When can debt be considered "good"?
Is there even such a thing as "good debt"? For instance, I maintain a low credit card balance and pay it off in full every month to keep my credit cards active and to grow my credit score, which has successfully worked.
On the larger side of the debt spectrum, I have car payments every month. Thankfully, it is a comfortable car payment, so I feel lucky to have a reliable car which allows me to commute to work and school everyday.
However, we all know debt is widely known as something to stay away from. So am I crazy to consider the "debt" I carry month to month to be "good" debt?
You are thinking about it in the right way. There is such a thing as good debt and bad debt. High interest rate debt that you take out to pay for consumer items, think credit card debt, is typically “bad” debt. You are using your credit card in a positive way, keeping a manageable balance that you pay off each month means you are not being charged interest and you are building your credit score. Bad debt tends to allow you to live outside of your means for a short period but ultimately will hurt you in the long term.
Good debt is the debt that allows you to improve your economic situation in the long term. A car loan so you can purchase a vehicle, to take you to work to earn dollars and advance your career can be a type of good debt. This is only true if the terms of your loan are sound, i.e. a low interest rate and a repayment term that matches or is shorter than the useful life of the vehicle.
Typically, the most common example of “good” debt is a home mortgage. The reason for this is many individuals place great value on taking out a loan to purchase a potentially appreciating asset that may be tax deductible. Again, you need to examine the terms of the underlying loan to make sure it really is good debt.
As long as you are consistently paying it off each month, the credit card can be convenient and provide extra perks and rewards. However, the credit card company's ability to provide those rewards comes from the vast majority of cardholders who accrue a balance overtime and use the card more for pleasure or as an emergency fund.
As a general rule, you want to avoid using debt for depreciating assets. This can be difficult when in school or just starting out because you may not be able to afford to not take a bank loan. But the tendency is for people to continue taking on car loans as income increases, which allows them to buy more expensive luxury cars or have excess cash for other purposes. Say you have $20,000 in savings (above your emergency fund) and you need a car, costing roughly $20,000. You can either pay cash for the car or take a loan. The only reason to take a loan is if you're very confident the $20,000 can be invested to earn greater returns than the interest you would pay on the car note.
Student loans (for certain degrees) can be "good debt", plus the advantage of the interest tax deduction. A mortgage also gets an interest deduction, and is an example of an appreciating asset. But even when you buy appreciating assets, using debt can be risky. You want to make sure the asset is (1) very likely to increase long-term at a greater rate than the after-tax cost of the debt and (2) maintain enough equity (value - debt) so you'll be okay even if the asset does experience a loss.
In summary, debt can be used for beneficial purposes. But it takes significant willpower to not use debt to finance lifestyle.
Debt is not automatically "good" or "bad", it depends on how you use it. For, example let's start with an assumption that you have $20,000 in cash. You also need a new car that you could buy or lease. Let's further assume that the car loan is going to cost 6% a year in interest and the money is sitting in a money market account earning .5%. Paying 6% and earning .5% doesn't make sense. You are behind by 5.5%. Better to pay cash and save the payments to replenish your savings and this debt goes into the "bad" column.
Yet, let's change the assumptions and instead of assuming the cost of the lease or loan is now 3% and the investment is not a money market but an investment in a stock portfolio you expect to earn 6% per year over the long term. Now the borrowing is can be used as a constructive tool by earning more than you are paying and therefore goes in the "good" column.
As you can see, there is no automatic good or bad debt. If you can earn more of your investments than the debt costs, great. If not, the debt can be "bad".
No, you aren´t crazy. There is such a thing as ¨good debt,¨ provided you are responsible with it and don´t get carried away. Generally speaking, good debt is debt that you use to purchase an investment or an asset that then appreciates in value or generates income. Bad debt is everything else.
Personally, I do the same thing with credit cards. I use them for most of my spending and then pay them off at the end of each month. You do have to be careful with this of course, and make sure that you dont miss a payment or anything. But by doing this you can earn points for cash-back or travel and of course build your credit score.
I would challenge you to get rid of that car debt as soon as you can. Since cars are depreciating assets, ideally you would not have debt against them. Plus, from my experience, probably the number one reason people aren´t saving for retirement is that the average American car payment is now about $500/mo.
Thank you for the question. Bad debt would be considered for the most part a loan taken out on a depriciable asset or carrying a balance on your credit card. The way you are using your credit card, paying it off month to month can actually be a good thing as long as you stay disciplined and don't carry a balance. I say this because of the perks that some cards offer such as cash back. Good debt would be considered something such as buying a home. This is because the house could be tax deductible and appreciate in value over time making it a good investment.