Good Debt versus Bad Debt

good debtThere is a lot of talk going on regarding good debt versus bad debt, what each one is, and how one can benefit and or be harmed by them. Here are the basics.

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, they decrease in value.

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.

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 $700/month on a $40,000/salary and trying to get a mortgage. Most likely it will not happen.

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 a few months 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 ans options you have in life. Find out how much your debt is really costing you by using this loan interest calculator. Here are 5 steps to help you pay off your student loans. Additionally, here is how you can pay off your mortgage quickly.

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  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

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