Good Debts Versus Bad Debts
- Good debt is classified as debts that lead to achieving greater goals, such as home ownership, starting a business, or an education leading to higher pay.
- Bad debt is any use of debt to fund short term consumer spending with no chance of a return on your investment.
- Debt should be avoided in almost any situation, but is acceptable if used as part of a well thought out budget.
First, let’s get this out of the way. All debt is basically bad debt. As a rule, at least when discussing anyone’s personal finances, I don’t believe in debt. Anyone attempting to satisfy their current needs or wants by borrowing from their future is not making a sound financial decision. In certain instances, though, debt can make financial sense. I classify types of debt into three categories, good debt, okay debt, and bad debt.
Good debt is debt that I can live with. It’s debt that has greater goals compared to just funding lifestyle or short-term desires. Good debt always leads to achieving some greater goal, or it gives you a reward beyond the object or service you are purchasing.
Of course, a mortgage is good debt. No one, unless you received a significant financial windfall, can pay cash for a home. Therefore, if the alternative is to pay rent, then making mortgage payments is almost always better. Why? First, your home’s value will likely increase over time, building equity which leads to a potential financial gain upon sale of the home. Second, the interest portion of each mortgage payment is tax deductible, up to $750,000 of mortgage.
A student loan should be avoided at all cost, but I still classify it as good debt because if the alternative is no education, it is probably worth it. Getting a college degree historically leads to much greater pay over a lifetime, so the idea is you will turn a profit compared to the amount of debt incurred.
I would not suggest getting into debt to start a business, but the fact is, starting a business can be so rewarding and profitable in the long run, it may be worth the risk. It’s an issue of how much risk you are willing to take. A majority of businesses ultimately fail to make a profit. When you add debt service to the already considerable list of monthly expenses you will need to overcome you realize using debt should be a last resort.
Home Equity Loans
Home equity debt is fine if the funds are being used to add to the value of your home. Again, I still recommend paying cash for that new bathroom, but if you can’t, at least the interest payments on a home equity loan are tax deductible and your loan comes with a fixed payoff period.
What about using the proceeds to pay off consumer debt or credit cards? Only if you are willing to stop using your consumer debt or credit cards. Think about it, a home equity loan can take up to 30 years to pay off. Do you really want to pay for last night’s dinner or that new dress you purchased for the next 30 years?
Okay debt should be avoided at all cost, but I classify it as okay if you really know what you are doing. Additionally, okay debt, like good debt, will lead to a reward beyond the product or service that you are buying.
I classify credit cards as both okay debt and bad debt, because it depends on how you use them. If you are using your credit card as a convenience, completely paying off the balance at the end of each month, you can not only rack up rewards points without paying any interest or fees, but you also go a long way to building up your credit, saving you money when you apply for a car loan or mortgage. I almost never use cash, I use my credit card for just about all my daily purchases. But I never run a balance, ever. If you are running a balance, see below under bad debt.
For those of us who don’t live inside a major city, we probably need a car. Cars are expensive though, so I classify car loans as okay because they have a fixed payoff period, you know how long your payments will continue and they are fixed in dollar amount, so they can be accounted for in your monthly budget. I would still rather see you pay cash for a car, but it’s not always feasible. To be clear, purchasing an $80,000 car using debt when a $25,000 will do the job is not a good thing. Be reasonable.
Whether done through a bank loan or a home equity loan, it is okay to get into lower interest or tax-deductible debt if it means paying off higher interest debt. Just make sure you are doing it as part of a serious budget and you are sure you are not going to get into more high interest uncontrolled debt.
Bad debt is any debt used to fund short term wants simply because you don’t have enough cash, and you just can’t help yourself. Everything on the list below should be completely avoided, no exceptions.
Credit Card Balances
I listed credit card use as a convenience as okay debt, largely because when you pay off the balance at the end of each month, it is not really debt. If you are running a balance, even for just a few months, you are paying fees and interest and just making the bank rich and yourself poor.
Personal loans, bank loans or consumer loans should be avoided. A consumer loan is debt you have incurred to purchase something consumable, or something that has little value in the long run. Think clothes, electronics, toys, furniture or jewelry. I know some of these things are expensive, but unless you can pay cash for them, you can’t afford it. What if you really, really, really need a new couch and you don’t have the cash? Buy a used one. What about that 55-inch TV? Get a smaller one and save up to eventually buy something larger down the road.
Pay Day or Finance Company Loans
Any loan designed to front small dollar amounts for short periods of time will come with exorbitant fees and interest. The fees on these loans are typically high and when you can’t pay them off a few weeks down the road, they roll over and begin accruing interest that can easily cause the balance to skyrocket within a short period of time.
Tax Refund Anticipation Loans
Many tax preparation companies offer refund anticipation loans. The idea is the preparer fronts you the money that they know they will get back from the government in the form of a tax refund. The problem is, the fees and interest tend to be high. Often, you are not even aware of the amount you are paying in fees because the preparer simply hides them by not telling you what your complete refund was supposed to be without their fee.
Just About All Other Debt
Let’s be honest, I don’t really need to list more examples of bad debt. Anything that gets you into debt or requires you to commit to monthly payments greater than the value of what you have purchased is considered bad debt and needs to be avoided.
- Any transaction that causes you to get into debt to finance a short-term desire or even need is a bad debt.
- Any debt that does not lead to a financial gain in the form of profit or increased pay in the near future is a bad debt.
- If you can’t pay cash for something, you probably can’t afford it.