The Myth of ‘Good’ Debt

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You’ve probably heard of ‘good’ debt and ‘bad’ debt. Good debt is when we borrow to buy something that generally goes up in value, like a home. Bad debt is when we borrow for anything else, like a car, a boat, a meal, a dress, a cruise, a wedding and so on.

Many teach that good debt is fine, while bad debt is not. The theory goes that good debt makes us wealthy as the value of our purchased assets go up, while bad debt makes us poor as we struggle to pay debts for which we have little to show. In fact, it’s a philosophy I’ve followed my entire adult life. And its flawed.

Not all debt is created equal, to be sure. A debt backed by an appreciating asset is far better than debt used to fund a lifestyle we can’t afford. Why? If for no other reason, we can always sell an asset to pay off good debt. With bad debt, all we have is the debt.

But the problem with ‘good’ debt versus ‘bad’ debt thinking is that it makes good debt seem more appealing than it really is. And there are two reasons for this.

First, debt, whether good or bad, takes away some level of our freedom. In my case, I’m 42 with enough ‘good’ debt for two families. If I were debt free, I could quite my day job and run this site full time. I’d really enjoy that, along with a few other business ventures I’d undertake. As it stands, my ‘good’ debt is requiring me to keep my 9 to 5 job. Thus, ‘good’ debt is preventing me from living the life I’d like to live.

Second, selling the assets that underlie good debt is not always practical. For most of us, good debt is our mortgage, and that’s true for us. We have a mortgage and a home equity line of credit used to renovate our home several years ago. We could sell our home, even in the current market, and pay off all of our ‘good’ debt. We would have enough money left over to pay cash for a home in many areas of the country, but not we we currently live outside of Washington, D.C.

It’s certainly a choice we could make. We would uproot are two high school children, sever all of our friendships, and leave many of our family members behind. We’ve chosen not to do that, and that’s the right choice for us. But that just brings me back to all of our ‘good’ debt.

Borrowing to buy a house is a perfectly rationale decision. In our case, perhaps we purchased more home than we needed, although we do enjoy where we live. But the fact remains that ‘good’ debt, at least for individuals, is a myth. Instead of ‘good’ debt and ‘bad’ debt, maybe we should just think of it as debt and bad debt.

Published or Updated: June 2, 2009
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Apologies but I have to disagree with this. Using myself (and my wife) as case studies, the “good debt” we have taken on is enabling us to reach our financial goals much quicker than if we didn’t borrow at all. Thanks to the debt we used to buy assets (all real estate), our wealth has grown quicker than if we had purchased fewer assets for cash only. As a result we will be retiring years earlier (should we choose to). The “good debt” is accelerating the path to financial freedom.

    • DR says:

      traineeinvestor, that’s a good point. We have debt from real estate investments, too. The debt payments are completely covered by the rent the properties generate, and we have additional positive cash flow. That type of debt, so long as the business continues to do well, does increase wealth and doesn’t restrict our life choices. Good point.

      • Keylon says:

        I guess finding useful, reliable infrmoation on the internet isn’t hopeless after all.

    • Luigi says:

      I think you’re missing the point. Having debt means you owe someone else (a creditor) money. This creditor usually charges you interest for the privilege of using their money. Ideally you’d have a bank account, or a mattress, with enough money to accomplish your goal. If you do not, you can either spend more time saving or carry a debt. What the debt is incurred for is what’s good or bad. Mortgage, good. Vegas bender weekend, probably bad.

  2. Charles says:

    The definition I prefer for “good debt” is debt that is producing income to cover the debt (and hopefully more). Your home would be considered “bad debt” for the reason you provided, which is it limits your freedom. If you were renting rooms in your home to cover part or all of the mortgage, I would consider it “good” then (this is what we do at our home).

    • DR says:

      Charles, that’s consistent with traineeinvestor’s experience. Actually, it’s one of the few good points in ‘Rich Dad, Poor Dad.’ While our homes may go up in value, we shouldn’t look at them as an investment.

  3. dawn says:

    The only good debt, IMO, is a mortgage and student loans, but even then, saying it’s good debt is not a license to overextend yourself. You seemed to suggest that you bought more house than you needed or could afford and in that case, it’s not too much fun to have such a nice house if you’re struggling to come up with the mortgage or what not.

  4. Dave says:

    Very good post DR. Is there ever a good reason to take on debt? Sure. To buy a home to live in is a good reason. As long as it is within the time-honored guidelines of the debt not being more than about 30% of your income. And, if you make arrangements to pay that mortgage off as fast as possible. Taking on mortgages for investment property is a business decision which entails risk. In my town, there are a lot of empty homes with “For Rent” signs on them. I can’t help but wonder if those owners are footing a mortgage on those empty houses. I paid off two mortgages on two home within 15 years. There’s something to be said about your spendable income going up 30% overnight just from paying off a mortgage! DR, you noted if you didn’t have any debt, you could do what you love (running this website) full time. Listen to your “common sense” and make that a reality. Debt with no plan to pay it off fast is a battleship anchor around your neck.

  5. Alex says:

    I think your post seriously overlooks two significant qualities about “good debt.”

    1.opportunity cost- owning good debt allows you to save your money to earn better investments on it elsewhere. The above commenter is right that your home is not a great investment. Given that fact, why would you invest in it anymore than you had to in it???

    I recently refinanced my house at 4.5%. By pouring money into my mortgage, I would be earning a guaranteed 4.5% (ignoring tax considerations). Whoopee, 4.5% …. Or I could take those hundreds of thousands of dollars and invest them elsewhere, perhaps in a mix of equities and other investments paying a better rate of return. Perhaps I could make 8% (I think I could, but I admit I’m arrogant). Over the course of a 30 year $300K mortgage, I would make an extra $500K over someone who paid for his house in cash.

    Second point (Leverage): your house is not a good investment for a number of reasons, but one of the main ones is that the rate of return on a lot of real estate is not all that great. Say your house appreciates at 1%. If you prepay your mortgage down, you have all your money invested in your house, and you get a rate of return of 1%. Whoopee…. However say you only have 20% of your $300K house owned ($60K). Now if your house value goes up 1%, you just earned 5% on your investment, while also earning the same amount of money as the guy who sunk all his cash into his house.

  6. DR says:

    One thing I’ll add to this discussion is that my attitude toward debt has changed as I’ve gotten older. In my late 20′s, having graduated from law school and started working, debt to buy a home was the natural next step. I certainly don’t regret that decision, but at 42, I now see debt differently. At the start of my career, debt wasn’t holding me back; now it is. Again, the debt I have for real estate investments isn’t holding me back because my business partner and I have positive cash flow. But my personal debt, mainly a mortgage and a school loan (yes, even at 42!), are keeping me from doing what I’d like to do. To me, that is the fundamental definition of “bad” debt.

  7. Liko says:

    No such thing as “good” debt. It’s better than other debt… but it certainly isn’t good. I have to agree with the author here. There is no house or money in the world that would make me trade my freedom up for it. I heard of a 31 yr lady that had about $200k worth of student loans from dental school. Her husband was making good money, but not enough to afford her student loans and the mortgage. She hated her job, and wanted to quit and raise a family instead, but couldn’t because of her “good” debt. She was forced to keep on working; that was the only big enough shovel that could pay this loan off.

    Second Point: Time the market: The freedom of having no debt helps you to better time the market, leading to more profitable business decisions. When I was in my early twenties I bought a property for $65k (minimum down). 3 months later I lost my job. I couldn’t afford the payments and was forced to sell right away (I broke even). The month I sold the property, I got hired again. The same property was estimated around $135k less than two years later.

    Third Point: Live anywhere you want: The freedom of having no debt allows you to move anywhere anytime, opening up the job market to any part of the country. Last year my company here was laying people off left and right. Meanwhile, another company across the state was hiring like crazy. I had a very good job offered to me, paid a lot better, but I had to turn it down. I was stuck in a $2000/mo payment and couldn’t afford the rent over there and the payment here. The real estate market was also really slow, and I couldn’t dump the condo even if I wanted to.

    Forth Point: Everything is cheaper with cash, especially in this market. When I buy homes I don’t pay any finance costs, points, and other misc costs to banks. I avoid the extra higher interest rate people pay for investment loans too (typically around 7% for rental property). I can pick up foreclosures at around 70% of the retail costs. If I can’t find a renter right away… no problem… it’s not costing me any additional payments.

    Fifth Point: Sleep better at night. Today, I have no debt. I sleep better. I don’t worry about the first of the month. In fact, that’s the best time of the month as a landlord. I don’t care Banks, Freddie, Fannie, Sallie, and certainly not about Obama.

  8. JimBob says:

    “Good Debt” is not anything within a particular category (i.e. School Loan or Home Loans). Liko, you seem to think that poor woman’s 200K of educational debt would be considered “good debt” by the mere fact that it was debt incurred to fund education… I would say Good debt cannot be defined in categorical terms as some seem to be trying to do. I incurred around $100K in loans to complete Law School. Had I simply “paid as I went” I would have been 38 before I could have started earning a lawyers salary. I finished at 27 years old and consolidated my debt into a 2.3% interest loan, and had a six-figure income my first year as an attorney. I feel like the four years I spent as an engineer may have been a waste, I could have perhaps been making a six-figure salary for 4 more years as opposed to the $55K entry-level engineering job I held prior to studying law. Do the math, how much more income do I have now, because I incurred some reasonable debt. Even if you go to Harvard, you have to estimate what your post-graduation salary will be. It wouldn’t make sense to get $300K in debt for an Art-History degree from Harvard, when you’re not likely to earn more than 29K/year with such a degree….

  9. shadox says:

    Well – “good debt” is all about leverage. Amplifying the returns on your equity investment by using borrowed money. The strategy obviously makes arithmetical sense – you can’t argue with the numbers – however the trade-off is a considerably higher degree of risk and volatility in your returns, and in many cases, as you state, loss of certain other options.

  10. Mack jackson says:

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  11. Mr. Charles' debt guide says:

    Good post, despite debt can be “good” it can still limit our freedom. so in that that case i guess we can just label debt as being well…debt! not something too good, because in turn we still have to pay off, thats why its called a debt. great post.

  12. Citibank says:

    Owning a house for our family or getting an educational loan for our children are some reasons why we get into the world of debt. The best thing to do is to limit ourselves, prioritize those things that are more important.

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