DR 122: Good Debt vs. Bad Debt

A lot has been written about good debt vs bad debt. As the names suggest, the idea is to avoid bad debt and embrace, at least to a point, good debt. But what do these terms really mean, and how can they help us make sound financial decisions?

Like so many financial rules of thumbs, the distinction between types of debt can help us look at debt differently. There are, however, limits to how much these definitions can help us make financial decisions. As a starting point, we need to make sure we understand the meaning of good and bad debt.

Let’s start by looking at how others have defined good debt.

What is good debt?

In a CNN article, good debt was defined as follows: “Good debt includes anything you need but can’t afford to pay for up front without wiping out cash reserves or liquidating all your investments. In cases where debt makes sense, only take loans for which you can afford the monthly payments.”

In contrast: “Bad debt includes debt you’ve taken on for things you don’t need and can’t afford (that trip to Bora Bora, for instance). The worst form of debt is credit-card debt, since it usually carries the highest interest rates.”

While the definition of bad debt seems on target, the definition of good debt misses the mark. It may be a definition of when you have to go into debt if it’s truly a need. But defining such debt as “good” just because you don’t have other options is questionable.

Perhaps the best article I’ve found on the subject is by Sophia Bera, a certified financial planner at Gen Y Planning. Her article, which appeared on Daily Finance, noted that the answer depends not just on the type of debt and the reason you borrowed, but also on how much debt you have: “So could there ever be good debt? There’s no hard-and-fast answer. That’s because how you use debt has a big impact on whether or not you can consider it “good.” And you can have too much of a “good” thing — and that’s when it can turn into bad debt.”

Personally, I’m not sure I would ever describe debt as good. Rather, I would classify debt into three kinds: reasonable debt, bad debt, and horrible debt. But because the term “good” debt is so in vogue, I’ll stick with it here.

Good Debt, Bad Debt, and Horrible Debt

Good Debt

Good Debt is used to buy something that either (1) will go up in value, or (2) produce income sufficient to justify the debt.

For most of us, examples of good debt include:

House – A home’s  value can go down in the short term, but over long periods of time, it goes up in value. It also insulates us from rent inflation and offers excellent tax incentives.

Rental Property – It can both go up in value and produce income.

Education -A school loan can enable us to get an education that increases our earning potential.

Hence, “really good debt” is debt that builds wealth. If used properly, it can help us build wealth over time. However, not all school loans can be considered as “good” debt. A school loan on a computer degree can be considered good debt while many liberal arts degrees would qualify as bead debt.

The thing about good debt is that it can just as easily become bad debt.  We’ll come back to this in a minute.

Horrible Debt

Horrible debt is  debt used to finance a lifestyle with no significant assets to show for the money you’ve borrowed. Horrible debt includes debt used to buy clothes, eating out, vacations, or gadgets. These sorts of lifestyle decisions somehow force you to finance usually with very high interest rates and over a very long period of time.

Because there are no meaningful assets purchased with horrible debt, you can’t sell what you bought to repay the loan.  You are simply spending today your future earnings.

Bad Debt

Bad debt is where things get interesting.  It’s the grey area.  It includes good debt gone bad and what I like to call avoidable debt.

Good Debt Gone Bad

Remember the examples of good debt I listed above?  Borrowing to buy a home, for rental property, or an education can all be really bad debt in certain circumstances.

For example, borrowing far more than you can reasonably afford for a home is bad debt.  Borrowing to buy a rental property when your own finances are not in order is bad debt.  Spending $200,000 on a liberal arts education is generally bad debt, and I was an English major.

There are rules of thumb when it comes to a mortgage or school loan.  Many say to keep your monthly mortgage payment to no more than 20% of your gross income.  Likewise, some say to keep your school loans to no more than your first year’s income after college.  These are worth considering as you make decisions.

The point is that we can’t blindly take on debt because some label it as “good” debt.

Avoidable Debt 

The second type of bad debt is what I call Avoidable Debt.  For most of us, car loans fit into this category.  While the ideal is to pay cash for a car, I’m not a fanatic about avoiding car loans.  I am a fanatic about borrowing to buy more car than you truly need.

It’s one thing to finance a $5,000 car so that you get to work and back.  It’s another thing to finance a $45,000 car while other financial goals are not being achieved.

Is the distinction between good debt and bad debt helpful?

The distinction between good and bad debt cannot tell us when we should take on debt.  There are just too many factors to consider beyond a label we add to debt.  But it can help us better evaluate our options.

First of all, it helps to understand that not all debt is created equal. Borrowing money on a credit card to go on a vacation and to eat out all the time is totally different than borrowing money for car or to buy a home.  Good vs bad debt helps us understand the difference.

Second, just because something falls into a bucket that most people would describe as good debt doesn’t mean it’s good debt for you. While buying a home  represents the American Dream for many, it may not be important to you.  Further, spending too much on a good thing can quickly turn it into really bad debt.

Ultimately, this is something you need to figure out based on what’s important to you and what your income will support.

Topics: Personal FinancePodcast

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