Having financial conversations with friends and family is often taboo, but these are my favorite kinds of discussions! A few years back, my neighbor was absolutely convinced that her car loan was “good debt” because it allowed her to get to work and earn a living. I strongly disagreed and left that conversation shaking my head. But who was right? And what is the difference between good debt and bad debt?
My Research Led Me to a Childish Outburst
When I started looking up various opinions on this topic, I came across an article from CNN Money. This is how they chose to begin their article:
“It’s almost impossible to live debt-free; most of us can’t pay cash for our homes or our children’s college educations. But too many of us let debt get out of hand.”
My initial response to this was, “Why can’t we pay cash for our homes and our children’s college educations?! Are we as Americans so dependent on debt that we can no longer fathom having $100,000 in our bank accounts?”
….Then I had to check myself….
Ok, hold on a sec. I didn’t pay for my house with cash. In fact, I still have a mortgage as we speak. And, I didn’t pay for my college education with cash, so who am I to have such an outburst because of this CNN article?
This inspired me to research this topic all the more. Was it dumb of me to rack up $12,000 in college loans or to take out a $71,000 mortgage on my home? Probably not. So when is it okay to take on debt, and when is it just plain stupid?
The Difference Between Good Debt and Bad Debt
Many people (including financial experts) would classify good and bad debt with the table below:
Basically, they define good debt as “needs that you don’t have enough money for, so you reach out for a loan” and bad debts as “wants that you cannot afford, but buy with debt”, which fits well with the table above. I however, strongly disagree.
Almost everyone can save up enough money to buy a $2,000 car. And, even if they can’t, they probably have the option to ride their bike or to take the bus. There are so many different ways that a person can get to work. They DO NOT need to get a car loan to make money at a job. This statement is simply ridiculous.
Also, many consider it to be a good idea to take out a loan (or at least co-sign for one) for their child’s college education. Let me ask you this – did your parent’s pay for your college education? Many of you probably had to figure out how to make it on your own, and it’s okay to allow your kids to do the same! By learning to pay their own way, they will watch their expenses more closely and will likely not take their education for granted. If you start taking on debts for them, chances are that they will party harder and get a degree that is meaningless in the working world. It’s best to give them guidance and wisdom, and with that also give them the gift of financial responsibility.
My definition of good debt and bad debt
In my financial dictionary, I label good debts as “money that is borrowed to increase your assets/earnings to a greater extent than the interest owed on the debt” and bad debts as “money borrowed for items that depreciate in value or contribute no future value”.
In other words, debt should only be used if the loan is going to earn you more money than the interest that you have to pay back. Some people put this principle to work in real estate investments. They purchase a property with the bank’s money and earn more dollars each month when compared to what they owe the bank. If you have the stomach for this (ha, which I don’t), then this can be a good use of debt.
As for loans, if your debt is going to earn you more money in the future through your job, then a little bit of debt might not be a bad idea. Be sure to run the numbers to see if you are likely to earn a considerable amount more than the loans you need to take out. If your education is costing you $100,000, but will only give you a $5,000 boost in pay each year, then the debt probably isn’t worth it.
Here’s is my quick summary of what I consider to be good debt and bad debt:
Basically, if you are borrowing money for pleasure, this is just plain stupid and should be avoided at all costs. This includes vacations, a beastly car loan, fashionable furniture, and a lavish college experience for your children.
If you do not have the money for a vacation, then you probably don’t deserve to go on one.
If you need furniture, but don’t have money, sit on the floor or find a freebee on Craigslist.
If you don’t have a car and have no money, figure out the busing system or learn how to pedal.
If you don’t have money for your children’s college education, tell them early and give them the chance to do something about it. Do NOT take out a loan for them.
I have followed my own advice above, and I currently have the wealth of the average 50 year old (I am currently 29). Almost every form of debt out there is bad debt. If you can avoid it, your chances for success in life will dramatically improve.
Do you agree with my definitions of good debt and bad debt? Am I being too harsh?
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.