There was a time that I used to think that all debt was “evil”. But if you look at the big picture, this country wouldn’t run too well without it. If you can imagine this — in some nations, there’s no concept of mortgages or borrowing to buy a house. In these cases, you’d have to have all the cash needed to buy a house in order to own one. Seems like this could be pretty restrictive if we had the same rules over here in America.
Yet on a personal level, people have varying attitudes towards debt much of which are rooted on their past experiences with borrowing and using credit cards and handling loans. Emotions aside though, we can view debt as having various forms. It’s often misunderstood so I thought to offer this review, noting how debt needs to be differentiated. Which leads to this basic question:
What’s the difference between good and bad debt? The easy answer is that good debt allows you to make money while bad debt just makes you lose money. So if you were going to borrow money to do one of these things…
Scenario 1: Trick out your house (aka Home Renovation)
Scenario 2: Trick out your car
you would actually be applying your loan to good use in only one of these cases. Sinking borrowed money into improving your car’s appearance is a poor way to use debt for the simple reason that it won’t lift your car’s resale value.
Good debt is the kind of borrowing you do to finance or purchase something that appreciates and gains in value. In my mind, if you are borrowing money to invest towards something that gives you some return in the future, then you’re being shrewd. You’re able to use somebody else’s money to make more money. What you don’t want to do is to borrow in order to buy something that easily gets consumed or depreciates over time. Taking out loans for the sake of sheer consumption will only spell financial disaster later on.
What are some examples of good versus bad debt? Here’s a quick rundown for you.
The Faces Of Debt
Good debt: Having a mortgage, getting a home equity loan or line of credit to fund a home renovation or remodeling job Bad debt: Borrowing money to trick out your car to impress your friends, or just yourself.
Good debt: Getting student loans to attend college Bad debt: Using your credit cards while at school to buy groceries, throw parties or accumulate stuff. Many students are saddled with insane amounts of debt after they graduate. Average credit card debt after graduating from college: $3,000.
Good debt: Leverage in real estate or using the bank’s money to invest in real estate. You can use leverage by borrowing funds to get into real estate investing with the expectation of turning in a profit. Bad debt: Leverage in Wall Street or borrowing money to buy stocks. In my opinion, buying stocks on margin is a bad idea. This is a subjective opinion because I’m sure there are a lot of successful margin players out there. As an average investor, I’d avoid trading on margin like the plague. There’s a difference between using a loan to invest in real estate versus investing in the stock market: if the real estate market drops, you are not forced to pay off a mortgage in short notice. With a drop in stock prices, you’ll be subject to margin calls that will force you to raise more money to hold on to your position or else force you to redeem at poor market prices. Using leverage takes a good amount of risk, the question here is if the risk is reasonable and if you’re fairly comfortable taking it.
Good debt: Applying for a business loan and borrowing for business. Many ventures need cash flow that they don’t have at the moment to run their operations or expand their facilities. Using loans to grow a business is a sensible approach to take. Bad debt: Using your credit card to go on vacation, travel or to just have a good time; borrowing for pleasure. Once the vacation is over, you’re left with fun memories and a financial obligation to pay up.
Closing Thoughts
Debt is a loaded word. Some hate it, others embrace it.
I shouldn’t really be too surprised at how many people take extreme sides to this matter. Despite your personal feelings about this though, it’s worth realizing that debt (or money in general) is merely a tool and a means to an end. As some people have sworn never to touch debt based on their own value system, others have loved it as they rake in more money by using leverage wisely. It all depends on upbringing, personal experience and exposure to this matter. It depends on how debt has treated an individual and how that individual responds to it. With regards to this subject, I’m a moderate (in fact, I take this stance with almost everything), so I prefer to see and *make* these distinctions about debt in order to take advantage of the benefits of borrowing. I’m going to use it as the tool that it is — to get myself further along towards my financial goals.
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{ 18 comments… read them below or add one }
I’ve found, after a couple of years of blogging, that most people start out w/ good intentions, trying to use “good debt” and not “bad debt”… but, almost inevitably, they end up venturing into the realm of “bad debt”… For me, it’s conceivable that I could borrow money to purchase a home… but I’d much rather pay cash. No matter what type of debt you have, if something “happens” (health issue, job issue, family issue) you will be faced w/ payments, interest, etc. Why not work for your money, save it up, and pay cash? Good article! I enjoy reading other perspectives…
NCN
“borrowing for pleasure” That always sums up a bad debt.
As always borrowing for anything that returns more value is smart. Borrowing for pleasure is not smart.
So far, College and a mortgage are 2 things that make a good debt. HELOC or HEL are borderline good debt.
That’s a good breakdown. So many words in ‘financespeak’ end up categorized as positive or negative but there’s always a shade of gray. Student loan debt can be very, very good debt for an undergraduate degree, or questionable for a doctorate, since future earnings decrease. But too often personal finance blogs hear the word ‘debt’ and run away screaming in anger, and it doesn’t always have to be the case.
I totally agree with you, not all debt is bad. Especially since we pay less for mortgage than we would if we were renting a comparable place since housing prices have gone up so much. That said, just because something falls into the “good debt” category doesn’t mean you should just go ahead and rack it up – education is a good example here, since there is often a choice between a $20,000 four-year education at a public institution versus a $120,000 education at a private institution. I’d say it’s pretty unlikely that you’ll get $100,000+interest worth of better education at the private institution. You may have to work harder to open some doors, but you’ll be a lot less stressed about your finances.
I am living proof that sometimes student loans can be bad debt. I went from $4,000 in the bank (about $20K in today’s dollars) to a huge negative number by going to college and ultimately taking out student loans.
The distinctions I’ve made here are purely objective and are standard ways of looking at debt. Unfortunately, people’s debt attitudes are colored by a lot of experience, emotion and learning that they’ve done on their own and one’s good debt can very well be someone else’s bad debt. Debt is a tricky beast and for some people, ANY debt can be a bad thing. So yeah, debt comes with some HUGE caveats.
hey there, found your article while search for “debt-payment vs investing”. say in my situation, i have $10,000 @ 3.9% for life (sometimes you just have to call them up) in credit card debt. how much of $1,000 would you put toward debt payment (on top of minimum payment) vs investing each month?
Well I’m no financial whiz kid, but I see one glaring omission — no matter what “kind” of debt it is, anything under 10% could potentially be “useful” debt, if not “good” debt. It all depends on how you use the extra cash flow you would normally be paying above your minimums, right? A mortgage or IRA that you open five years earlier (while you’re still paying off debt), or even an index fund, could put you way ahead of the game financially, as well as giving you a morale boost. Theoretically.
That being said, personally we are going for paying off our last debt, the student loan (the big one), before buying property or investing deeply. (And our first married year we paid off 20,000 of the high-interest stuff, yay!) However, we did open our Roth IRAs last year (at 22 & 23) with substantial contributions. Don’t we all wish there were personal, foolproof roadmaps available?
In our case at least, with our past painful history, we’re ditching all debts — outside of planning to pay only half in cash for our house someday. And all theory aside, debt is a major pain in the ass.
I thought this was a great article. I’ve been reading on quite a few of the blogs lately about how horrible it is to have any sort of debt. Honestly, I can see their point. My preference would be to never have debt. However if I were to save up to afford to pay for a house in cash, while having to pay someone else’s mortgage with my rent money, I think I’d be losing out. Taking on the risk of the home loan has it’s advantages. I’d rather be building the equity in my home than paying for someone else’s equity. Even if I have to pay some (tax-deductible) interest along the way.
Another thing to mention about good and bad debt is that with many forms of good debt (e.g. student loans or home loans) there may be tax benefits.
“good” debt is little comfort when you have high monthly payments.
I don’t care what monetary value something is likely to have in the future- if it matters to you or me, then it has value. don’t let somebody tell you that buying groceries is “bad” debt because it “depreciates”. if someone bought you a gift on their credit card, is that “bad” debt? enough with labels.
Good article, Please tell me about a debt which is taken for 4 years for investment. You have mentioned debt for margin is “Bad Debt” i fully agree this point. but what about debt with Small monthly installments for 4 years. and the money if invested in emerging markets like India then wouldn’t it be a good debt?
Thanks
Vikrant
Oh c’mon… a DeLorean is so worth the debt!
Great post, I already want to say I’m debt FREE! I am trying the IVA program, I want to get out of all my debts.
Borrowing to buy a house is always good debt because the house always goes up in value?
Tell that to the Americans who took out mortgages in 2006 and went underwater as house prices went down 50 per cent.
@Richard,
It’s good debt relative to all other debt out there, as it’s an appreciating asset. The issue you bring up is of “timing”.
For instance, I would never have thought of buying a house during a mania. I’d keep my eye out for a buyer’s market before I think of buying. In the meantime, I’d rent. So in effect, the issue of debt is separate from the issue of timing or determining the best time to buy a house.
Mortgage debt is still good debt — just make sure you apply for your loan when the market is on your side. If you’re ever going to borrow for something, that something should be an appreciating asset.
Interesting concept – illustrating good debt and bad debt. It’s easy for consumers to become bogged down with press associating all debt as being almost world-endingly-bad. I think more pieces like this online and in the mainstream media would work absolute wonders.
It’s education that debt ridden consumers need – not a “don’t borrow money, just say no,” approach.
Great piece.
Omg It’s been a long time since i have seen a de lorean.
This is a great write up I wish you would have dug just a little deeper into how you can use debt to run a business.
The only “good” debt is paid off debt 😉
Wise up!