One of those financial tips that seem somewhat sound, but are not when you think about it, is “All debt is bad. Assuming that all debt is bad, few individuals would ever purchase a house, invest in a business, or attend college without paying for it all out of pocket in cash; and few successful individuals would have ever had the resources to build what they built.
It is not about debt is good or debt is bad, it’s about knowing how to differentiate between debt that can help you become more financially stable and debt that can make you less financially stable. When you’re able to distinguish, the choices to borrow become much easier to make.
If debt is considered good, what does that mean?
There are a number of things that good debt has in common. It’s employed to gain an item whose worth or earning capacity rises gradually. It typically has a fairly low interest rate. It’s not only borrowed in an amount that you can afford to pay back, it is borrowed within a limit of your ability to pay back without putting your bank account at risk.
The standard one is the mortgage. You’re borrowing for an asset that, historically, has increased in value over time, and you’re paying an interest rate that is usually much lower than other types of borrowing. While you’re in debt, you’re also creating equity every paycheck; and, over the years you make those payments, the property can appreciate as well.
Student loans, used for the purpose of education that does actually enhance earning potential, can also fit in this category, but there are more caveats to this than you think, and we’ll get to that.
For instance, if a business loans a sum to purchase equipment, inventory or marketing which is more successful than the cost of the loan itself is another example. The debt is used to finance something that will generate more returns than the interest being paid on the debt.
What’s the Problem with Debt?
Bad debt on the other hand, has the opposite qualities. It is used to purchase an item which has no return value or decreases in value right away. Usually includes a high interest rate. It’s often used for things it really didn’t need and maybe it could have been bought cash in hand if some of the plans had been slightly changed.
The most typical one is credit card debt for basic expenses. There are 20-30% interest rates on credit cards, and purchases of food, clothing, day-to-day expenditures don’t earn money or appreciate. When you don’t fully pay off your balance each month, you are most likely making much more than they cost.
Payday loans and other short-term, high-interest loans are definitely in that camp, with effective annual rates that are often quite a bit higher than just about any other line of credit.
A car loan is a little more complicated. Cars are assets that are depreciating, so technically the debt is funding an asset that is decreasing in value over time. However, if you have a reliable car that is getting you to work, it can be a good debt and not just bad, especially if the loan payments are reasonable and the car is reasonably priced in comparison to your income.
The current condition of a line changes over time.A line is not always clean
It’s good debt versus bad debt, and that’s a helpful, but not definitive, guideline. If your house payment is putting you in a squeeze and you can’t really afford the mortgage, it becomes very clear that it’s not a good debt, even if the home is appreciating. Being a theoretically productive debt doesn’t keep you safe if the monthly debt payment is financially dangerous.
Likewise, student loans taken out on an education that won’t earn enough in the real world to cover the costs of learning, or a degree that is much more expensive than what it is really worth, can act like bad loans, despite all the rhetoric that education is an investment in yourself.
That’s why the question that is most helpful is not “Is this debt good or bad?,” but rather “Does this specific amount, at this specific interest rate, fit within what I can actually afford, and am I using it to improve my situation?
One way to assess any debt you’re considering
When looking to add on to your debt, you’ll want to ask yourself three questions. Where is this money going and will it increase in value or make me more money? What is the interest rate and how does it compare with other sources of credit that I can obtain? Will I be able to handle these payments if my income were to be reduced or an unforeseen expense were to occur next month?
If the answers are in favor of an appreciating asset, a reasonable rate and comfortable repayment then it’s probably debt that is working in your favor. If the responses are in a direction of depreciating purchase, high rate, and your payment is going to be a strain on your finances, then it is worth reconsidering, or at least try to limit the amount you borrow.
Why This Difference is Important in Your Financial Plan
The change in understanding alters priorities in paying off. Unless you have both a low interest mortgage and high interest credit card debt, it is almost always advisable to pay off the high interest credit card debt first, as it is costing you the most and is not doing you any favour.
It also puts a new perspective on the way you view decisions around new borrowing. Its debt that is used for an investment property or business expansion which is likely to produce returns, as opposed to a vacation or discretionary purchases on a high-interest card, which are also on paper debt.
The Bottom Line
There are different sorts of debts that warrant different degrees of urgency and different reputations. Debt can be a very effective financial instrument if you are able to take out debt that is appreciating, at a reasonable interest rate and within your budget. Any debt that makes a depreciating purchase with a high interest rate is a debt to be eliminated as soon as possible.
The objective is not to have no debt at all, but to know what type of debt you are carrying on and how to deal with it accordingly.
Frequently Asked Questions
Is a mortgage considered good debt?
Generally yes, as long as the payments fit comfortably within your budget. Mortgages typically come with lower interest rates than other debt types, and the property often appreciates in value over time.
Is credit card debt always bad debt?
Carrying a balance month to month on a high-interest credit card is typically considered bad debt, since the interest costs usually outweigh any benefit from the purchases. Paying the balance in full each month avoids interest entirely, which changes the picture.
Are student loans good or bad debt?
It depends on the return. Student loans for a degree that meaningfully increases earning potential relative to the loan amount can function as good debt. Loans that far exceed the realistic salary benefit of the degree behave more like bad debt in practice.
Disclaimer:
This article is for general informational purposes only and does not constitute financial advice. For guidance specific to your situation, consult a licensed financial adviser.
