Good Debt vs. Bad Debt

Growing up in a household where I was always taught to not spend what money you do not have it was hard, at first, for me to grasp the concept of good and bad debt. You see, contrary to popular belief, not all debt is bad. There are, in fact, some instances of debt that can be beneficial to your financial health.

Defining Good and Bad Debt

The guidelines for determining good and bad debt are pretty straightforward.

Good Debt:

makes you money rather than costs you money
will gain value over the lifetime of the debt
whatever you purchase will outlast the debt
will provide you with positive financial leverage
should be tax deductible
should have a low interest rate
contributes to your overall financial health

Bad Debt:

costs you money rather than makes you money
will lose value over the lifetime of the debt
whatever you purchase will not outlast the debt
does not provide you with financial leverage
is not tax deductible
usually has high interest rates
takes away from your overall financial health

Not all debt will conform to each set of rules. You may have good debt that has some bad debt characteristics. For example, while going into debt to renovate your home may increase in value (by adding to the value of your home) and may be tax deductible, unless you are planning on selling your house in the near future then it may not provide financial leverage or add to your overall financial health. The best way to classify debts like this is to see how many good and bad characteristics the debt has. If it has four bad and three good characteristics then it is probably a bad debt.

So…What’s Good and What’s Bad?

Now that you know the guidelines, let’s take a look at some of your current debts and label them as either good debt or bad debt.

Retail Debt, Credit Card Debt, Personal Loans, etc.

In the United States, this is the most common debt amongst households. According to the guidelines listed above these types of debt would, without a doubt, be listed as bad debts. When you go into debt to purchase clothes, perishable goods, consumable goods or other things of this nature you are breaking several of the “good debt rules”

Generally speaking, they cost you money, but do not make you any money in return.
Clothes and other consumable goods lose value the minute you purchase them.
Consumable good and clothes will not outlast the debt.
They provide no financial leverage.
For the most part, they are not tax deductible.
If you use a retail card, or other credit card to finance the purchases you will probably have a high interest rate.
In most cases, despite what you think, those $400 shoes, or that $1000 suit will not contribute to your overall financial health

If you must take on debt to purchase clothes or other consumable goods then you should never take on more than you need or more than you can afford. If you use a high interest credit or retail card (or any card for that matter!) you should pay the balance in full each month!

Mortgages

In most cases, buying your own home is classified as good debt. There are some cases, however, when buying a house could be labeled as a bad debt. To be sure that your mortgage is considered good debt, compare it against the “good debt rules”:

Does your house make you money? In most cases if this is a personal home then the answer is no.
Does it gain value over the lifetime of the debt? Usually, this is a yes.
Will it outlast the debt? Barring any natural disasters, a well built home will still be standing when the mortgage has been paid off.
Does it provide you with financial leverage? Yes: In most cases you can loan against the equity in your home to finance other investments.
Is it tax deductible? Yes, the interest that you pay each year is tax deductible, among other things.
Does it have a low interest rate? Again, in most cases, you can get a home loan with a good rate.
Does it contribute to your overall financial health? Generally speaking a home is a great tool to increase your financial health.

Like anything else, the key to buying a home and avoiding bad debt is to not purchase a house that is more than you need and can afford. Start off with a small house that has a small monthly payment. Save and invest your money. Then buy a larger house and start generating passive income by renting out your first home.

Auto Loans

In most cases, according to the guidelines, an auto loan is easily classified as a bad debt. Let’s take a look:

Does your car make you money? Other than the fact that you drive to work, in most cases this answer would be a no.
Does it gain value over the lifetime of the debt? A car loses value the second you drive off of the lot.
Will it outlast the debt? Possibly. If you only get a three or four year loan then your car may outlast the debt. Never finance a vehicle longer than five years (I prefer four!)
Does it provide you with financial leverage? Very rarely will a car provide you with financial leverage.
Is it tax deductible? In some cases, auto-related expenses are tax deductible
Does it have a low interest rate? Unless you have excellent credit then an auto loan may have an extremely high interest rate.
Does it contribute to your overall financial health? A car is usually more of a status symbol. Rarely will it contribute to your financial health (unless we are talking museum-quality classic cars)

Student Loans

Everyone has a different opinion when is comes to student loans being good or bad debt. My solution: put it to the test…

Does your education make you money? Hopefully, yes!
Does your education gain value over the lifetime of the debt? As my grandfather used to say: “The only thing they can’t take away from you is your knowledge!” I’m not sure who “they” are, but he had a good point nonetheless. A good education is invaluable as long as you put it to use!
Will it outlast the debt? Yes! A good education is timeless.
Does it provide you with financial leverage? It depends on how you look at it. I say yes since you can use your knowledge as a bargaining tool to increase your salary.
Is it tax deductible? Yes, in a lot of cases your education-related expenses are tax deductible.
Does it have a low interest rate? If done correctly, then your student loans should have relatively good interest rates.
Does it contribute to your overall financial health? Once again, as long as you put it to good use, your education will take you far in life!

A Few Things to Remember

Never, under any circumstances, should you deplete your emergency cash in order to avoid bad debt (you do have a stash of emergency cash right?) You should never spend more than 10% of your cash reserves for these purposes, even if it means that you must take on some bad debt.

Be very careful when investing with borrowed money. In fact, I personally say you should avoid it. My reasoning is simple: You will have to generate even more profit with borrowed money just to break even. On the other hand, if you can borrow money at a rate of 5% and get a return of 11% or 12% then it may provide you with some financial leverage, but this brings us to my next point…No investment is guaranteed! In my eyes, you would be doing the same thing if you took out a bank loan and went to the casino and gambled with the money! You may hit big, or you may go home empty handed.

Classify Your Debts and Eliminate the Bad!

Now that you know the difference between good and bad debt you should classify all of your debts and start eliminating the bad! If you are unsure whether a debt is good or bad simply put it to the test. Remember, good debt: