Good Debt vs. Bad Debt

When you think about debt, you usually think of all the negativity that surrounds it. Drowning in credit cards because you've only been able to make minimum payments. That dreaded monthly payment that makes you stressed out when you see it hit your bank account.

While debt can be a source of immense negativity to some there is some debt that is good and even advisable. Let's take a look at some examples of debt and determine whether they are good or bad.

What Is Good Debt?

Now before you throw a fit, know that I am a big fan of being financially responsible. There are some people who should not take on any debt because of their habits. Any debt is bad debt for them.

Debt is similar to fire. Fire can burn down a whole forest or it can be used to cook your food. The main question I ask when accumulating any debt is “will this debt help me get ahead financially?” If the answer is no, it's bad debt and I run away.

In broad terms, good debt is debt that you're able to pay off responsibly based on the loan agreement. Good debt is debt that is taken on to assist with generating income and building net worth. Good debt is often long-term and low interest. This type of debt will help you to achieve a financial goal. (ie. own a home free and clear)

Taking on too much of any debt-no matter what kind-can turn it into bad debt.

The saying goes “too much of anything is not good.” That is certainly true about debt.

Examples of good debt

• Education: People who graduate college are more likely to have higher earning potential, and having a degree generally makes it easier to find employment. Your student loans should pay themselves off within the first few years you are employed. Make sure the payment stays below 10% of your projected after-tax monthly income. Keep in mind that not all degrees are of equal value, so make sure that you are considering the short and long-term prospects for any field before entering it. Before taking on any student loan debt you may consider interning or taking a year before your university studies and work in the industry. What happens if you graduate with a college degree in a field you hate? Don't do that. Research extensively first.

• Small Business Loans: Being your own boss is often rewarding and challenging both emotionally and mentally. If you succeed with your business, you should be able to pay off your loan within a time period that makes it a worthwhile investment. Before taking on any small business debt make sure you talk to older and successful people in the industry. An individual business owner who is on the tail end of their career has lots of wisdom to share and can be a valuable mentor and resource to you.

• Mortgages: A good strategy as a homeowner is to buy a home, live in it for a few decades, and then sell it for a profit. Or if it's your “forever home, you can own a home free and clear with no monthly payment. Mortgages can also be an attractive option if inflation is higher than the interest rate on your loan. If inflation is 5% and your mortgage rate is 3% the mortgage company is actually paying you to borrow the money for your home. How about that? Homeowners also enjoy certain tax breaks that are not accessible to renters. You can also generate income through renting out your whole house or renting out individual rooms in your house. Before renting out your house you'll want to make sure the finances make sense and you are cash flow positive.

What Is Bad Debt?

In simple terms, bad debt is debt you are not able to repay or is on something that does not have positive cash flow. Think anything that is hindering you from progressing financially.

Debt with high or variable interest rates that is accrued for personal expenses and depreciates in value is bad debt.

Sometimes bad debt is also good debt that has gotten out of control, such as credit card debt. If you're paying off the entire balance every month, then it's not an issue. But when you're only making the minimum payment and the interest is racking up, credit cards can turn into bad debt quickly.

Here's a simple rule to follow. If you do not have the money to buy the item in cash right then, keep the credit card at home. I keep all mine in a fire safe and only take them out when I need them.

Recovering shopaholic here…

Examples of bad debt

• Auto Loans: Cars can be difficult to live without, but financing them is not always the best option. By the time you drive the car off the lot, it is already losing value. And we are talking substantial value here. You can't take out a loan and then sell the car and make a profit. If you absolutely need a loan to buy a car, look for loans with very low interest (sub 3%), so at least when you're making payments you have to pay a small amount of interest. If you can live without a car, do it. If you absolutely need one, buy an older model and forgo the monthly payment. You'll thank me later.

• Personal Loans: Clothes, vacations and lifestyle “luxuries” fall into this category. Clothes are said to be worth half of what customers pay for them, and this becomes very apparent when you walk into any second-hand store. Borrowing to buy with a high-interest credit card is never wise, especially if you have impulse issues with shopping. Always make sure that if you are using a credit card with high or variable interest, you are able to pay off the full balance every month. Personal debt can be good in some cases, such as using a credit card that gives rewards or air miles. I have seen people go into debt to buy a video game system, furniture and a laptop computer. You don't need to keep up with the Jones family, they are not watching you.

• Payday Loans: Payday loans are debt that can quickly turn into a nightmare. Payday loans come with interest rates up to 300%, making them instantly unaffordable for pretty much everyone. How they “get” you is they encourage you to “renew” the loan. This simply pays the interest and does not pay any of their principal balance. This means your loan balance does not decrease from the payment you are making although it may seem that way. Stay away from these at all costs.

How to Avoid Bad Debt

If you decide to make a purchase that will increase your debt, ask yourself if taking on the debt will benefit you financially in the long run. Is it financing a venture that could reward you in the future, or is the money for a short-term impulse purchase that is satisfying an immediate desire?

Make sure you have an emergency fund in place with 3-6 months' worth of expenses so that a credit card or personal loan is the last resort.

Try and keep your debt to credit ratio low to avoid being viewed as a risky borrower by lenders. Focus on paying off current debt and try hard not to incur new debt during your debt payoff journey.

Other Considerations

Taking out a debt consolidation loan from a bank or other reputable lender can be beneficial because they have lower interest rates. Just make sure to use the cash from the loan to pay off debt and not use it for personal purchases. Also, make sure you are creating new financially savvy habits to replace the bad ones. I have seen dozens of people take out a consolidation loan to pay off their credit card debt only to charge up the credit cards again. Now they have the consolidation loan and credit card payments. A lose-lose situation.

You can also borrow to invest. If you have an account with a brokerage firm, you may have access to a margin account, so you can borrow money to purchase stocks.

Buying on margin has the potential to make you money if the stock goes up in value before you have to pay back the loan, but it also has the potential to lose you money if the stock loses value before you pay back the loan.

Buying on margin is not an activity for inexperienced investors.