Good Debt vs. Bad Debt
But I thought that debt was debt. Isn’t all debt “bad”?
I would say that most debt is “bad”. Think about it: interest doesn’t take sick days or vacations and works 24 hours a day, seven days a week, to take our hard earned money. Bad debt is a burden. It robs us of our quality of life and keeps us poor.
Here are some examples of Bad Debt:
- Cars. Cars loans are often the first step we take toward financial bondage. New cars lose much of their value the minute they are driven off the lot. More people are taking out longer-term car loans in order to be able to make the payments. Unfortunately, the car has lost most of its value by the time we make the final payment. Bad debt.
- Department store credit cards. Things you buy in a store decrease in value - yes, even that blender that blends, chops, and makes meatloaf. I’ll admit, quite often I fall for the enticements of department store credit cards. It’s hard to pass up $10 off my first purchase. I always plan on paying the balance in full at the end of the month. Many times, I don’t. Other expenses always come up. Department stores lure you into getting a credit card by offering a significant discount. What they don’t tell you is that if you don’t pay off the full balance each month, you will be paying astronomical interest rates on your purchases. Bad debt.
- High-interest installment loans. Don’t be tempted to take out a loan for a vacation, Christmas, or for any toys. You will end up paying significantly more than your original purchase price. Bad debt.
- Revolving credit cards. Remember, it is the goal of credit card businesses to make money. With high interest rates, and hidden, and not so hidden fees, revolving credit cards can lead to financial trouble. Bad debt.
Avoid bad debt. If you use credit to buy something that decreases in value, it’s considered bad debt.
So is debt always bad? In my eyes, cash is always king. Yet, how many of us have loads of money lying around to pay for college and to purchase a home? While I hesitate to say that some types of debt are “good”, there are times when debt can be used as a tool to help us get ahead financially. Good debt can help us buy things that increase in value - or in other words: assets.
Here are some examples of “Good” Debt:
- Home purchase. Homes generally increase in value, even if their values temporarily decrease. There is some debate as to whether or not homes are an asset or a liability. An asset puts money into your pocket. A liability takes money out of your pocket. In my opinion, a house is both. While you’re living in it, your house takes money. When you sell it, it makes money. In today’s world, people don’t stay in their homes for long periods of time, so it’s important to make sure you will have equity in your home when it comes time to sell it. Tips: When you buy a home, don’t buy more house than you can afford; and make sure to buy under current market value. This way, if the market fluctuates, you can still make money on the sell of your home. Good debt.
- Education. With the soaring cost of a college education, it would take a pretty good chunk of change to be able to pay cash for tuition. It’s possible to do, but difficult. If you need to take out a low-interest student loan to pay for your education, it is considered a good investment – if you make the most from your college experience. Don’t take out hefty loans only to party, fail classes, and end up as an assistant lettuce washer at the Burger Barn. That would be a bad investment. Use your student loans to help you get a high paying, more fulfilling career. Money used toward a college degree is considered good debt.
- Business loans. There are many benefits to owning your own business. Getting a loan to buy a business can be a good investment. Make sure you do your homework on the prospective business before securing a loan. Good debt.
Remember, avoid bad debt. Use good debt, when needed, to wisely purchase investments.
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May 1st, 2008 at 7:02 am
You allude to this a little bit… but I think you should only use good debt when you NEED to! When college kids go apply for a loan and can get $15,000 in loans a year - they shouldn’t take it all and spend half of it on nonsense! You should just take on the amount of debt that is absolutely necessary - even if it is good!
May 1st, 2008 at 7:11 am
JB,
I totally agree!
May 1st, 2008 at 7:19 am
I wouldn’t strictly say that car debt is bad debt. In most situations it is, but there are a lot of situations where it’s necessary: your first car (which enables you to get to your first job), or an exchange of an expensive car for a very fuel-efficient one.
May 1st, 2008 at 8:59 am
In agreement with Trent, I’ll also add that revolving credit card debt isn’t always bad either. Having your credit cards at 40% capacity and properly managed as opposed to maxed out and poorly managed is good debt - debt that increases your credit rating. Too often people make the assumption that all credit card debt is bad and that simply isn’t the case.
May 1st, 2008 at 9:47 am
I disagree with Trent, car debt is always bad, even if it’s necessary in some situations. If you can avoid a car loan, then you should. This is what a saving account is for, so you can borrow against your money rather then someone elses. Just because you need to get a car loan, doesn’t mean you should tell yourself that it’s good debt. A good long-term goal is to get into a financial situation where you no longer need car loans.
May 1st, 2008 at 10:18 am
@Curt - You’re right. Just because a car is sometimes a necessity (for a first job) doesn’t mean that the debt is good!
May 1st, 2008 at 10:42 am
Paying interest on a hybrid vehicle is tax-deductible in most cases. For those who don’t have any tax deductions available in the form of a house or children, that may be helpful. As a general rule, yes, car loans are considered bad debt; however, in most cases they are a necessity and a way of life. Since many of us can’t do without car loans, the idea is to put the bad debt to good use. Instead of buying a ridiculous gas guzzler like a hummer or other large vehicle, get the hybrid. It’s better for the environment and, like I said, tax-deductible.
May 1st, 2008 at 10:51 am
I think when you are considering the use of credit for something, it’s important to ask the question: Is this the best way to accomplish what I need to accomplish? You may think of viable options without having to pull out the plastic. However, if using credit is your best option, keep this in mind: good debt, used wisely, can be used as a tool to help us get ahead financially. Kristy mentioned the importance of using a credit card to increase your credit rating. If the purpose of the good credit rating is to help you purchase a home, get education, or buy another asset, then the credit card is the tool to help you accomplish this. In this case, the credit card might be considered a good debt. Thanks for bringing that point up, Kristy.
May 2nd, 2008 at 6:14 pm
With the projected changes of the FICO 08 scoring model, I would hesitate to classify auto financing as “bad debt”. The newer algorithm is said to favor those with a healthy variety in the types of credit they utilize; that is, if your credit history consists solely of, for example, credit card payments, your score is going to be lower than if your report listed accounts for student loans, car loans, mortgages, credit cards, etc.
Note that I am not saying that the new model will favor those with more debt overall, but it will favor those with more variety in the kinds of debt they choose to take on.
Now if you judge auto loans to be “bad debt” because you are paying interest on a loan for a depreciating asset, then you would be correct in labeling it as such (except maybe in cases of hyperinflation, but I’m no economist).
May 12th, 2008 at 7:34 am
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May 12th, 2008 at 10:31 am
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May 12th, 2008 at 2:09 pm
Overall, a great starting point. Unfortunately, sometimes the difference between good and bad debt is no longer easily defined by the purpose. Just look at the the subprime mortgage mess and college graduates that are starting out with debilitating student loan debt.
While we payed cash for our current cars, I don’t think car debt is necessarily bad. To me, car loans become bad when they cause me to buy more car than I normally would, because the monthly payment increase is small.
May 14th, 2008 at 9:52 pm
You make a great point super saver, about buying more car than you normally would. I’ll add to that by calling out those who are upside down in a car; you’re not in the best financial situation. Usually there are mitigating circumstances involved with that, but it’s still something to avoid if you can. And I HIGHLY recommend that anyone upside down get the maximum insurance they can…load it up with extended warranty’s, GAP, MMP, whatever. Yes, it adds a little more to your loan, but if you total that thing you get a lot less from the value than what you owe. If it ends up being so bad you can’t drive it, you’re still out that money. GAP is important.