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 big-ticket items like homes and cars. While such loans usually are justifiable and bring value to the person taking on the debt, there is another end of the spectrum that involves taking on debt through careless spending on a credit card. While it's easy to differentiate between these two extremes, determining whether or not a debt is good or bad more often involves a deeper analysis of specific circumstances.
Good debt is exemplified in the old adage "it takes money to make money." If the debt you take on helps you to generate income and increase your net worth, that can be considered positive. There are a few notable things worth going into debt for:
- Technical or college education. In general, the more education an individual has, the greater that person's 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 opportunities should the need arise. An investment in a technical or college degree is likely to pay for itself within just a few years of the newly educated worker entering the workforce. To maximize the value of taking on debt for an education, degree programs must be chosen carefully. If there's no career path or little income to be earned from the degree you pursue, your student loans can quickly turn into bad debt.
- Small business ownership. Making money is one of the main reasons to start a small business, with being your own boss also a positive result of the endeavor. Not only can you avoid reliance on a third party to hire you and give you a paycheck, but your earnings potential can be directly improved by your willingness to work hard. With a bit of luck, you can turn your drive and ambition into a self-sustaining enterprise and perhaps, down the line, an initial public offering (IPO) that results in major wealth. Like education, this too comes with risks. Many small businesses fail, but your chances for success are greater if choosing to work in a field you are passionate and knowledgeable about.
- Real estate, including homeownership. There is a variety of ways to make money in real estate. On the residential front, the simplest strategy often involves buying a house and living in it for a few decades before selling it at a profit. Residential real estate also can be used to generate income by taking in a boarder or renting out the entire residence. Commercial real estate also can be an excellent source of cash flow and capital gains for investors.
What’s Considered To Be a Good Debt-To-Income (DTI) Ratio?
While good debt has the potential to increase a person's net worth, it's generally considered to be bad debt if you are borrowing money to purchase depreciating assets. In other words, if it won't go up in value or generate income, you shouldn't go into debt to buy it. Some particularly notable items related to bad debt include:
- Cars. New cars, in particular, cost a lot of money. While you may need a vehicle to get yourself to work and to run the errands that make up everyday life, paying interest on a car purchase is simply a waste of money. By the time you leave the car lot, the vehicle already is worth less than it was when you bought it. Put your ego aside and pay cash for a used car, if you can afford to do so. If you can't, take out a loan to buy the least expensive reliable vehicle you can find and pay it off as quickly as you can. Buyers who insist on living beyond their means and financing a new car should look for a loan with little to no interest. While you'll still be spending a large amount of money for something that eventually depreciates until it is worthless, at least you won't be paying interest on it.
- Clothes, consumables, and other goods and services. It's often said that clothes are worth less than half of what consumers pay to purchase them. If you look around a used clothing store, you'll see that "half" is being generous. As well, vacations, fast food, groceries, and gasoline are all items commonly bought with borrowed money. Every penny spent in interest on these items is money that could have been used more wisely elsewhere.
- Credit cards are one of the worst forms of bad debt. The interest rates charged are often significantly higher than the rates on consumer loans, and the payment schedules are arranged to maximize costs for the consumer.
[Important: Keeping a balance on a credit card is rarely a good idea; the interest spent on credit card debt offsets the value of potential rewards.]
Not all debt can be classified as good or bad so easily. Often it depends on your own financial situation or other factors. A few types of debt may be good for some people but bad for others:
- Consolidation loans. For consumers who are already in debt, consolidating higher-interest debt by taking out a loan at a lower rate of interest can be beneficial. The key is to use the cash that has been freed up from lower payments to keep paying down the debt.
- Borrowing to invest. Leveraging, or borrowing money at a low interest rate and investing at a higher rate of return (most likely with a margin account), may appear to investors as a solid way to achieve better-than-expected results. Unfortunately, it comes with numerous risks for the inexperienced, as well as the potential hazard of losing a significant amount of money and being required to compensate your broker for the borrowed funds. This is an option that should be pursued only by knowledgeable investors who can afford to absorb losses in the event an investment goes south.
- Credit card reward programs. There are some great credit card reward programs available for consumers. The money spent using credit cards can help buyers earn free airline tickets, free cruises, cash back, and a host of other benefits. If you have the discipline to pay off your balance every month, this is worthwhile. Otherwise, the interest spent on the credit card debt offsets the value of the rewards.
- Good debt is a loan that has the potential to increase your net worth.
- Bad debt involves borrowing money to purchase depreciating assets.
- Determining whether or not a debt is good or bad sometimes depends on an individual's financial situation, as well as other factors.