When it comes to financial planning, debt is often treated like a dirty word. Owing money to someone else is frustrating and every debt payment is money that could have gone towards your other goals. Not all debts are created equal though. Some do nothing but hold you back, while others come with helpful benefits. The best kinds of debts can actually help you accomplish a more solid financial history. To help you plan for the future, here is our list of top five absolute worst and best debts, in order from worst to best.
#5 Consumer Debt
Consumer debt is the worst kind of debt. This is debt you take on just for short-term spending with no real long-term benefit. This includes your credit cards, payday loans, and financing to pay off a vacation or jewelry. With these debts, you’re spending money to get some short-term pleasure now, and then you’re stuck paying the bill for the future.
Consumer debt doesn’t come with any financial advantages. Try to avoid these debts at all costs and try paying for these purchases with cash. It’s better to spend a few months saving up, than getting yourself locked into a bad loan.
#4 Tax-Deductible Consumer Debt
One step above consumer debt is tax-deductible consumer debt. This would be if you took out a home equity loan to pay for your spending like vacations, clothes, jewelry, etc. The difference here is that the interest you pay on your home equity loan is tax deductible, up to a maximum loan of $100,000.
Now, this still isn’t a great move financially because you’ll have to pay back your loan for several months or years, while not doing anything to advance your long-term goals. However, you’re getting a bit of a tax break by borrowing this way so it’s better than pure consumer debt.
#3 Debt to Buy an Asset
If you’re taking on debt to buy an asset, that’s not a bad financial move. This is when you take out a mortgage, car loan, or loan to buy an expensive appliance, like a washer and dryer. Most people don’t have the money to pay for these things all in cash so borrowing is needed. The reason these loans are better is because you’re actually building your net worth through these payments. Every payment makes you a little “richer” because you’re getting that much closer to owning a valuable asset outright.
A mortgage is a better type of debt than the other examples because houses tend to gain value over time. You’re taking on debt to buy a growing investment.
Cars and appliances are depreciating assets. This means they lose value over time. It’s still not bad to get into debt for these purchases because you’re buying something with some value, but it’s not helping you out as much as buying a house. That’s why many advisors recommend buying a cheaper car while buying the most expensive house you can afford.
Mortgages also have the added bonus of tax-deductible interest. Like with a home equity loan, when you pay interest on a mortgage, it lowers your tax bill at the end of the year. Car loans and loans for appliances do not.
#2 Debt to Grow your Income
When you borrow money to grow your income, the debt is actually helping you reach your long-term financial goals. You’re basically taking one step backward to take two steps forward in the future.
These debts include student loans, starting a business with a business loan, or buying an investment property with a second mortgage. All these loans will hopefully grow your future monthly income significantly. That way, your monthly debt payments are like an investment.
#1 Debt from Yourself
The best kind of debt is when you borrow from yourself. This is when you have enough money saved up in savings or your retirement plan that you can pay for major purchases yourself. The trick here is you want to set a monthly payment plan to yourself, just as if you were borrowing the money from the bank. Don’t just aim to pay the money back. Aim to pay the money back with interest. That way, you’ll have even more money in the future to repeat this strategy over and over again.
Work retirement plans, like a 401(k), are a good choice for this move because they let you take out loans and force you to pay yourself back with interest. You can’t use this strategy with an IRA because they don’t allow loans.
You could also borrow from your savings account or cash-value life insurance if you have it. If you’re going to use this strategy, be absolutely sure you’ll pay yourself back, otherwise, you’re just wasting your savings. If you can have this discipline, it’s the absolute best kind of debt because all the money goes back to you.
Debt is going to be a part of your financial plan no matter what but bad debt doesn’t have to be. By following these best and worst debt guidelines, be sure to borrow money that pushes you closer to your future goals, and always try to avoid or pay off consumer debt as quickly as possible.
David is a Certified Financial Planner who writes about financial planning, investing and taxes.