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Finance 101: Good Debt vs. Bad Debt

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I'm amazed by the number of people who seem to be against debt. Debt has become has a problem in America, but I think too many people clump the good with the bad. To the people that don't like debt, would you take a million dollar loan at 1% interest? I would. I'd immediately put it in a few interest baring accounts that are FDIC insured (I say a few because FDIC insurance doesn't cover a whole million). At today's rates, which are historically pretty low, you can make a guaranteed 3% on that money. That means the debt naysayers would be missing out on 2% of a million dollars, $20,000 a year. I'm pretty Lazy, but for $20,000 I can manage to set up some bank accounts.

Good Debt

When you can make more money than you are paying, that's an example of good debt. Some people call it leverage. Here are some other examples of good debt:

  • Student Loans - The idea here is that you choose to into a little debt now, so that you can make a lot more money through the rest of your life. That extra income, in theory, should be enough to pay back all that debt and then some.
  • Mortgage - This is an area of wide debate - it might even matter where you live. If you had a mortgage in the early 1990's there's a good chance that the debt allowed you to own a home that appreciated in value a whole lot. If you bought in some markets in the last couple of years, there's a good chance you've seen no appreciation and if you sold today would have been worse off than if you rented. In many cases, a mortgage is tax deductable and that's very nice benefit as well.
  • Work Necessities - Many people don't consider a car loan good debt. However, if you need a car to get to your work, I argue that it's good debt. For it to quality as good debt, you'd have to treat it as purely transportation between two points, not a status symbol. When an expense is necessary to protect your income stream, it may very fit into the good debt category

Bad Debt

Bad debt is debt that doesn't have an obvious way helping your finances. There's a lot of debt that falls into the category of bad debt, which is often where bad debt gets its name. Do you use a credit card to buy CDs and don't pay it off every month? That's a prime example of bad debt. Many companies will charge you interest of 20% or more. It's not long until you are paying twice as much for that CD as you should. This does not benefit your finances?

If you go into debt to afford a vacation, that's bad debt as well. You might feel more refreshed and ready to earn more money, but you need to get your finances in the positives first.

Three Debt Questions to Ask Yourself

I like to ask myself the following questions before considering taking on any kind of debt:
1. Am I going to pay interest on this purchase? With my credit card purchases, I pay them back, so the answer is usually no.
2. Does this purchase preserve or grow my current earning potential? If yes, then it has potential to be good debt. I say potential because it's not worth going a million in debt to earn a couple of extra thousand dollars a year. It's also not worth protecting a $20,000 a year job.
3. Am I buying this because I feel "I deserve it?" This is often a danger sign.

It's not always easy and straight-forward, but understanding the difference can be important.

Posted on July 8, 2008.

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20 Responses to “Finance 101: Good Debt vs. Bad Debt”

  1. PT says:

    You and I are on the same page here, Lazy Man. I’m in love with 3% and below interest debt, on the right asset. :)

  2. I am on board… My entire blog is about this subject.

  3. F20 says:

    I’m with you too.
    Debt is a tool. Much like a chain saw, it can be useful and safe when utilized correctly. However, in the wrong hands it can be dangerous.

  4. Llama Money says:

    That question #3 is a huge one – if you “deserve” it, chances are you can’t “afford” it.

  5. Hallelujah – another PF blogger who understands that not all debt is bad. Nice post!

  6. Mrs. Micah says:

    Indeed. I don’t have a problem with mortgages, especially if the family takes advantage of the time value of money for investing instead of paying down the difference. Or car loans. Both being done with the right intention to what’s needed vs. what’s status/desire they can’t afford.

    As it is, Micah’s huge pile of student loans and car loan may be “good” debt but they’re also debt we’re trying to erase as quickly as we can to get through them. At least the car debt. And a large portion of the over $100k student loan debt. The latter is just not a monthly bill we want to be paying for the rest of our lives…paying it off will help us afford a mortgage better.

  7. Lazy Man says:

    I know a couple that has student loans a ridiculous 1% (or something similar) for 30 years. They are holding on to that debt as long as they can, putting their money into other investments or larger debts.

  8. Santos says:

    The only “good” debt is paid off debt ;-)

    Wise up!

  9. cannonfodder says:

    If you can borrow at an after tax rate less than an after tax return of dividend income, diversify appropriately and have a long term horizon, this seems to be a winning formula to me.

    It requires no additional cash flow to, over the long term, create an additional portfolio of investments. What is interesting is over time your outstanding loan won’t change (assuming you only make interest payments) but your income stream and portfolio will grow.

  10. NCN says:

    Sometimes, ‘math’ isn’t enough…
    From my perspective, the psychological benefits of being debt free FAR out way the supposed financial benefits of going into debt…
    That being said, you did a good job of separating the two types…
    I would, however, note that all debt has to be paid back – and that being able to pay it back is determined by a LOT of factors, including health, future employment, etc. Taking a look at the economy now, who knows where we’ll be in five years…
    And, using the 1 million at 1% argument is a bit off the mark… In reality, unless you are willing to deal with credit card arbitrage and the like, borrowing money will cost you…
    Why not just save up for stuff and buy it when you can afford it?

  11. Lazy Man says:

    The million at 1% was an extreme example to prove a point.

    If I tried to save up for college, I wouldn’t have been able to until I was 35. If I had to save up until I could buy a home in either Boston or San Francisco (the two places I have lived), I wouldn’t have been able to do it until I was 50. Meanwhile people who have bought homes 15-20 years ago have made hundreds of thousands in equity (even in today’s market).

    Good debt is not something I’m willing to wait for. I won’t take on bad debt though without waiting.

    From my perspective, there’s a lot of psychological detriments to having missed a great opportunity. It out-ways the psychological benefit of being debt free.

  12. Troy says:

    Using an extreme example to “prove” a point is both misleading and foolish.

    In fantasyland, sure, laon me the money at 1%, and invest it risk free at 4%.

    Back in reality, it isn’t realistic. In fact, your example is quite wrong. IF you could borrow one million dollars at 1%, you would be able to borrow that because there were no other investments available to the lender that were less risk with higher return. therefore to assume you could leverage that money and “make” 3% is foolish.

    I know it is an example, but it is a crap example designed to support your position, which is flawed. No debt is good. The risk associated with leverage are too great for all but the most sophissticated of arbiters. The average person is not one of those.

    As far as saving up for college, get your head out of the Gen X mentality. Pay for it as you go, with a JOB. That’s what real studs do, mr. impatient.

    There is a very simple premise which debt “supporters” never mention. It is the association of risk and applying obligation on your future self.

    When you take on debt of any form, any rate, whether good, bad, naughty, sexy or any other descriptive term, you are trading in your future selves labor for your present selves pleasure. You are also assuming risk. All debt assumes risk to varying degrees. Most people do not assess the risk correctly, and they loose. It is the reason debt is available in the first place…because most people loose.

    As a previous poster said. Wake up. I used to think debt was great. That I was smarter than the system. Then we grow up, and realize having a simpl financial life is what is smart, and that means realizing no debt is good debt.

    You’ll get it some day:)

  13. Lazy Man says:

    I know plenty of people who have had $30K-50K at 0% interest from credit card companies. I know people who have 1% student loans over the next 30 years.

    Many people can’t pay the costs of college with a job while they are going to school. Some exceptional people manage it, but they are extremely few (about the same in number as the people who will lend you a significant amount of money at 0-1% interest).

    Far be it from me to think one should be able to finish a college education by the time they are 30 (yes, if you have a full time job why you are in college, it may take that long to graduate). I guess I am Mr. Impatient ;-).

    “When you take on debt of any form, any rate, whether good, bad, naughty, sexy or any other descriptive term, you are trading in your future selves labor for your present selves pleasure.”

    So getting an education is “pleasure?” I thought you was preparing yourself for the future. Trading your future self to prepare yourself for the future sounds a bit better.

    No previous poster said, “wake up.” However, leverage is how many people make there money. Did you know that Sam Walton started his first store with a $20,000 loan. It put him on the path to starting Wal-Mart. Without that loan who knows what would have happened, maybe it takes him another 10 years to get the money. By that time, maybe the idea is stolen by someone else or he doesn’t find it worth pursuing any more. For his finances (and all his heirs), I bet he’s pretty happy he took the $20,000 in debt. (That’s one example of a small business loan paying off, some do and some don’t)

  14. Steve says:

    I get a kick out of people who are completely debt/credit adverse. Here is your wake up call.

    Do you use electricity, water, and/or natural gas in your home/apartment? Guess what? You are using credit. Yes, credit. In a sense, you are in debt to the gas/water/electric companies. Why? They are providing a service and/or product to you before you pay for it…that is called credit (and in an abstract sense, you are indebted to the utilities.) How is this any different from any other form of debt/credit? You are getting something now with the promise to pay for it later. If you pay on time, then no fees are attached. Wow, that sounds a lot like a CREDIT CARD!

    Everyone uses credit unless you are completely off the grid. I would say that this is the extreme exception.

  15. Pete says:

    I think it’s a bit comical how bent out of shape people get about this whole topic.

    I think it’s ok to just say that some people are more debt averse than others, and some people are willing to take on more risk by going into debt.

    I think that a lot of people really shouldn’t use debt – whether you call it “good debt” or “bad debt” just because they’re not good enough with their finances to be able to manage it well.

    Others may be more on top of things, and be able to use/leverage debt to their advantage. As long as they understand the risks of going into debt, it’s fine by me.

    For me and my family, we’re trying to live debt free for the most part, and I’m not willing to take the kind of risks some of you are talking about with debt. I prefer to pay things off, and save/invest -as opposed to leveraging someone else’s money.

  16. JoeTaxpayer says:

    To those who are anti-debt extreme, I’d ask, if my mortgage is my only debt, and I am saving, oversaving in fact, to my retirement account, and kid’s college fund, given the choice between spending the rest and enjoying the fruits of my labor, or paying the mortgage off extra early to then have even more extra money every month, what to choose? At what point do you actually get to have fun?

  17. Tech Buzz says:

    Debt is a tool. Much like a chain saw, it can be useful and safe when utilized correctly. However, in the wrong hands it can be dangerous.

  18. OrthodoxAtheist says:

    I agree with both sides, but one more than the other. Some debt can be good, as the OP describes. I also agree the psychological affects of being debt free, are fantastic. Here is the elephant in the room: Debt = Risk. If the debt has no real risk, then its good. For example, the OP says they take a loan of $1million and invest it. If they need to pay that money back, they still have it. If you have a mortgage and car loan, and you end up losing your job, or become unemployable for whatever reason, and you can’t pay that debt, your situation fast gets ugly. You receive harassing calls (somewhat illegally of course), and your friends (references, etc.) get harassing calls. I’d much rather know that if my life crumbles… I owe no-one anything. So when saying Debt can be good, the words you truly should be using are Risk can be good.

  19. Kansei says:

    I think the good debt is oversimplified. All of the “good debt” can easily be a “bad debt.” Many student loans are bad debt. Examples are students attending overpriced for-profit online universities where they can attend in-state school for like third of the cost. Also, many employers may not respect your online degree and since you took the courses online, you don’t have the opportunity to network as much. Or, students attending private or out of state school and getting a degree with low average salary.
    For housing, if you buy a house with no down payment, you’re going to be paying so much interest as well as extra insurance since you have no equity in your home. Or, if you buy a house that you cannot afford, you may be able to make your mortgage payments, but most likely will be racking up credit card debt.
    As for a car, there is no need to go into a 4 or 5 year loan. You should be able to find a nice car that’s under $6000 that will last you for years without too many problems.

    So again, I think this is too simplified in categorizing good and bad debt where many of the good debt can just as easily turn into a bad debt. And unfortunately, many people believe that any student loan,any mortgage, and any car loan is a good debt so that’s why so many people are drowning in debt.

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