Debt is bad. But some debt is good. I hear this all of the time. People arguing over the difference of good and bad debt. It gets really confusing because many times people will just use a blanket statement like “debt is bad”. Well if all debt is bad, how can there be something called good debt?
And 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 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.
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 $6,000. The underlying asset (the car) decreased in value. Same concept for most 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 OK to have and bad debt is bad to have. 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 for a job that only pays an annual salary of $20,000 per 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 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 per month when you are paid $2,000 per month. 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.
What I am saying is that before you do, 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. Lastly, make sure that the annual salary you expect to earn will allow you to pay off your student loans.
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.
You can play with the calculator below to see how much your monthly payment would be given the size of the mortgage and your interest rate.
For example, 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.
When Bad Debt Is Good
So if we can have good debt that is actually bad, can we have bad debt that is good? Technically you can. If you are able to get a 0% finance offer, then the bad debt isn’t so bad.
For example, let’s say you are buying a new car. You could pay cash for it or you could finance it at 0% interest. The reason you may want to finance it is because you come out ahead financially.
If you leave your money in the bank and it earns 1% interest, it will continue to grow even as you take out money each month to pay your loan balance. The bad debt you took out doesn’t cost you more money since you are not paying any interest.
As a result, you come out ahead financially. Same idea holds true with credit cards. If you can get a 0% offer, you can use that to your advantage by reducing your payments and save money in the long run.
Understand I am not encouraging either of these. You have to be smart and disciplined with your money to make them work out for you. In some cases, they make perfect sense, but in other cases, you are playing with fire.
What If It’s Too Late?
What if you are reading this and you already took out student loans for a career that isn’t paying you enough to afford to live? The easiest thing to do is to refinance. You can check out your refinance options for free here.
Just plug in some information about your student loans and you will get a handful of refinance options from various lenders. You’ll see your new interest rate and how much lower your new payments will be. It’s free to do and there is no obligation.
When it comes to a house, things are a little tougher. I would suggest you read my post on how to pay off your mortgage fast to see if there are any tips you can take advantage of.
If nothing is beneficial there, you should call your lender and see if they can help in any way. Other than that, you can bring in a roommate like I did. Or you could try to cut some other monthly expenses to free up some money so you can afford to make payments.
The goal here would be to get the balance to a point where you could refinance and lower your monthly payments. When you are in a position to refinance, use my calculator above to see how much you could save each month.
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. The same applies to bad debt as well. In some scenarios, bad debt can be good.
Once you buy your house or earn your college degree, you will still want to make it a point to pay off your good debt. And of course, you want to pay off any bad debt quickly too.
The less debt you have, regardless if it is good debt or bad debt, the more freedom and options you have in life.