The Common Pitfalls of Debt

A dark hole with a light at the end represents hope for financial freedom
March 25, 2023

Borrowing money for education, mortgage, business, transportation, and other things is common. The bottom line is how we make our decision. We must consistently ask ourselves if the debt will increase our income, net worth, and value.

Debt can be in the form of money, product, or services rendered. It has an obligation that requires the debtor to pay the agreed value to the creditors on an agreed timeline. Careful situation analysis and decision-making are necessary before taking advantage of debt.

Many people need help deciding accurately and finding themselves in the depth of debt in the long run that bound them in a financial crisis. Debt is secured with interest, usually a very high interest. Common interest from bank entities is between 6% - 8%, and much higher interest from private companies. It will attract more customers.

Nonetheless, debt can be your way to financial freedom or a way to build wealth. Debt has two sides, such as good or bad debt. Your decision on how to use it will affect your finances. Below is a typical example that differentiates good debt and bad debt.

Debt is good if it helps build wealth, generate income, and increase net worth. Good debt provides income and positively affects your long-term overall financial health. Debt is beneficial in many situations because that allows you to grow financially and strengthen your earning ability.

Below are the common examples of good debt.

1) Student loan debt

Borrowing money to invest in yourself is a perfect example of good debt. A student loan is expensive, but it's worth it. You are investing in yourself to get higher education like a bachelor's degree, master, or doctoral degree multiplies your future earning potential. It increases your values that never depreciate. 

The slogan 'to get a good job, get a good education" has been proven and tested true over time. You may earn a good paycheck with less education at a young age. Still, the salary gap between peers with less education and peers with higher education widens as age increases. Considering lifetime earnings, those who pursue education have a more significant earnings difference. 

2) Home loan debt

Probably one of the wise decisions you will ever make is to apply for home loans. Why? Because your monthly payment builds equity in your home and converts your home into one of your greatest financial assets. Home value never depreciates.

You will be surprised over time that what you put in will pay you back double or more than that. I knew a couple who bought a home and lived in it for a few months and resold it at a higher value or paying a home loan on residential real estate while making their unit for rent. They are getting rent pay more elevated than their monthly payment.  

 3) Business loan

Another good debt is borrowing money to start your own business. It is an attempt to generate income from the money you borrow. I say it is an attempt because even though a business loan is a good debt, risk comes with it. Courage and taking risks would provide you with opportunities to grow.

Many businesses fail and fall into the pit of the financial crisis. On the other hand, the debt is worth it if your business succeeds. To lessen the risk, drafting a business plan will help you determine the strengths and weaknesses of your business.

4) Borrowing to invest

Investment is like a coin. It has two sides. If you flip it, either you win or lose. It is the same with investment. If your chosen market goes up, your investment will make more money. However, if the market falls, you lose. Your key to investment success is your careful understanding of your chosen market. Less-risk investments include real estate, stocks, mutual funds, and bonds.  

Want to know what is considered bad debt? We may regret plenty of bad debts, like using the money for something that won't increase our future value, net worth, and income. Bad debts commonly fall into losses or expenses. Most bad debts carry high-interest rates. Below are joint bad debts.

5) Car loans

Transportation is one of our necessities in life. However, borrowing money to buy a car for personal needs may not be significant. Car value rapidly depreciates as soon as you drive out from the casa. 

The depreciation value of a car mostly starts at 15% and gets higher over time. In addition, the model depreciates yearly because the automobile company releases new models annually, which causes your car's value to decline faster. You can justify a car loan if you use it for a business that generates profit after deducting your monthly payment. 

6) Computers and electronics

If you are borrowing money to update your computer or gadget, it can be a bad debt. Almost every quarter, electronics companies release a new model with additional features that cause your electronic device to depreciate.

The best path to take is to save money to purchase your desired gadgets to prevent paying loan interest on top of the gadget price. 

7) Borrowing to pay off debts

If you are already in debt and cannot repay on the agreed value and time, borrowing to pay off debts is not a good idea. Borrowing to pay off debts will cause you to pay interest twice. You must review your spending and allocate savings to pay your debt. 

Bad debts are not healthy for our financial health. It can cause us financial bondage for an extended period. To help us get out of bad debts, I listed a few steps we can consider.

8) Plan your finances

Planning is one way to manage your financial resources properly. Review your income and expenses. Allocate a budget for the monthly costs or save money for buying your necessities. If you can conduct planning, you will know if you need to adjust your expenses or increase your income. You can set your priority as well on what debts you should pay down first.

9) Shorten the length of your loan

The interest rate is based on the size of your loan. The longer your loan, the higher the interest rate you are paying. Check your finances and see if you can shorten your loan to save money from cutting interest rates.

10) Consolidate your loan

Most bank entities offer loan consolidation. It is a process of using a personal loan to pay off all other existing debts to ditch high-interest debts and transfer them to a single loan with a lower interest rate.

11) Boost your income

Another effective way to get out of debt is to boost your income. If your income increases, you can prevent debt, or you will have enough money for your monthly payment. Different ways to boost your income include asking for a raise, finding better opportunities, getting an additional part-time job, or starting a small business. 

Borrowing money for education, mortgage, business, transportation, and other things is common. The bottom line is how we make our decision. We must consistently ask ourselves if the debt will increase our income, net worth, and value. Through this, we can avoid bad debts that bind us and take our financial freedom. The key is financial planning and wise expenditures.