3 Types of Good Debt & How You Can Make Them Work for You

Debt is a word that is usually associated with negative connotations, this is usually due to the abuse of personal debt by some people for unnecessary purchases. However, debt in itself is not bad and can actually be advantageous when used correctly.

Debt can be used to finance a car, buy a house, invest in a business, and more. In this post, I would like us to take a look at “good debt”, which is essentially a debt that is taken out with careful consideration into the use and returns of the debt. Examples of good debt include student loans, mortgages, credit, and more.

Please note that what I cover within this post is not financial advice and is intended as a guide for anyone who wants to better understand “good debt” and how it can be utilized to your advantage.

Credit

Credit is the ability to borrow money or purchase goods or services without having to pay upfront. This is done with the understanding that the full balance will be paid off at a later date. Credit is important since it allows you to purchase vehicles, services, and property as well as take out personal loans which can be invested into a business venture, for example, a lawn care business or direct-to-door dry cleaning service.

In order to take out a loan or buy a product or service on credit, you need to have a good credit score (or credit history). Your credit score is a numerical representation of your capacity to pay your bills on time or your creditworthiness.

You can improve your credit score by buying products (for example a smartphone) on credit and paying off your balance every month. You can also take out a credit card and use it to buy products and services on credit and then repay the balance without any delays. Failing to repay your debts will reduce your credit score and make it less likely for you to take out a loan in the future since it's very likely that you won't be able to pay off the debt in time.

When it comes to repayments, the terms and interest rates depend on the vendor and creditor you are dealing with. For example, some stores allow you to buy electronics (for example a games console) with no repayments for a certain period (6 months - 2 years for example) and 0% interest as long as you pay the full balance on the due date. Failing to pay on the due date could incur very high-interest rates, so it's best to make sure the balance is paid off in time.

Other terms could include a fixed percentage interest rate or no interest rate (for example with a smartphone contract). Having a good credit score is essential for anyone who plans to buy a house or start a business since you'll have access to capital that can be put towards those goals.

Auto Refinancing

Auto refinancing is where you take out an additional loan to pay off the balance from an existing car finance loan. This new loan replaces the previous loan and usually comes with modified conditions such as lower repayment rates. Reasons for people refinancing their car loans can include reducing their monthly payments, lowering their interest rates, and increasing the duration of the loan period.

Reducing your interest rates is one major benefit of refinancing a car loan. The current interest rate in the USA is 0.75%, even though it is up 0.25% this year, it is still down from a high of 1% in 2020 and 2% in 2019. Lower interest rates allow you to save money on your monthly repayments so auto refinancing can be considered during times like this.

Lowering monthly payments on a financed vehicle is another significant advantage when it comes to auto refinancing. This usually works by increasing the repayment period on the new loan. Longer repayment periods equal lower repayments since the costs are spread out further.

If you refinance an auto loan with a longer repayment period, look for interest rates that are lower than or at least equal to your previous loan. According to RateGenius, 56% of borrowers saved $50 to $149 per month by refinancing their auto loans.

Another report by RateGenius showed that borrowers saved over $90 per month on average after refinancing their car loans. Refinancing an auto loan can also be beneficial if your vehicle has a resale value that is higher than the amount of money owed to the finance company. You can benefit from this situation by refinancing your auto loan with a cash-out option. This works by taking out a loan that is larger than the amount owed and keeping the difference between the two.

Essentially you get to pay off your previous debt as well as keep some additional cash as long as the value of your vehicle is higher than the amount owed. This works best when the new loan has a lower interest rate.

Mortgage Refinancing

Mortgage refinancing works similarly to auto refinancing, you're essentially replacing your current mortgage with a new one, sometimes with new terms or new rates. Refinancing your mortgage may be done for a variety of reasons, some of which include decreasing your monthly payments, lowering your interest rates, and expanding the length of time you have to pay off the loan. According to Statista, refinanced mortgages made up 50% of all mortgages in Q4 of 2021.

One major benefit of refinancing a mortgage is being able to lower your monthly repayments (similar to auto refinancing), however, this is more likely to be beneficial for older mortgages. You can also get access to additional capital through cash-out refinancing, which allows you to borrow additional funds which can be invested or used for other purposes. The difference between this version of cash-out refinancing and the auto refinancing version is the probability of your debt increasing, however, you're likely to get a lower rate for repayments.

Closing fees, which normally range from 3% to 6% of the loan's principal amount, play a role in how much money you may save by refinancing. For example, sake, let's say you borrowed $100,000, and the percentage of the loan that goes toward closing costs is 5%. In this scenario, you would be required to pay back $5,000. Shaun Connell from Rental Property Calculator believes that one tip for battling personal debt in 2022 is to stop focusing on trying to pay off lower interest debts:

During a cycle that includes rising interest rates and high inflation, don't become obsessed with paying off your lower interest debts. If you have a mortgage of 2.75% and inflation is 7%, then you're actually profiting 4.25% per year for free.

Shaun continued to share his thoughts on paying off lower interest debts:

Paying that debt off will cost you money. Instead, focus on higher interest debts or make purchases now before their prices increase. Strategically paying off your debts works better than blindly making payments. This is how banks manage their debts, and it's useful for consumers to do the same thing.

As an alternative to requiring a large sum of money in advance, many lenders allow you to finance your closing expenses as part of the loan. Remember that adding such charges to the loan merely raises the total amount that accrues interest, which will eventually cost you more.

You will not begin to see the advantages of refinancing until you reach the point when your savings outweigh your upfront expenditures. To establish the point at which your refinancing will pay for itself, divide the closing fees by the amount you will save each month with your new payment.

Conclusion

Debt, like money, is a tool that should be utilized correctly to benefit the person taking out the loan. The three examples outlined in this post constitute a few examples of good debt and hopefully, this gives you a baseline understanding of how you can make good debt work for you.