M4 The Real Difference Between Good Debt and Bad Debt

The Real Difference Between Good Debt and Bad Debt

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“What does not kill you makes you stronger.” Words such as these are comforting to hear when you’ve just suffered a disappointment, but “lethal” and “fortifying” aren’t the only two categories out there. It’s unfortunately easy to think of many examples of harmful things which are neither.

When it comes to debt, however, this distinction pretty much rings true. Any kind of loan you can take out either builds you up financially or slowly drains your ability to live the kind of life you want. So, what is the difference between good debt and bad debt, and how can you tell which you’re about to get? These are obviously important questions – but no bank or financial company is under any obligation to determine this for you. As long as you can afford the repayments, they’ll allow and indeed encourage you to take the loan.

Why Is Debt Bad in Some Cases and Good in Others?

Rather alarmingly, the average American carries debt of $92,727. We hope that most of them have at least taken a moment to think about what distinguishes good debt and bad debt. For comparison, here are median retirement savings by age group (though these figures are from 2015 and have almost certainly dipped since then):

good debt and bad debt and savings

For most people, going into debt at some point is unavoidable. Very few parents are wealthy enough to pay for all their children’s college expenses, virtually everyone needs a mortgage to afford a house unless they already own a similar property, and even buying a car with only the cash in your bank account is kind of a tall order for most of us.

So, why is debt bad, at least potentially? Well, that’s because, like mold, it grows over time. This increase is usually specified in terms of an annual interest rate, which may be as low as 3% for a mortgage or as high as 25% on a credit card.

Now, presumably, you plan on buying something with the money you borrow (this can also be something intangible, like an education). The crucial difference between good debt vs bad debt comes down to what you purchase with it.

If you buy something that automatically increases in value to keep pace with the interest you pay, as is the case with most real estate, you’re breaking roughly even. The capital appreciation simply cancels out the finance charges you pay to the bank. In the meantime, you can live there without paying rent, reducing your monthly expenses, so this – buying a home with a mortgage – is usually good debt.

We find even better examples of good debt when we’re talking about buying something that ends up making you money. This is most often why people take on student loans: if you’re paying 5% interest on a debt that lets you earn 30% more than you would have otherwise, you’re definitely coming out ahead. The actual calculation is a little more complicated; perhaps your loan isn’t federally subsidized and interest starts accruing as soon as you sign the paper rather than six months after graduation. The principle behind this being good debt remains the same, though.

So, what are some examples of bad debt? They are not hard to find: just take a look at your most recent credit card statement. Any expense on there that doesn’t somehow make or save you money, and indeed more money than the interest you’ll end up paying on what you borrow, is bad debt. Restaurant meals, gas, clothing, groceries, entertainment – all these lifestyle, consumer, day-to-day expenses should ideally be paid for out of your normal income, not your future earnings.

Of course, if you pay off your balance on time and in full every month, your credit card is just a convenient replacement for cash instead of a source of debt. With the average American owing thousands, though, it’s a certainty that few people actually follow this best practice.

So, to sum up the above:

  • Bad debt is spent, good debt is invested.
  • If debt lasts longer than the thing you use it to finance, it’s probably bad.
  • If debt causes your net worth to rise over time, it’s probably good.

Good Debt vs Bad Debt in Practice

Theory is a fine thing, but it’s only useful to the extent that we can relate it to the real world. It’s rarely a good idea to make important decisions based on general, rule-of-thumb advice like you’ll hear during two-minute finance segments on TV, or indeed the guidelines you’ve just read. Maxims like “neither a borrower nor a lender be” can be a great help with choices you have to make in an instant, but aren’t appropriate for situations where you can take your time in weighing all the facts.

Let’s try a little exercise: see whether you can determine whether the following are examples of bad debt or good at a glance:

  • Credit cards
  • Student loans
  • Mortgages
  • HELOCs
  • Auto loans
  • Small business loans
  • Personal loans
  • Payday loans

Unless you’re happy staking your financial future on knee-jerk reactions, it’s not actually that easy to tell. Generalizations aside, treating a whole class of debt as if it were all the same is a little like not caring whether you bet on the Lakers or Clippers – both teams are from LA, after all.

Let’s re-examine one of the examples above, namely buying a house. Having a mortgage does have some tax advantages and is usually the only way to – one day – own your own house. Most people therefore assume that it’s one of the best examples of good debt.

Property values can go down as well as up, though. The general assumption is that the interest rates on adjustable-rate mortgages are always just a little over gains in the housing market. The housing market nationwide or in your state is mainly of interest to economists, though: you have to worry about your particular piece of real estate, not some average. If you’re unlucky in your choice of neighborhood or time the market wrong, you may end up losing money instead of gaining equity as you planned, even at a low interest rate.

unexpected examples of bad debt
Image courtesy of CCPixs.com

As they say, prediction is difficult, especially about the future. Many students have embarked on their debt-funded studies with stars in their eyes only to graduate and find that getting a job at the salary they were counting on is near-impossible. It could well be that fields that are currently receiving a lot of hype, like data science, will see way more graduates than jobs in five years. So, student loans can also be examples of bad debt – if you back the wrong horse or, of course, fail to graduate.

On the flipside, customary examples of bad debt can also sometimes be good for your finances, depending on the situation. Let’s say you’ve just found your dream apartment available for cheap, but you don’t have the cash for the deposit needed to secure it. Borrowing a few hundred bucks at nearly any interest rate is probably the smart financial move in this case. If you’re a contractor who needs a few tools you can’t afford to finish a job and get paid, charging them to your credit card ends up making you money. In certain types of emergencies, the good debt vs bad debt equation doesn’t really matter at all – if you or your family’s health is at risk, for instance, monetary considerations have to take a back seat.

Other Examples of Good Debt and Bad Debt

We’ve just seen that traditional assumptions about good debt vs bad debt aren’t always valid in the real world. A loan can stay with you for ten or twenty years and be either a blessing or a burden during that time. Relying on general advice like “a house is an investment!” is no way to make this kind of decision. Let’s look at how you might approach some specific scenarios:

Auto Loans

Unless it belongs in a museum or is about to win a major race, every car is a depreciating asset. It’s never going to rise in value.  In fact, its price drops pretty rapidly, making an auto loan bad debt almost by definition. There is more to the story, of course: having a reliable car that’s pleasant to drive does impact your quality of life in a major way and may be a prerequisite for your job.

People choose which cars to buy based on much more than each model’s functional value. In general, though, it’s best to think of your vehicle as an expense rather than an asset. Choosing the cheapest one that meets your needs makes it much more likely that your auto loan will turn out to be good debt vs bad debt. Shaving a percentage point off your interest by refinancing later will tilt the scales a little, but not nearly as much as making a prudent choice to begin with.

Buying Investments on Credit

There are very few instances in the nuanced world of finance where a global pronouncement can be made on whether something is a bad idea. However, when it comes to inexperienced investors buying shares or other volatile investments using debt – “on margin“, in other words – the answer is no, never, nunca, niemals, nikogda, and jamais. Professional traders sometimes follow this risky strategy, but retail investors should steer clear.

The basic problem with leveraging your investment in this way is that your exposure to both profits and losses is multiplied. This means that using debt to finance investment only makes sense when you have a sure thing. Plenty of people in 1929 thought they had a sure thing; most of them lost their shirts and some of them lost their lives.

There are a few exceptions to this rule. One is the carry trade, where an investment bank borrows money in a country where interest rates are low and invests it where it can get a high return. This is still risky, though, and if you had access to transactions like these you’d probably be reading Bloomberg Businessweek rather than ProMoneySavings. Another is when investing based on information not available to the general public, in which case you’re risking jail time as well as steep losses.

Borrowing Money for a Business

In a practical sense, making frequent trades on the stock market is just as much a zero-sum game as poker: for someone to win, somebody else has to lose. (This obviously does not apply to a buy-and-hold strategy). Owning your own business, or part of one, is a completely different animal: not only are you acutely aware of the likely ups and downs it might experience, but you can also play an active role in making your loan create wealth – a characteristic of many examples of good debt.

In other words, if you need money to finance expansion or a bridge loan to complete existing contracts, the only thing to do is to see if the numbers make sense. Borrowing money to start a new business, on the other hand, requires a little more thought.

examples of good debt taken thoughtfully

In general, there are two ways to get your hands on the capital required to bring a business idea to life: take out a loan or find investors. In the latter case, other parties share some of the risks but will also take their share of the possible rewards. If you choose to borrow, the loan may remain long after the business has shuttered its doors, but you also don’t have to share the profits. Many if not most businesses get their initial funding from a combination of both sources.

The question of whether any given new business loan constitutes good vs bad debt requires a time machine or crystal ball to answer, neither of which is sold at Walmart. The best advice is to err on the side of caution: the odds of a new enterprise succeeding are not in your favor.

Taking On Debt in an Emergency

In some cases, it’s worth taking on high-interest debt like a payday loan. This is usually not for optional spending or to earn more money in the future, but in order to avoid losing more money than the interest will cost you.

Every self-employed person or small business owner knows the sinking feeling of their cash flow dipping into the red. If you can’t pay urgent expenses like rent or wages, you’re in serious trouble. If your car has broken down and you can’t get to work otherwise, you have a choice between taking out a loan, perhaps the first one you can get approved for, or losing your job. If you’re about to get evicted but you have some guaranteed money coming in next month, you can rely on short-term credit instead of having to pay for moving to a new place.

When things like these happen, the most prudent solution may well be to apply for a personal loan or stretch your credit cards temporarily. If you tighten your belt in other areas, you should be able to pay back the money you owe fairly quickly, limiting the amount of interest you’ll have to shell out.

Using Debt to Finance an Education

The rule of thumb for student loans is that you shouldn’t borrow an amount greater than what you expect to earn in your first year after graduating. Instead of pursuing your dream career (which often turns out to be less exciting than you thought once you enter the workforce), you should do a kind of audit of your skills and the professions open to you, as well as the cost of completing a degree. This approach generally favors engineering, business administration, and related majors.

This is not to say that liberal arts degrees are “useless”, as is often claimed. Having a degree of any sort increases your earning potential, even if you can’t or choose not to work in that field. More importantly, society as a whole is better off with trained historians, literary critics, philosophers, and other supposedly non-productive experts.

When considering whether it’s worth going into debt to get such a degree, however, it’s a good idea to remember that someone with sufficient dedication can also study these subjects by themselves. You won’t achieve the same level of accomplishment and satisfaction as if learning in a full-time academic environment, but you can more than satisfy your interest by reading books and discussing material with people who share your curiosity.

Why Is Debt Bad News for so Many People?

Once you turn 18, you’re considered an adult in almost every sense of the word. You can sign contracts, take out debt, own real estate, serve on a jury, get a tattoo, and join the army. From the moment the clock strikes midnight, you’re also assumed to have suddenly transformed into a responsible person who knows what he or she is doing – you can then, for instance, be sued in civil court.

Barely anyone at that age, or in fact much older, really has the maturity and restraint necessary to manage their finances effectively. It’s hard to resist the allure of a new car that comes with “easy” financing; it’s easy to swipe a credit card without considering the consequences. By the time they’re 30, many Americans are deeply in debt – much of this of the bad variety, especially due to chasing short-term gratification on credit.

A good FICO score is most certainly not a license to go out and buy a bunch of stuff you don’t need. Doing that, in fact, is exactly how to ruin your credit score. At the same time, the good kind of debt can make it possible for you to afford things you’d never be able to buy outright. Finance your consumption with earnings, not debt. Don’t dip into the credit well unless it’s fairly certain that the loan will end up paying you back: either by allowing you to save money elsewhere or by letting you earn more than you pay in interest.

I make a few points in this article that I considered leaving out, as some people may find them controversial. If so, please feel free to disagree in the comment section.


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    David

    9 thoughts on “The Real Difference Between Good Debt and Bad Debt

    1. Lorena Blair says:

      Not everybody has rich parents, so we have to make our way through life, sometimes with taking credits to be able to finish the university.

    2. Thomas says:

      I try to avoid borrowing money as much as possible. But sometimes we do not have other option

    3. Merlin says:

      If you start borrowing money there is no way back. You will be in a circle. The main issue is to change the way of life and make some budget to live from your own income

    4. Irnes says:

      Whenever you need to borrow some money you should check all the options and to make sure that you will have some benefits from it.

    5. Essy says:

      Buying shares on credit is not a smart option. You have to be professional and know the market well to do so.

    6. Rendy says:

      We all have times in our life when we need cash or live on plastic cards. It is how it is

    7. Loren says:

      We can not plan some things in our life. We take some money to buy a car and have a detailed plan how to repay it. In the meantime we are out of work and the plans change. That’s how it is.

    8. Esmerlada says:

      Living up to your limits is the smartest. And whatever money you borrow just make sure that you will be able to repay it

    9. Marisol says:

      There are emergencies in everybody’s life when you need cash, so lending money is only way out. . You just need money to cover some expenses

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