I have a long commute, and I often find myself listening to a few personal finance radio shows while I sit in bumper-to-bumper traffic. The so-called experts on these shows listen to the questions and concerns of callers trying to build wealth in the current economic climate, and inevitably, when talking about good debt vs bad debt, their advice is this:
Never have debt.
Pay down all your debt.
Live a debt-free life.
At first blush, it may seem like this is good advice. After all, debt comes with all sorts of extra costs beyond paying back the principal — interest payments, application fees, service fees, late payment fees, and annual fees.
Plus, debt tends to have a significant psychological toll; ample research indicates that people with debt experience high levels of stress, which can cause problems in relationships, impair sleep, and have severe ramifications on mental health.
It makes sense that financial advisors to the masses would try to keep their financially struggling listeners away from the terrible ills of debt.
Yet, I’m not so sure debt deserves the demonization it so often receives. For one, debt allows people the opportunity to acquire things they want and need. For another, debt is essential for the creation of credit, and good credit gives people advantages and opportunities that they might not otherwise qualify for.
So, which perspective is correct? Is debt a true evil, or is debt a useful financial tool?
Frustratingly, the answer is both — it depends.
The truth is that there are two different kinds of debt: good debt and bad debt. If you want to gain all the benefits of debt and avoid all the downsides, you need to understand the difference.
Defining Good Debt and Bad Debt
In as simple terms as possible, good debt is debt that you can pay down relatively easily. Often, good debt helps finance something you need and something that helps you build your wealth. Ultimately, good debt should allow you to develop a favorable payment history, which allows you to increase your credit score.
Perhaps the best way to understand good debt is through some examples:
Mortgage loans
Though the number of all-cash real estate buyers is rising, most home purchases today still rely on a mortgage. Fortunately, mortgage loans are almost always good debt.
Homeownership is rewarding in several ways, not least because the equity you put into your home, through mortgage payments and home improvements, has immense value. Owning your home helps you build wealth, as home values are almost always rising. Plus, you may be able to deduct the mortgage interest you pay from your taxes.
These days, it isn’t particularly easy to acquire a mortgage loan; lenders check and double-check your ability to pay the loan back before letting you acquire property, so you aren’t likely to be saddled with more debt than you can handle. You should expect to field all sorts of questions about your finances during the lending process.
Because the lending process can be so rigorous, you may want to prepare your finances in advance of applying for a mortgage — both to make the process easier and to ensure that you are in a good financial position to take on such a significant debt. There are a few key questions you should answer for yourself, such as what different mortgage terms mean and how much you should save up. You might evaluate different types of lenders to determine which can provide terms that suit your needs. Doing all this work ahead of mortgage application allows mortgage debt to remain good debt for the life of the loan.
Student loans
The more educated you are, the higher your earning potential becomes. You should be interested in improving your knowledge, skills, and credentials to reach the best jobs — but higher education is expensive in the United States.
If you need to take on debt to position yourself well within the job marketplace, you will be happy to learn that student loan debt is usually considered good debt. Like mortgages, student loans tend to have lower interest rates, tax-deductible interest, and high barriers to acquisition.
You should try to stay away from private student loans, which offer less favorable loan terms and will never be eligible for federal forgiveness programs.
Business loans: There is incredible variation in the amount of capital necessary to launch different kinds of businesses. But if you have an idea that requires major initial investment, you might need to take on all sorts of varieties of business-related debts, from term loans to lines of credit to invoice financing and more.
Because this debt is essential for starting or growing your business, it is generally considered a good type of debt. Still, you should be careful to take on only as much debt as your business can responsibly shoulder.
What Is Bad Debt?
Bad debt is any debt that creates financial strain without generating future value, and bad debt is always debt that you are unable to repay. Despite what the personal finance gurus say, most bad debt isn’t inherently bad; there are plenty of good ways to utilize the examples of bad debt listed below.
What’s more, even the types of good debt listed above have the potential to transform into bad debt if your financial situation, or the broader economic landscape, shifts. Yet, most consumers use so-called bad types of debt poorly, and bad debts like those listed below have the most potential to cause serious financial harm.
Here are some easy-to-understand examples of bad debt:
Credit cards
It is possible to use credit cards safely and beneficially — but many people don’t. It is remarkable how little time it takes to rack up a vertigo-inducing balance on a credit card, and if you have a high interest rate, you might never be able to pay it all back. Unfortunately, credit card debt is among the most common forms of debt, with Americans collectively suffering under about $1.142 trillion in debt.
Personal loans
Personal loans are often used for very costly but not very practical expenses, like luxurious vacations, opulent wedding celebrations, or elaborate home improvements. Though it is possible that a personal loan well-invested could provide a good return, they rarely do. Even worse, personal loans generally have high interest rates, so repayment almost always proves difficult.
So, good debt is good debt, until it becomes bad debt, and bad debt is bad debt, unless it is good debt. Did that clear up your questions about debt classification? No?!
Debt is a tool, and like almost any tool, it can be good or bad in different circumstances. You might think of a hammer — if you need to pound a nail, a hammer is a great tool, but if you need to sharpen a pencil, having a hammer in your hand will only slow you down. Therefore, before you start accruing different kinds of debt, you might need to learn a more practical system for identifying good and bad debt.
Key Factors to Identify Good vs. Bad Debt
Throughout history, unscrupulous lenders have worked to create loans that are all but impossible for borrowers to pay back, which ensures that lenders continue receiving payments, collecting collateral, and generally turning a remarkable profit with little effort.
These days, usury laws generally prevent the most nefarious lending behaviors. However, it is possible to recognize which loans can yield long-term benefits and which loan products are not as favorable for borrowers by considering the terms.
Mortgage and student loans tend to have longer repayment periods and lower interest rates, which keep monthly payments manageable and allow borrowers to pay down their debt with reliability. In contrast, credit cards can come with abominably high interest rates and a heap of hidden fees, making it much more difficult for borrowers to make payments on time and in full.
Even with modern laws protecting consumers and borrowers, lending terms are not always easy to understand. If you are struggling to decipher whether a lending agreement will give you good debt, you might turn to an expert, like a trusted accountant or lawyer, for help.
Purpose of the Debt
Even if the terms are good, the debt might not be good for you, depending on how you are using it. Let’s return to the tool analogy: A hammer isn’t good for sharpening a pencil, and debt isn’t very good for spending that does not provide any financial return.
Before you take on debt, you should think long and hard about what you are going to use the loan to buy and whether it is worth the extra money you will pay in interest. Here’s a rule of thumb you might use to guide your debt acquisition strategy: If the debt allows you to build more wealth than you are spending in paying for the loan, then the debt is good. In contrast, if the debt merely drains your bank account, it is bad debt.
Should you take on debt to buy your first house? Probably, yes.
Should you take on debt to go on a luxury vacation? Probably not.
Should you take on debt to acquire an advanced degree that could double your annual salary? In many cases, yes.
Should you take on debt to buy a cool boat? Almost always no.
It might take some practice before you can easily determine whether the purpose underlining a specific debt is good or bad. Again, if you are struggling, you might talk it over with a financial expert or maybe a friend with a good financial compass.
Personal Tolerance
Some people love to put their money on the line, take big financial risks, and see what pays off. Other people are much more conservative with their spending and prefer more stable investments. Generally, the latter is a smarter financial strategy — but that’s not to say that risk-takers never prosper.
In fact, plenty of people who have a high tolerance for risk have found great success in utilizing bad debt for personal gain. The right investments at the right time can result in enormous earnings, much more than the debt required to make them. Only the people who feel comfortable taking on such significant risk stand to benefit from these kinds of financial moves.
By no means is this advice that you should build up your risk tolerance and acquire bad debt in the hopes that you make it big. Rather, I’m trying to say that it is important for you to consider how you feel about taking on a certain kind of debt before you decide whether it is good or bad.
If you already have a mortgage and credit card debt to contend with, you might not feel confident taking on additional debt, even if that debt is conventionally “good,” like student loans. Then again, if you have a high personal tolerance, this financial situation might not cause you to worry.
Your tolerance should not be the only indicator you use to determine whether debt is good or bad. However, it may be helpful if you are otherwise on the fence about whether another loan will be good or bad for your financial situation.
The Trouble With Auto Loans
Auto loans are in a tricky gray zone, lurking almost smack-dab in the middle of the good-bad debt spectrum. On one hand, auto loans typically don’t have very favorable loan terms; they tend to have higher interest rates and must be repaid in full in just a few years. On the other hand, across America, most people need a vehicle to get to work, which means an auto loan has a good and meaningful purpose.
If you can’t buy a car with cash and must rely on an auto loan to acquire a vehicle, you should be extremely careful to use the debt on the best possible investment. You should thoroughly research makes and models to ensure you are buying a car that will suit your needs perfectly.
You should also make sure that your chosen vehicle will last for a long time, well beyond the term of the loan, so you won’t have to continue wasting money and energy on successive auto loans. It’s common wisdom that used cars tend to be a better value than new cars, as new cars will depreciate by as much as 40% in their first year alone. However, if you do invest in a used car, you need to be certain that it is in good repair — no one can afford an auto loan on a lemon.
Strategies for Managing Debt
Now you have a better sense of good debt versus bad debt — so what? Using this information, you can begin developing strategies for personal debt management, which will make it easier for you to grow real wealth.
Setting Your Financial Goals
As is the case for any difficult task, you will have more motivation to succeed if you have a sense of what success is. As you begin the journey of managing your debts effectively, you should set yourself some reasonable financial goals, which can help you determine the right path through debt acquisition and management.
Financial goals are incredibly personal. You should think about what you want for your life — what kind of lifestyle you hope to develop — and choose goals that help you achieve your dreams. For example, if you want to be the kind of person who owns a boat (hopefully bought with cash, not credit) then you may need to focus seriously on increasing your earning potential. Alternatively, if you want to maintain a moderate lifestyle and focus on time with family and friends, you may want to focus on acquiring a few valuable assets and growing your savings.
Good financial health looks different for everyone, but there are a few financial goals that benefit almost everyone. These include:
- Paying off bad debts
- Saving for retirement
- Owning a home
- Filling an emergency fund
Eliminating Bad Debt
The reason so many personal finance gurus stridently recommend that listeners focus on paying down their debt is that most people struggling to manage their finances are saddled with way too much bad debt. In this sense, the advice to get rid of debt isn’t terrible; in fact, you should try to clear your slate of any bad debts before you consider taking on any new debts, regardless of whether the new debts are good.
While paying down your bad debts is undeniably difficult, it is rarely truly impossible. Here are a few common strategies for getting rid of bad debts that are holding you back:
- Snowball method: With this strategy, you focus on paying off your smallest debts first, only paying the minimum on any larger debts. When you wipe off your smallest debt, you use that money to pay off the next largest debt, and so on. As your debts disappear, the amount of money you roll forward grows larger — like a snowball — making it easier to tackle your largest debts.
- Avalanche method: This strategy prioritizes debt based on interest rate, with your highest-interest loans being paid off first. This tends to make the process of paying down your debts go quicker and save you money over time. However, it could take a while to eliminate that first debt, so you have to keep yourself motivated until your efforts start to pay off.
- Consolidation method: Debt consolidation involves taking out a special loan that combines multiple debts into one monthly payment. In addition to making debt management more convenient, consolidation usually provides a lower interest rate, further improving your ability to pay your debts down.
Prioritizing Good Debt
Once your debt slate is wiped clean, you can consider accruing the forms of debt that help you build wealth. You should decide which types of debt to take on based on your financial history and goals.
For instance, it may be wise for you to open a credit card, so you can make on-time payments that increase your credit score. It’s possible to get a loan with bad credit. But a good credit score is generally a requirement for most forms of good debt, so if you want to own a home, you might need to put effort into improving your credit before you can acquire a mortgage loan.
Conclusion
I don’t truck with the prevailing financial wisdom that suggests all debt is bad; that’s quite like saying all knives are bad because some people use them as weapons. What about kitchen knives, which help us make yummy food? What about box knives for opening packages? And what about Swiss army knives?
There is good debt and bad debt in the same way that there are good people and bad people — the label kind of depends on perspective and behavior. Now that you know a bit more about the different kinds of debt and the different ways they can be used, you are much better prepared to utilize debt in a way that feels and does good.
FAQs
Can credit card debt ever be considered good debt?
If used responsibly, like paying off the full balance each month to avoid interest charges, credit card debt can be good debt. However, because credit cards are primarily used to purchase consumer goods, not to build wealth, they are rarely considered a good debt option.
How can I turn bad debt into good debt?
The best way to transform bad debt into good debt is to pay it off and acquire new loans with more favorable purposes and terms. You can talk to a credit counselor to learn more about ways to improve your personal debt situation.
Can good debt turn into bad debt?
Yes, good debt becomes bad debt when it is unmanageable. When it comes to debt, is such a thing as too much of a good thing, as too much debt will jeopardize your entire financial situation.
What are the warning signs that debt is becoming unmanageable?
If you are struggling to make minimum payments and borrowing more to pay off existing debt, and if you have little to no savings, your debt situation is not particularly strong. You should find ways
