Have you ever heard the phrase “good debt”? Someone might tell you, “It’s okay to take out a loan for this purchase, that’s good debt.” This implies the existence of bad debt—debt you shouldn’t take on. The concept of good and bad debt, while a little simplistic, can help you consider when it’s wise to borrow money. Certainly, it’s a step above treating all debt as bad.
The Basics of Good and Bad Debt
There’s one simple rule of thumb to distinguishing good debt from bad debt. Good debt is debt that will eventually pay for itself by helping you earn more money, while bad debt provides no payoff to counteract the risk. That’s why experts generally recommend you don’t go into debt to buy luxuries, but encourage you to borrow money for a house or a college education.
This makes sense. Given money has time value, you will always pay interest on money you borrow. Money you have today can be used to make more money in the future. But money you borrow today will be paid off at a higher price in the future. So if you are spending it on something that will never make you money—a new outfit, a wedding, or a vacation—you can expect to spend a lot more when you borrow than when you save up and then purchase the item.
Worse, you take on a risk. If you borrow money to pay for a $20,000 wedding, you’re making a bet that you will be able to pay for it in the future. But how do you know you will remain able to make payments on that debt? If you lose your job, you’ll have less time to find a new one and more to worry about in the meantime. You may find yourself trying to scrape together more loans just to pay off the debt you already have. Lives are sometimes destroyed by debt.
When a Good Debt Turns Bad
Of course, it’s not always this simple to tell when a debt will pay off. Obviously a wedding was never expected to be an investment. But what about a house? Real estate often increases in value, so buying a home is often considered good debt. Not only does it save you money on rent, but you may well make a profit when you sell the home. However, if the house is in a flood zone or purchased during a housing bubble, you may instead find it loses value. In that case, it might have been a bad debt the whole time.
The same is true of a college degree. It should be good debt, because you can get a job with the degree once you’ve earned it. But if your major turns out to be in low demand, you’ll struggle to make payments on your loans. Careful research is required to make a judgment about whether the risk is worth it. Experts recommend not spending more on a degree than the average annual income a graduate makes after college. Even then, however, there’s never any guarantee.
Business opportunities can be another bad debt masked as a good one. Just because you have a business idea doesn’t mean your startup will be successful. About half of new businesses fail, including franchises. So when you borrow money to start a business, make sure you’ve thought through the risks and the market. Consulting a business expert is essential. This is especially true when you’re buying into someone else’s business idea, whether it’s a buddy starting a store or a friend recruiting you for a sales venture. How much do they expect you to borrow? How certain is the profit? Find a reliable third party to advise you.
Good Debts that Look Bad
Not all good debts are mortgages, student loans, or business loans. Some might be small purchases that keep you out of a tight spot. For instance, putting a suit on a credit card so you can go to job interviews might in fact be a good debt—if you pick an affordable suit and maximize your odds of getting hired soon.
Cars are a debt that can be good or bad. It doesn’t make sense to borrow $100,000 for the flashiest new car you can find. Much of the value of that purchase will vanish the second you drive it off the lot. But borrowing a reasonable amount to buy a reliable used car can make a lot of sense. It will get you to work, allowing you to pay off the debt. And repair costs are often much less on a mid-range used car than on a beater you could afford with cash.
Lastly, using a credit card for emergencies such as medical bills, home repairs, or car breakdowns may not even be optional. Ideally, you should have a large enough emergency fund that you can handle most unexpected bills. But if it will take you a few days to withdraw the money, it makes good sense to use the credit card now and pay it before the end of the month. And even if you aren’t able to do that, you may find it’s better to use a credit card on a bill than gather late fees or credit damage for not paying it. Just make that balance a priority and pay it off as soon as you can.
Advice for Debt Decisions
Unsure whether a loan you want to take out is good or bad? A second opinion can be invaluable. Never look for disinterested advice from a loan officer or potential business partner. Instead, find an advisor with a fiduciary duty to look out for your interests. To meet the right advisor for you, contact us today.
