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What is the Difference Between Good Debt and Bad Debt?

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:

Good debt vs. bad debt

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:

Good debt vs. bad debt 2

 

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?

Get Out of Debt Money

AUTHOR Derek

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.

17 Comments

  1. Sometimes i think we have gone off the rails with debt. You start to wonder when it became so fashionable. From country debts, company debts to individual debts…it’s just debt, debt, debt.
    There is good debt of course…and I like your definition, “money borrowed to increase assets/earnings to a greater extent than the interest owed on the debt”. If you can’t afford it, save till you can…or maybe we do need a movement back to cash…it’s hard to spend what you don’t have in the first place!

    • Ha, I bet most economists would be fainting at your suggestion to do away with debt and use cash only. If our economy could handle it (because I’m sure it would take an immediate dip initially), I would be all for that idea! Once my house is paid off, I don’t ever plan to go into debt ever again, and I simply can’t wait! ๐Ÿ™‚

  2. I used to think only a mortgage was good debt, since it’s an “investment”. Now, I’m not even so sure about that. I now think the mortgage is only an investment if you actually think this will be the only home you’ll ever have. Otherwise. It’s still a gamble (especially in today’s market) that the hi use you bought three years ago will sell for a higher price now.

    Between my husband and I we have six figure student loan debt, so I’m pretty anti-student loan. However, I’m not going a mall loan that is easily paid off in the first year of employment wouldn’t sit poorly with me. It’s all about how much the student is borrowing and how much can they make? The key is really understanding the earning potential because that’s where my husband went wrong.

    • Exactly. If someone is going into debt, they need to do so very consciously. If there is a high likelihood of earning more than what you borrowed, then the debt is probably acceptable. If not, then I say the debt is just a foolish decision.

      It sounds like you have quite a long road ahead of you to get rid of those student loans, but if you just live cheaply and keep plugging away at them, they’ll certainly disappear. It won’t feel speedy, but if you stay consistent you’ll get rid of them for sure. Good luck and thanks for the comment Kirsten!

  3. I would go one further: I would say the mortgage on your home is not necessarily good debt either. Good debt (for me) is something which produces more money than the cost of servicing the loan. So an investment property (as long as it’s cashflow positive after all expenses are paid) would be an example of that, but a home is just a place to live and doesn’t produce money for you: if you can rent a home for the same as the cost of your mortgage, you’re not willing financially unless you’re sure the value of the property is going to increase between buying and selling it.

    • Are you saying it is a wash between renting an owning your own home?

      • I’m saying good debt could be seen as debt which covers costs and provides cashflow: a rental property, for example. Clearly there are advantages to owning the property you live in (the landlord can’t kick you out and you make money in a rising market) but there are also disadvantages if prices fall or if you have to move to a different town: the costs of buying, selling & taxes are considerable.

        • Luckily, I bought my house at exactly the right time. Back in 2011, I paid $75k. Today, it is worth over $120k! Much better than renting! ๐Ÿ™‚

          • Ahahaha! Now THAT’s some GOOD debt!

  4. Well if you ask me, I hate Fugging Debt lol!

    I’m down to just my house and student loans. With the student loans I have just been awarded a 2% interest rate which is awesome so I think I am not going to attack it hard and fund my DG portfolio more.

    Also, with Loyal3 (no trading fees) you can use credit cards so I am adding to my positions while accumulating reward points on my card.

    • Sounds pretty sensible Ced. I currently only have my house debt left, but I plan to get rid of that by the end of this year! I just heard Dave Ramsey say something today that I think I am going to try. “Once you get that house paid off, take your shoes off and walk through the grass in your backyard. It just has a different feel to it when it’s totally yours.” Sounds awesome! Of course, my house will be paid off in December/January…so it might be a little chilly, but what the heck, why not??!! ๐Ÿ™‚

  5. If somebody goes into debt, they have to try and do thus terribly consciously. If there’s a high chance of earning over what you borrowed, then the debt is maybe acceptable. If not, then I say the debt is simply a foolish call.

    • I mostly agree with you Linda. But, the more money I am able to save up, the less I feel like I really need debt to succeed. The low-risk nature of these investments has a huge appeal for me. I honestly never want to go into debt ever again!

  6. I agree for the most part about your definition of good and bad debt. However, good debt can also be bad in my eyes if you take out a loan for a house you can’t afford or take out student loans of $100,000 for a degree that will pay you $30K a year.

    • Great point Jon. Every debt has to be within reason. Personally, I tell college students that they should try to get through college with absolutely no debt. As for the homes, one should always look for a bargain and be able to comfortably pay it off in 15 years (if not faster).

  7. I just found your blog, & I love it. I’m currently a GV student and I share many of the same views on debt & saving as you. Mostly because I was raised with a mother who doesn’t even have a savings account and swears debt it a good thing. Could you write an article with advice for college students? I find most articles are written for students with no idea that they’re in debt or what that means.

    • Hi Sierra! It’s pretty cool to hear from another GVSU student. I did my bachelors and masters there and it was an awesome experience. I am so glad to hear that you are cautious with your debt and I can’t wait to hear about your success stories in the future! And you know what? I’m going to plan a college advice article for Monday for you. Stay tuned! ๐Ÿ™‚ Oh, and be sure to subscribe, Like, and follow me on Twitter for other updates.


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