Good Debt vs. Bad Debt

The accumulation of debt is can be a necessary evil for personal finances. The majority of us don’t have enough cash on hand to pay for a child’s education or a house. However, a majority of people often let debt grow to dangerous levels. This is due to wanting things now and not putting money aside to have for emergencies, such as replacing a water heater.

Although debt is bad it may not be the best idea to shun it completely. The goal is to have an understanding of debt that is good and debt that is bad. Having a knowledge of debt allows you to effectively manage borrowed money. Good debt will consist of things that you will need, but cannot afford to purchase using cash. Any items being bought with borrowed funds that are not otherwise affordable or not needed is bad debt.

One type of good debt that you will typically have results from the purchase of a home. The way that a home is typically purchased is by obtaining a mortgage. Mortgages come in various types with different interest rates. You need to determine the type of mortgage to meet your needs and the current mortgage rates that apply to these loans. A traditional mortgage requires twenty percent down to avoid PMI.

Good Debt vs. Bad Debt

Being able to help your child afford college is a relatively good debt. However, this a type of debt a child should take instead of a parent. You do not want to spend funds set aside for retirement or used to pay for unexpected expenses to pay for your child’s education. Your home should also not be used as a source of funds to pay the tuition costs for a child. A few of the best ways to pay for your child’s college is to look into financial aid, scholarships, and grants.

The purchase of a car is also considered bad debt. Automobile loans can be obtained for lengths ranging from 60 months up to 72 months or more, unfortunately the value of this car drops, often times the value of the car will drop below the outstanding balance on your loan.

The best example of bad debt is credit card debt. Credit cards offer people a convenient way to make a purchase. However, they also provide the fastest way for people to get in trouble with their spending. Credit card users do not always think about the balance that needs to be paid back for each credit card that they use. The interest compounds the matter by making it harder to get out of debt. Credit card debt will continue to grow when only minimum payments are made on cards that have a high interest rate.

As you can see not all debt is created equal. Some debt funds things that are a necessity in life that you are not able to purchase outright, while other debt can get in you trouble quickly by allowing you to purchase things you cannot afford.

Author: KC Beavers

KC Beavers is a semi-retired entrepreneur. The subject of personal finance has always fascinated him. In an effort to not bore those around him with all his love of personal finance as much he has come here to bore all of you instead.

4 comments
Modest Money
Modest Money

I'm about to take on some good debt soon...my first mortgage.  It is true that with that kind of debt it is really an investment, especially if you are in a strong housing market with constantly increasing property values.  Few people would look at a mortgage as bad debt, but there are people who are extremely negative about debt and wouldn't even take on a mortgage.  They fail to think about how they can earn more on that saved money with a solid investment.  I also agree with snarkfinance about car loans.  Since a car is a necessity for many people, sometimes it makes a lot of sense to finance.

snarkfinance
snarkfinance

KirkKinder is correct, all debt not used for productive assets is bad debt.  I will slightly, slightly disagree when it comes to car loans.  If you have a credit score and down payment that can bring the monthly payment to a reasonable spot with an interest rate that is very low, there is a case to be made for using a car loan in place of cash and "playing the spread" with the remaining funds through intelligent in investing.  For example, my car loan is 2%, and the funds I didn't put down are now invested in an apartment building which provides a 24% ROE.  

KirkKinder
KirkKinder

All debt not used for productive assets is bad debt. Productive assets are your home, investment property, business loan, etc. Even for productive debt, you need to understand the three types of debt as described by Hyman Minsky, an Austrian economist. He identified three types of debt: hedged, speculative and ponzi. Hedged debt is where the borrower can handle the interest and principal while speculative borrowers can only pay the interest. Finally, ponzi debt describes a situation where the borrower can pay neither the interest or principal and relies on asset appreciation to manage the debt (think housing bubble). If you aren't a hedged borrower, don't borrow...ever.

bigcajunman
bigcajunman

So this whole need to pasteurize a bad thing is amusing. All Debt is Bad, however some debt is not as bad as others, is really what is going on. Good Debt is a creation of Banking institutions and lenders, if you learn to HATE debt, you will then try a lot harder to get rid of it.