Managing Debt: Good Debt vs. Bad Debt

Managing Debt: Good Debt vs. Bad Debt
Eileen St. Pierre, The Everyday Financial Planner

“Remember the good ‘ole days when we used to pay cash for everything? We didn’t need credit.” I heard this many times from my older audiences when I travelled to small towns in Oklahoma to present personal finance workshops for the Cooperative Extension Service. I would politely explain that the world has changed, for better or worse – it is now imperative for young adults to build a credit history.

However, not all debt is the same. There is good debt and bad debt.

Good Debt

Good debt has the following features:

  • It helps you produce wealth in the long run. This is the argument for why student loans are considered good debt. They help to increase the value of your human capital leading to higher future earnings.
  • It is used to finance assets you believe will go up in value (appreciate), such as a new home or business.
  • It tends to be secured, which means there is an asset backing it as collateral.
  • It may generate tax benefits, such as the mortgage interest tax deduction.
  • It generally carries a low interest rate, reflecting the decreased risk faced by the lender.

Good debt can also help you pay for things you need but can’t pay for all at once without wiping out your cash reserves or liquidating your investments. A car loan is a good example. Since a car depreciates in value as soon as you drive it off the lot, financing a car would be considered bad debt in theory. But few of us can afford to pay cash for a car – you do not want to cash out your 401(k) to buy a car. We need cars to get to work to earn a living. Thus taking out a car loan makes sense.

Bad Debt

Bad debt is used to buy something that immediately goes down in value. It is typically used to purchase something that can be consumed – so there is no asset backing it as collateral (unsecured). It does not generate income in the long run. It tends to carry a high interest rate and does not produce tax benefits.

"Here & Now" Road Sign with dramatic clouds and sky.Examples of bad debt include:

  • Credit cards – both major and store cards
  • Payday loans
  • Pawn shops
  • Loans from your retirement accounts and life insurance

The Good Can Turn Ugly

According to Debt.org, good debt can become a negative if

  • The interest rate is variable or higher than otherwise available. A good example of this is a home equity loan used for remodeling. If your timing is off or you don’t do your homework and shop around for a good interest rate, you may end up paying much more for the loan than you originally planned.
  • You do not take advantage of tax breaks. For example, you have a mortgage on your home but you do not itemize on Schedule A – you file Form 1040 EZ instead because it is easier and less intimidating. You will end up paying more in taxes.
  • You have too much debt in your retirement years, when you are on a fixed income. Unfortunately, this is a problem for many Baby Boomers approaching retirement.
  • Your debt-to-income ratio is greater than 36%.
  • You have too much secured debt. This could lead to a lower credit score.

The next column in the Managing Debt series will discuss how to improve your credit score.  Visit my Debt Management page for more information.