower interest rates. Bad debts tend to present red flags to lenders and make them more cautious about lending you money. These debts typically come with higher interest rates to make up for the added risk the lenders are assuming.
To help you better understand the differences, let’s review the characteristics of both good and bad debts.
Unsecured Debt vs. Secured Debt
Most debt falls into two categories:
- Secured Debt
- Unsecured Debt
Secured debt is debt that is “secured” by collateral. What that means is that if you do not repay the debt as promised, your lender can repossess the security to satisfy your debt. Examples of secured debts include:
If you fail to make your car payments, the lender may repossess your vehicle to make up for some of the financial loss they will incur.
Unsecured debts are debts that have no collateral assigned to them. They represent more significant risks to lenders because there is nothing they can claim in return for your debt if you do not repay as you agreed. As a result of the increase in risk, the interest rates are typically higher. Examples of unsecured debts include:
- Credit cards (the most common by far)
- Personal loans
- Payday loans
The goal is to limit your use of unsecured debt and to repay those debts as quickly as possible. In the case of credit card debt, paying the full balance off monthly, whenever possible, will serve you best, especially since the interest rates are so high on bank and store credit cards. Short-term personal loans also carry higher than average interest rates, encouraging prompt payments.
For many people, unsecured debt such as payday loans can become a trap that is difficult to escape. It is easy, thanks to their extremely high-interest rates, for these bad debts to become impossible to repay, which can damage your credit for many years to come.
Good or Bad — How Can You Know the Difference?
For the most part, good debts are debts that help you secure better positions in the world. This is why student loans, while unsecured, can be good debts. The big caveat here is that you are pursuing a profitable degree and that you complete your education. In these instances, the debt helps you secure better jobs and increase your earning potential.
Taking a mortgage out on a home typically is a good debt, too, as long as you make your payments faithfully and on time. A mortgage is a long-term investment where your goal is to ultimately have no home or rent expenses later in life.
Auto loans, while secured, can become bad debts if the interest rate is excessive or if the loan terms are unfavorable. On the other hand, your new car can become the vehicle that takes you to a better job and a better life.
Bad debt typically offers temporary gratification and brings no real value to your long-term financial landscape. In fact, that is one of the questions you can ask yourself when considering debt. “How will this impact my long-term financial health?”
We’re Here to Help!
As a credit union, we’re dedicated to helping you achieve your financial goals. From providing education to extending good debt and more, we’re prepared to help you build your credit and avoid unnecessary bad debt traps.
Simply email us at email@example.com or give us a call at 202-479-2270 to start your journey.