Ask anyone struggling to pay their bills, as opposed to someone who has profited from leveraging debt, and you will find two very different attitudes towards carrying debt. When used correctly, YES, debt can grow wealth and enable you to do things that would otherwise be out of reach. Buying a home is a prime example.
However, the other side of debt is that it can be a noose around your neck that prevents you from moving forward, saving for retirement, and otherwise reaching your financial goals, when it is not managed properly. Clearly, this side is NO!
But, it’s not as easy as defining what is a YES or NO type of debt. Conventional wisdom places debt into categories of good and bad debt, or preferred terms used today “better” and “worse” debt. The challenge with this thinking is that it assumes a certain category of debt will always be good where another will always be bad. The truth is not as cut and dry.
Traditionally Debt Is Broken Down Accordingly:
|Good Debt||Bad Debt|
|Mortgage Debt||Credit Cards|
|Student Loans||Store Cards|
|Real Estate Loans||Auto Loans|
|Business Debt||Personal Loans|
In this scenario, debt that creates wealth or increases in value over time, is considered good debt and debt that depreciates over time is bad debt.
Under this logic, all student loans would be considered good debt, even if they did not result in a better paying job. All credit card debt (even 0% offers) would be considered bad debt, because the value of the items you purchase depreciates over time.
Looking at Debt Differently
Over the past decade things have changed. Homes no longer automatically appreciate over time, college degrees no longer guarantee the graduate will be making the estimated million dollars in additional earnings, and auto loans are commonly found with 0% offers.
These changes in the products lenders offer and the way consumer’s use debt, should cause you to reexamine your attitudes towards debt.
Home Loans. We would quickly become a nation of renters if homes could only be purchased with cash. Nearly all homes are bought with bank funds added to a down payment. Home purchases offer low interest rates and tax deductible benefits that reduce the effective interest rate even lower.
However, homes that are not maintained, are purchased in declining neighborhoods, or other factors can lead to declining values and a poor investment. When home purchases factor in the potential to build wealth, significant gains can be enjoyed. For example: you may personally only need 2 bedrooms, however, a 3-bedroom home is much easier to sell and will impact your rate of return.
A home could be good debt if you buy at the right price, in the right neighborhood, and live in the house long enough to take advantage of appreciation. The other benefit of owning a home is that in many cities mortgage payments are lower than rental rates for a comparable home, truly solidifying the home as an investment even when debt is accrued.
Student Loans. College students traditionally make substantially more than those without a degree. Yet, student loan debt as a category, does not take into account whether a degree was obtained and the field is competitive. Not finishing gives you very little employment benefit but can still straddle you with heavy debt loads from the years you attended.
The next key to making college loans a good investment is the degree you obtain. A college degree is meant to open doors to better employment. Choosing a degree based on passion and not employability could easily result in student loan debt that is difficult to pay off. With $98.1 billion dollars in student loans debt in default, impacting 7 million borrowers, clearly not all student loans are good debt.
Real Estate Loans and Business Debt are both gambles. The value of the debt is directly impacted by the decisions made with regard to the debt. Our economy thrives when small businesses succeed. Yet startup failure rates range from 80% to 90%, depending on which statistic you reference. With such high rates of failure, you would be hard pressed to place business debt into the good debt category automatically.
On the flip side, many small business owners become millionaires by starting businesses or building a viable real estate portfolio. A major contributor to success is the availability of affordable loans. Real estate investments and new, start-up businesses would be limited to a few wealthy investors if financing were not available to average folks willing to take a chance.
Credit Cards and Store Cards are at the top of the list when it comes to bad debt. For the most part this holds true. Typically credit card purchases buy disposable goods that are no longer working or useful by the time the high interest is paid off. Carrying high debt balances and pay double digit interest, is a form of bad debt you are anxious to eliminate at almost any cost.
Those who use credit cards as a resource for an interest free loan can improve cash flow and save financial reserves. When the balance is paid in full each month, or before the end of a promotional period, credit card usage can be a real benefit. It can even out cash flow and provide a convenient way of tracking expenses. Taking advantage of interest free offers for major purchases might eliminate the need to dip into savings with minimal costs. Not all credit card debt is bad debt.
Auto loans are also considered bad debt by the experts. Considering that today’s vehicles are more efficient and last longer than older models, vehicle debt is not always negative. It is true that vehicles are depreciating assets, but in most cities you must own one to function effectively. Given that low interest rates are common it might be a better option than paying cash. If you obtain a 0% loan that eliminates the need to tap into funds paying 5% in gains, you are better off taking the loan. If you drive the car beyond the loan payoff, it might also make financing the best option. Older cars are less efficient, have higher repair costs, and must be replaced sooner.
Good debt and bad debt are more about the interest rate and terms you are able to obtain, rather than the specific category it falls into. Debt is more about the value you gain for taking on the debt, than the specific item purchased. When financing is obtained as an investment for a home, education, or business, it can pay high dividends, increase your standard of living, and allow you to save more for your future. These actions improve your life.
Debt that turns sour, goes into default, or purchases goods that are not needed, are not good uses for debt, even at a zero percent interest rate.
Careful consideration at each intersection of debt accrual will help you make the personal decision about the value of your purchase and its long term ability to leverage your money effectively. Impulse purchases and debt incurred without much thought and consideration, will almost always be “bad debt” in terms of the value it adds to your life.