Good Debt vs. Bad Debt: An Overview
There certainly is an argument to be made that no debt is good debt. But borrowing money and taking on debt is the only way many people can afford to purchase important big-ticket items like a home. While those kinds of loans are usually justifiable and provide value to the person taking on the debt, there is another end of the spectrum that involves debt that's taken on carelessly. While it's easy to differentiate between these two extremes, some other debts are harder to judge.
- Good debt has the potential to increase your net worth or enhance your life in an important way.
- Bad debt involves borrowing money to purchase rapidly depreciating assets or only for the purpose of consumption.
- Determining whether a debt is good or bad sometimes depends on an individual's financial situation, including how much they can afford to lose.
What Is Good Debt?
Good debt is often exemplified in the old adage "it takes money to make money." If the debt you take on helps you generate income and build your net worth, that can be considered positive. So can debt that improves your and your family's life in other significant ways. Among the things that are often worth going into debt for:
- Education. In general, the more education an individual has, the greater their earning potential. Education also has a positive correlation with the ability to find employment. Better educated workers are more likely to be employed in good-paying jobs and tend to have an easier time finding new ones should the need arise. An investment in a college or technical degree can often pay for itself within a few years of entering the workforce. However, not all degrees are of equal value, so it's worth considering both the short- and long-term prospects for any field of study that appeals to you.
- Your own business. Money you borrow to start your own business can also come under the heading of good debt. Being your own boss is often both financially and psychologically rewarding. It can also be very hard work. Like paying for education, starting your own business comes with risks. Many ventures fail, but your chances for success are greater if you choose a field you are passionate and knowledgeable about.
- Your home or other real estate. There are a variety of ways to make money in real estate. On the residential front, the simplest often involves taking out a mortgage to buy a home, living in the home for a few decades, and then selling the home at a profit. In the meantime, you also enjoy the freedom of having your own home, plus an assortment of potential tax breaks not available to renters. Residential real estate also can be used to generate income by renting it out, and commercial real estate can be a source of cash flow and eventual capital gain, if you know what you're doing.
What’s Considered To Be a Good Debt-To-Income (DTI) Ratio?
What Is Bad Debt?
It's generally considered to be bad debt if you are borrowing to purchase a depreciating asset. In other words, if it won't go up in value or generate income, you shouldn't go into debt to buy it. For example:
- Cars. While you may find it impossible to live without a car, borrowing money to buy one isn't a great idea from a financial perspective. By the time you leave the car lot, the vehicle already is worth less than it was when you bought it. If you need to borrow to buy a car, look for a loan with low or no interest. While you'll still be investing a large amount of money in a depreciating asset, at least you won't be paying interest on it.
- Clothes and consumables. It's often said that clothes are worth less than half of what consumers pay for them. If you look around a used clothing store, you'll see that "half" is being generous. Of course you need clothes—and food and furniture and all kinds of other things—but borrowing to buy them by using a high-interest credit card isn't a good use of debt. Use a credit card for convenience, but make sure you'll be able pay off your full balance at the end of the month to avoid interest charges. Otherwise, try to pay cash.
Credit card reward programs give cardholders an extra incentive to spend. But bear in mind that unless you pay your balance in full every month, the interest charges may more than offset the value of your rewards.
Not all debt can be classified as good or bad so easily. Often it depends on your own financial situation or other factors. Certain types of debt may be good for some people but bad for others:
- Borrowing to pay off debt. For consumers who are already in debt, taking out a debt consolidation loan from a bank or other reputable lender can be beneficial. Debt consolidation loans typically have a lower interest rate than most credit cards, so they allow you to pay off existing debts and save money on future interest payments. The key, however, is making sure you use the cash to pay off debts and not for other spending. Investopedia publishes regularly updated ratings of the best debt consolidation loans.
- Borrowing to invest. If you have an account with a brokerage firm, you may have access to a margin account, which allows you to borrow money from the brokerage to purchase securities. Buying on margin, as it's called, can make you money (if the security goes up in value before you have to pay back the loan) or cost you money (if the security loses value). Obviously, this kind of borrowing isn't for inexperienced investors or those who can't afford to lose some money.