Owing a lot of money can be really stressful and many people aim to avoid debt at all costs. But debt isn’t necessarily inherently bad in every situation. In fact, debt can be a powerful tool to help you build wealth — depending on the kind of debt you take on and your reasons for borrowing.
It’s important to understand the differences between various kinds of loans so you can make a more informed choice about when borrowing may be a good idea. This guide can help you better understand why having a lot of debt isn’t always a bad thing — although it definitely can be.
There are benefits to certain kinds of debt
Some kinds of debt can be beneficial because they help you grow your income or your net worth.
Federal student loan debt, for example, enables you to significantly increase your earning potential — provided you study in a field where there are job opportunities and earn a degree from a respected school. If you have a lot of student loan debt because you became a doctor or a lawyer but you’re now able to earn hundreds of thousands of dollars per year, that debt isn’t a bad thing because you made an investment in yourself that paid off.
Mortgage debt can also help you grow your net worth. Homeowners as a group are significantly wealthier than renters. And when you use a mortgage to buy a home, you can benefit from real estate appreciation, as well as from building equity in your home with each housing payment. I have borrowed — sometimes a lot — for several houses, and I’ve sold those houses for a generous profit that wouldn’t have been possible if I hadn’t taken out loans to buy them.
This isn’t to say it always makes sense to take out substantial student loan or mortgage debt — but it can be a smart move as long as you’ve researched the potential return on investment and know what your goals are for borrowing.
In fact, there are many cases when it makes sense to borrow for a home or for your education, even when you could pay cash. That’s because you may be better off borrowing at a lower rate and investing your money in the market where you can earn a higher return. This is especially true given that student loan interest is tax deductible if your income isn’t too high, while mortgage interest is deductible if you itemize your deductions.
Not taking on debt could have an opportunity cost
Sometimes, the cost of not borrowing — or of borrowing less — can actually be greater than the cost of taking on more debt.
I explained above how it can make sense to get a mortgage or a student loan. But there are also other times when not borrowing could be worse for you. For example, if you borrow a small amount of money to buy a used car that enables you to get to a job that pays much more than the one you could have if you took public transportation alone, taking on a car loan may make sense.
Likewise, if you borrow a little bit more to buy a reliable used car, you may be better off in the long run than if you pay cash for a very cheap one that runs only for a short time, or that costs you a fortune in repairs.
Debt can affect your life in both positive and negative ways
While you need to consider the opportunity costs of not borrowing, it’s also important to know the downsides of having a lot of debt.
The most obvious one is paying interest. Even a low interest mortgage or student loan could cost you tens or hundreds of thousands of dollars in interest when you’re paying them off over decades.
There are also other costs. If you’ve borrowed too much, those are obligations you have to fulfil. That means you could face serious financial trouble if you hit an economic hard patch and end up missing payments or defaulting on your loans.
Owing a lot also could make it more difficult for you to get a loan if you need one in the future. If you have tons of student loan debt, for example, mortgage lenders may not be willing to give you a loan to buy a house, so your dream of homeownership could be delayed.
Sometimes, the benefits do outweigh the negatives, and having a lot of debt is still a net good. But you do need to consider the downsides and determine if that’s true for your particular situation.
Some types of debt are always bad news
While there are times when it can make sense to take on a lot of debt, there are also circumstances where owing is always bad.
This is true, for example, if you take on high interest credit card debt or payday loan debt. These types of loans are simply too costly to ever be considered good debt and you need to pay them back as soon as possible.
Borrowing for unnecessary purchases that can’t increase your net worth is also a bad idea. This type of debt has no benefit to your life and only brings downsides, including potential damage to your credit.
Debt can be both bad and good
Now you know more about why having a lot of debt isn’t always a bad thing — depending on the kind of debt you take on. If you’re smart about when and how you borrow, you can build credit, improve your net worth, and avoid missing out on opportunities.
This content was produced by The Ascent, a personal finance brand by The Motley Fool.