Good Debt versus Bad Debt

good debt and bad debtDebt is bad. But some debt is good.I hear this all of the time. People arguing over the difference of good and bad debt. Can debt be bad but good at the same time? I guess it can since we all have a bad movie we love and we all love some foods that are bad for us – pizza, I’m looking at you my friend.

I decided to take some time and come up with an explanation for both good and bad debt so that you can distinguish between the two and know one from the other. Let’s start off with good debt first.

Good Debt Versus Bad Debt

Good Debt

Good debt is debt that you take on in which the underlying asset can increase in value over time. The two classic examples of this are homes and education. With a home, you go into debt and historically (though not recently) homes increase in value. So, if you took out a $200,000 loan for a $225,000 house in 1990, today that house is worth $350,000. The debt you took on the house was good debt because the asset (your house) increased in value. Same concept holds true for education. You take out student loans to get a better education. This qualifies you for better jobs, and therefore a higher salary. Again, the underlying asset (your salary) increases in value.

Bad Debt

On the other hand, you have bad debt. Bad debt is debt that decreases in value. For example, you take out a loan to buy a $25,000 car. In five years, that car is now only worth $9,000. The underlying asset (the car) decreased in value. Same concept for mostly everything you put on your credit card. The item, be it clothes, gifts, whatever, decrease in value.

In addition to the underlying asset losing value, you also have the added cost of interest if you do not pay your balance off on your credit card each month. In this case, not only is the clothing less valuable used, but you paid more than sticker price for it because of the interest on the debt itself.

Why Not All Good Debt is Good

Most articles you read will simply tell you that good debt is good and bad debt is bad. I disagree. Here is why. Not all good debt is good debt. If you buy a house you cannot afford, that good debt suddenly becomes bad. Granted the house may increase in value over time, but you cannot afford it. You will either have to resort to going into more debt just to stay in the house (bad debt) or you will lose the house and be foreclosed upon. This will ruin your credit.

Here is a personal example of this in action. I bought a house back at the height of the housing boom. I bought way more house than I could afford. That reality hit me when 2 months in, I was struggling financially. I had my good friend move in with me and his rent helped to keep me afloat. But in order to stay in the house, I took on some credit card debt because money was so tight. In this case, the good debt of a mortgage was really bad debt disguised as good debt.

Similarly, taking out student loans to pay for college may not be good debt. Taking out $60,000 in loans to get a degree that only pays an average annual salary of $20,000/year is not a wise decision. You are hurting yourself in the long run. This is also true if you are unsure of your career. Before you go into $200,000 worth of debt to become a doctor, you better be extremely certain that you want to become a doctor. Otherwise, you are stuck paying off $200,000 in loans on a $40,000/salary. It will add stress to your life and will make it hard to survive in general. Imagine having to pay $1,700/month on a $40,000/salary. Good luck surviving financially.

Be Rational With Good Debt

What is the point of all this? That if used wisely, good debt is good. But used unwisely, good debt can be bad. It all comes back to living within your means. Do not buy a house you cannot afford. Do not take out $60,000 in student loans if the increase in salary does not offset the amount. Don’t think I am implying that you should not go to college or get an advanced degree. You should, if you want to go to college. What I am saying is that before you do so, research to make sure you will be making substantially more per year from the advanced degree, and make sure what you are going to school for is what you want to do.

The same holds true for a house. Make sure you can afford the payments before you buy. The easiest way to do this is to save the amount that would be your monthly mortgage payment. If the house you want would have a monthly payment of $2,000 then save that amount each month. If you are renting (or already own a house) and your current monthly payment is $1,000 then you should treat that $1,000 as half of your new house payment and put another $1,000 into a savings account. If you can comfortably survive by doing this, then you can afford that monthly payment amount.

Final Thoughts

Simply put, be aware of debt and the fact that just because others claim it is good debt, it may not be good for you. Once you get the house or your college degree, you will still want to make it a point to pay off your good debt. The less debt you have, regardless if it is good debt or bad debt, the more freedoms and options you have in life.

Here are a few debt resources to help you out:

[Photo Credit: William Brawley]

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Comments

  1. says

    Think twice if you are going to borrow or not? If it is for emergency and you a have an expected income then borrow for the need. However, if we are going to borrow for our luxuries, maybe it is best to wait for the right time to splurge. We may also borrow to leverage. Borrow to earn from that money. Always bear in mind that the money you are using is not yours thus spend it wisely and with moderation. Focus first in saving it.
    anthony a. @ financial freedom ideas recently posted..A debt elimination program will help you achieve financial freedom.My Profile

  2. says

    Like this topic Jon! And I have no problem with your categorizations. I think one could easily make an argument that all debt is bad, specifically focusing on the fact that it introduces risk into the equation. Even when I took out a mortgage that was within our means to pay I opened myself up to risk. I reduced my freedom to use my money in other ways because I was legally beholden to pay back the bank. That creates a lot of life pressure and frustration if things start to head south financially for other reasons. I’d counsel anyone thinking about going into debt to avoid it at all costs (morally and ethically of course).
    Brian @ Luke1428 recently posted..Would You Use Cheap Toilet Paper For a Penny?My Profile

  3. says

    Liking the new layout here, looks like you’ve changed it?
    Agree on the good vs bad debt, it’s then about aligning the goals with the risk appetite..

    Then even within good and bad debt there’s a scale between what how good the good debt is and how bad the bad debt is depending on the interest rate etc although this is probably a bit too advanced :)

    • says

      Yeah, I did change things up a little bit…thanks for noticing!!

      There are all sorts of criteria to look at. A car loan is generally a bad thing, but it you get it for 0% or 0.9% that might change things. It all comes down to your preferences.
      Jon recently posted..Top Posts of 2014: A Year In ReviewMy Profile

  4. says

    An excellent point! Purchasing a home within your means, financing it with a 15 year mortgage, and/or making extra payments each month is a smart way to handle “good debt”, because it is still debt as you said.

  5. says

    Great article!

    You have some really good tips here, I think its really valuable for people to understand the difference between good debt and bad debt so that they can make informed decisions that will benefit their financial future.

  6. says

    You make such a great point that good debt can be bad debt in disguise. We also bought a home before the last housing bubble burst, and when we moved in 2012 we could not sell the house because it had dropped in value and we didn’t want to move our price that low (we would have had to pay in when we sold). So we kept it two years, just selling it a couple months ago. We had renters in there the majority of the time, but the amount of rent we were able to get did not fully cover the mortgage (it was close, but we still lost something like $100 every month after we paid the property manager). Talk about a bad debt! We felt a million pounds lighter the day we finally sold the house and were able to dump that debt once and for all.
    Dee @ Color Me Frugal recently posted..Debt is Not Forever!My Profile

    • says

      Great to hear you sold the house! I am pretty much in the same boat. I just signed up new tenants for another year. I’m hoping the prices in my area go up a little bit so I can get closer to breaking even on the sale. I really don’t want to bring a ton just to unload the place.
      Jon recently posted..Should You Borrow To Invest?My Profile

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