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‘Good Debt’ vs. ‘Bad Debt’

Is there such a thing as good debt?

The answer to that question depends on whom you ask. By and large, however, financial experts seem to agree that there are some forms of good debt.

Most often, it’s debt that helps you to amass valuable assets that will grow in value, or debt that will somehow boost your overall income or wealth. Bad debt, on the other hand, does just the opposite, adding little value to your long-term prosperity, sometimes even diminishing it.

Here’s your go-to guide detailing exactly what types of debt fall into each category, according to personal finance experts from across the country.

What Is Good Debt?

If there truly is such a thing as good debt, it’s debt that results in more personal wealth, according to experts.

Among the most popular examples are mortgages, which help fix your housing costs and gradually build your net worth, and student loans used to finance higher education or professional certification which, if all goes well, can open the door to higher-paying jobs and an increase in lifetime earnings.

“Good debt is debt used to acquire assets. It’s that simple,” says Byron Tully author of The Old Money Book and Old Money, New Woman: How To Manage Your Money and Your Life. “The definition of an asset is something that’s going to put money in your pocket each month or appreciate in value over time.”

A mortgage is viewed in a positive light because, ideally, the property increases in value while you own it — or better yet, generates rental income, says Tully.

Higher education, meanwhile, should help you qualify for better jobs and result in a higher quality of life, Tully continued.

Good debt, he added, can also take the form of an investment in an existing business, either as a partner or in the form of stocks, which would pay you dividends.

Need still more help determining whether the debt you’re about to take on is good or bad?

Mike Pearson, founder of Credit Takeoff, a personal finance site that helps people improve their credit, suggests asking yourself this question: “Does it give me the chance to provide a positive return on investment?”

“When you look at debt through that lens, it makes it much easier to figure out if it’s ‘good’ or ‘bad,’” says Pearson, who, like Tully, suggests mortgages and student loans are the types of debt that fall into the good column.

To this list Pearson adds small business loans, which could also potentially end up increasing your wealth over the long run if your business becomes successful and revenue generating. However, Pearson adds an important caveat.

“The thing to keep in mind about these ‘good debts’ is that there’s no guarantee it will end up being a good investment,” he explained. “You may end up getting poor grades in school and never land that six-figure job; you may never end up getting that promotion at work despite the certification; you may end up losing money on your home or your small business may go under after six months.”

The Parameters for Healthy Debt

Kevin Gallegos, a senior vice president at Freedom Debt Relief, suggests it’s a good idea to view potentially good debt, which he calls “healthy” or “productive” debt, with strict parameters. All healthy or productive debt must meet several qualifying criteria, he says.

“The debt must be limited, without the ability to continue increasing. In contrast, a revolving account, such as a credit card, is not limited, and increases as you put more charges on it,” explained Gallegos.

The debt’s interest rate must be stable, at a reasonable, predictable level, he adds. In addition, the debt must have regular payment amounts that are manageable within a budget, and paid on time to avoid late fees and penalty interest-rate increases, Gallegos continues.

“The debt must have been acquired for a purpose that an average person would say was sensible. A good test is whether you will be able to remember in six months why you have the debt – coffee drinks or music downloads usually can’t pass this test,” he says.

And finally, as our other experts have suggested, the debt should be incurred for something that’s likely to appreciate, such as a home or a business.

What Is Bad Debt?

Bad debt is often tied to items that provide instant gratification, and offer little or no long-term value or financial return.

“[Bad debt] is consumer debt acquired by purchasing material possessions which depreciate in value as soon as they’re purchased, such as clothes,” said Tully. It also includes debt incurred by purchasing things that have no value once they’re paid for, he says. “This includes debt from restaurants and nightclubs, as well as other forms of entertainment,” Tully says — all of which are fine, he adds, as long as they’re paid for with money you already have.

Credit card debt is pervasive in the U.S., and it’s easily one of the worst debts to carry — whether it’s tied to buying clothes, furniture, meals out, or services with no lasting value.

As Andy Misek of Finance Guru explains, credit card debt almost always results from a consumer buying unnecessary things — and doing so at an exorbitant interest rate, anywhere from 18% to 24% APR. “Your debt could get worse, before it gets better,” says Misek.

While interest rates on auto loans are often among the lowest in the lending world, they generally fall into the bad debt category as well, says April Lewis-Parks, director of education for Consolidated Credit, the nation’s largest nonprofit credit counseling agency.

“An auto loan is actually a bad debt; although you gain an asset, your vehicle, it immediately and quickly starts to depreciate and lose value after the purchase,” said Lewis-Parks. “The same thing is true of in-store credit lines used to purchase things like electronics or furniture; these items lose value quickly after purchase, so you can’t recoup the purchase price.”

Less surprisingly, she says payday loans are also a bad idea.

“The problem with payday loans is that the finance charges range from 15 to 30 percent of the amount being borrowed, which can easily make the effective annual percentage rate (APR) on the loan in the triple-digit range,” explained Lewis-Parks. The steep interest charges and short-term payback windows force many borrowers to roll over their loan. “One of the biggest drawbacks is when a borrower falls into a cycle of repeatedly extending their loan,” she adds. “They find themselves unable to repay the loan when payday arrives, so they extend the loan for another pay period and fees continue to accrue. It turns into a vicious cycle.”

The Gray Area

At the risk of confusing matters, there is some debt that doesn’t necessarily fall so neatly into either the good or bad column.

For instance, Lewis-Parks says debt that would appear to be taken on with good reason may still in fact be bad debt. As an example, she points to healthcare related expenses.

“Medical debt, for instance, keeps you healthy so you can continue to earn income,” Lewis-Parks explains. “However, these costs would often be covered more effectively with better insurance.”

(This example is certainly worth keeping in mind, but doesn’t necessarily recognize the shortcomings of the health insurance offerings in America right now or the challenges many people have accessing good insurance, despite their best efforts.)

Using a home equity loan to renovate your residence is another type of debt that Lewis-Parks says falls into a gray area. Such renovations often increase your property value, meaning home equity loans could be considered good debt — but only if the investment pays off in the form of a higher sale price when the home is eventually sold.

“Good or bad, the important thing is that you manage your debt effectively so you can maintain stability,” Lewis-Parks concludes. “Make sure to keep debt at a manageable level and seek help if you start to get overextended.”

Let’s Change the Conversation

Todd Christensen, an accredited financial counselor and community financial educator for the nonprofit Money Fit by DRS, suggests the conversation surrounding debt should be changed somewhat.

Rather than viewing it in such a binary manner — good or bad — he says debt is better viewed in three categories: potentially beneficial; practical debt; and bad debt.

“Traditionally, the only three ‘good debts’ were mortgages, student loans, and business loans, because they’re seen as improving the household’s financial net worth over time. As the Great Recession taught us, these are only ‘potentially’ beneficial, not guaranteed,” Christensen explains. “Those who got into home loans and student loans that were too large found that the supposedly ‘good debts’ ended up ruining their finances.”

Thus, says Christensen, good debt is potentially beneficial, but must be considered carefully and in context.

Practical debt, on the other hand, is debt that’s used for convenience and doesn’t incur interest. For instance, credit card debt you rack up while on vacation but pay off in full with the very next bill would be considered practical debt, Christensen says.

Everything else? Bad.

“All other debts are bad debts, because you, as a consumer, end up paying more for the item or experience than what it adds to your net worth,” said Christensen.

Mia Taylor is an award-winning journalist with more than two decades of experience. She has worked for some of the nation’s best-known news organizations, including the Atlanta Journal-Constitution and the San Diego Union-Tribune. 

Read more by Mia Taylor:

Source | easywealth.fun

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