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What Is Good Debt vs. Bad Debt

By David Quilty

debt handcuffsWhile most of us cannot live entirely debt-free, there are major differences between what is considered “good” debt and “bad” debt. Though some debt falls into a bit of a gray area, good debt is simply defined as money borrowed to pay for items you truly need or that appreciate in value, and bad debt is accrued for items you only want and that generally depreciate in value.

To help you make this distinction, it is important to be able to differentiate between wants and needs. Moreover, before borrowing money, you need to determine whether the money is going toward something that will have a positive or negative effect on your overall financial situation. Ultimately, debt is not always bad – it’s how you use it that counts.

Good Debt

1. Borrowing Money for Education

When you take on student loan debt, you are rarely making a bad decision. Generally, those with college degrees tend to earn more money over their lifetime than those without a degree.

And taking out a student loan to pay for your child’s education sure beats using your retirement money to do so. After all, you cannot borrow to pay for your own retirement. There are many government programs offering low-interest or interest-free student loans, and you can often deduct student loan interest on your taxes.

2. Paying for Medical Care

While unpaid medical bills account for more than 60% of bankruptcies in the United States, there is no amount of money not worth borrowing to help pay to keep a loved one healthy. You can always pay back money you borrow, but you cannot replace a human life. If someone needs expensive treatments or surgery to regain their health, this an acceptable debt to take on, no matter what.

health care debt is worth taking on

3. Taking out a Mortgage on a Home

Make no mistake, taking out a loan of this size can be daunting, but buying a home builds ownership in something that not only provides a roof over your head, but also is a potential source of retirement money. And while your drive to stay out of debt may feel like encouragement to put any and all available liquid cash down as a down payment (which effectively reduces your monthly payment and interest charges), it may not be the smartest move.

Home mortgage interest is deductible on your taxes, and the interest rate is much lower on your home loan than it is on your credit card, so having cash to pay other expenses instead of using your credit is important.

While buying a house was formerly seen as a solid, future-proof investment, some homeowners are finding themselves upside down on their home mortgage loan, owing more to the banks than their homes are worth. But careful planning, buying only what you can afford, and keeping those interest rates low by having good credit enables you to buy a house that you will one day own outright.

4. Purchasing a Car

If public transportation is not available in your area, or you cannot find anyone with whom to car pool, you are probably going to need to buy a car. An auto loan can fall into that gray area between “good” and “bad,” but the key to keeping an auto loan closer to good debt rather than bad is to make sure you get the lowest possible interest rate on your loan. Also, it’s important to put as much down as possible, while making sure you still have cash on hand should you need it.

Your best bet is to buy a late-model used car rather than a brand new one, potentially saving you thousands on the sticker price and the interest paid over the life of the loan.

5. Business Loans

While this wouldn’t be considered good debt in every single case, borrowing money to start or expand a business is generally seen as a good idea, especially if business is booming. After all, it takes money to make money, right?

Sometimes you have to borrow capital in order to hire new employees, buy new equipment, pay for advertising, or just to manufacture the first run of a new widget you invented. As long as the money is borrowed with a plan in place to generate more business or income, then taking out a business loan counts as good debt.

borrowing capital for a business is good debt

Bad Debt

1. Credit Card Debt

The average U.S. household carries a balance of more than $10,000 on their credit cards each month. Credit card debt often piles up quicker than we realize, and is often used to pay for things we want rather than need. It’s much easier to think we can afford something using a card rather than paying with cash.

By the time credit cards are paid off, interest rates and minimum payments can turn $100 items into $200 items, and many items depreciate in value rapidly, making the loss that much more substantial. Credit card debt is without question a bad debt, and one that millions of Americans find themselves with today. It’s hard to get out of credit card debt and is best to avoid it in the first place – most Americans should not use credit cards.

2. Borrowing From a 401k

When you borrow money from your 401k plan, you have to deal with the IRS, and unless you are using the money to buy a home, you have to pay back the borrowed money within five years. If you don’t pay it back when you should, you could get hit with heavy early withdrawal penalties. Plus, the interest you’ll pay on the loan will effectively get taxed twice – first when you pay it, and again when you withdraw it during retirement.

You cannot borrow money to fund your retirement. Therefore, borrowing money from your retirement fund to pay for anything other than retirement is a bad idea. You put your retirement at risk when borrowing from a 401k, so don’t do it unless absolutely necessary.

3. Vacations, Jewelry, and Expensive Clothes

If you cannot comfortably afford to pay for these luxuries with cash on hand, don’t do it. These are not needs but wants, and thus bad debt. Wait until you have the money to pay for them. Going into debt just to pay for a vacation or a handbag is most definitely a terrible use of borrowed money.

do not accrue debt for items you don't need

4. Payday Loans

It may be easy to borrow money from payday loan companies, but it’s very difficult to pay them back. These companies loan out money with terrifyingly high interest rates, taking advantage of the fact that many people are desperate for cash. Even a small amount borrowed through a payday loan outlet can end up costing a small fortune when finally paid back.

Payday loans are often considered the worst kind of debt you can take on. If you are in serious need of a short-term loan, you are better off taking a cash advance on a credit card than borrowing money from these companies.

Final Word

Modern life requires many of us to borrow money at some point or another. But knowing the difference between good debt and bad debt can make a big impact on your financial health and chance of success.

It is best not to incur more debt than you can comfortably afford to pay back, regardless of whether it is good or bad. Also, don’t let debt add up to more than 36% of your total gross income, as credit agencies do not differentiate between good and bad debt when determining your credit score and credit-worthiness. If you find yourself too deep in the red, look for ways to snowflake your debt and get back on track.

Do not be scared of debt as a general concept. Instead, use it as a tool when seeking to improve your life or your financial situation, to increase earnings, or to invest in your future.

What types of debt have helped you improve your finances and your life? What do you believe is the worst type of debt to take on?

(photo credit: Shutterstock)

David Quilty
David Quilty is a freelance writer living outside Santa Fe, NM. After burning out working in the entertainment field in Los Angeles for many years, David decided to strike out on his own and follow his passions for writing, web design, politics, and green living on a dirt road in rural New Mexico.

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Comments

  • http://liverealnow.net/ Jason@LiveRealnow

    If one of our cars died today, we’d be going into debt to replace it. I hate the idea, but that’s the way it is. We’re a couple of years away from debt freedom and don’t have a replacement car fun, yet.

    • David Bakke

      Yes, well that was a goal of mine as well, to be able to handle something like that. If my car dies today, I’d have to go into debt also–but I would be able to put down about half, so the debt would be minimal.

      Being completely debt-free will take some time, and I still have a ways to go in that area as as well.

  • http://change-is-possible.net/ H Lee D

    What’s your take on debt to start a business?

    • David Bakke

      Now that’s a different story. Going into debt to start a business is something that will eventually generate income–so to me that’s perfectly OK.

    • Erik Folgate

      Lee, I’d be very careful with how much debt you go into for starting a business. If it’s something that you can slowly build up, work out of your home at first, and gradually build up customers/clients without taking out a loan, then I would go that route. If it’s a franchise type opportunity or something where you need to buy inventory and have a store front, I would save up as much as possible and only take out a manageable loan that you could repay if the business were to fail in the future. Good luck!

  • http://moneyobedience.com/blog/ Money Obedience

    The first two comments already add two other scenarios to the list. If you need a car to go to make money, it is ok to go into debt for getting it. The same goes for starting a business.

    I think the key is to evaluate why you are going into debt. If you are going into debt to acquire a wasting asset, it is bad debt. If you acquire an asset that helps you build net worth, it is ok. While a car is usually considered a wasting asset since it loses value quickly, it does not have to be a wasting asset.

    • David Bakke

      I think it also comes down to evaluating “wants” vs. “needs” in our life.

      Going into debt for a “want” (i.e. a new laptop) is different than going into debt for a “need” (i.e. transportation).

  • http://greenandchic.com/blog Carla | Green and Chic

    I think its OK to go into medical debt. It sucks, but you may need go into debt to save your life or maintain your health. I don’t have dental insurance, but my teeth is more important than saving money at this point. I’m about $3000 in the hole right now from necessary dental work and about $5000 for medical.

    • Erik Folgate

      Carla, once you’re able to pay off those debts, I would immediately open a savings account specifically for dental/medical expenses if you do not have dental/health insurance. If your employer does not offer health insurance or you can’t afford traditional plans, I would suggest looking into a high-deductible plan with a health savings account attached to it. You can go on DaveRamsey.com and go to his endorsed local provider section and look for a health insurance agent that could help you find one of these plans and give you quotes. They are typically MUCH cheaper because they carry a deductible of $2 to $3k, but it protects you from major medical issues.

      • http://greenandchic.com/blog Carla | Green and Chic

        Thanks Erik!

        I did have a savings account specifically for that, but it got drained quickly. I don’t have an employer – on SSDI right now. I have a chronic illness (and regularly go to my doctors) so most private health insurance options doesn’t apply to me.

      • http://greenandchic.com/blog Carla | Green and Chic

        Thanks Erik!

        I did have a savings account specifically for that, but it got drained quickly. I don’t have an employer – on SSDI right now. I have a chronic illness (and regularly go to my doctors) so most private health insurance options doesn’t apply to me.

    • David Bakke

      Again, Carla, this is a different area that i hadn’t even thought of. Of course, your health comes first! Thanks for weighing in.

  • Arthur

    So, if you need a replacement car, do you buy a $20,000 new car, or spend $4,000 for a used one? I know which choice I would take. If you have to take on debt I would put some major restrictions on how much you take on.

    • David Bakke

      Personally, I would go the $4K route. One, because I’d never spend $20K on a new car.

      Actually, if my current car broke down in the morning, and I had to have more transportation that day, I would probably buy a used car that was about 2-3 years old.

      I would put down about $5K on it, and finance the rest–hopefully at 0% or real close to it. Then, I would bust my butt to shave expenses anywhere I could to pay that debt off as fast as humanly possible.

      So in a technical sense I guess you could say that I am saying that it is OK to go into debt for a car, but we are talking about an emergency situation.

      • http://www.debt-tips.com/blog/ Kris @ Debt-Tips

        Last summer I bought a great car for $4k. No, I don’t look as cool as those driving their $50k cars (and there are lots in my town) but I’m ok with it.

      • http://www.debt-tips.com/blog/ Kris @ Debt-Tips

        Last summer I bought a great car for $4k. No, I don’t look as cool as those driving their $50k cars (and there are lots in my town) but I’m ok with it.

  • http://griyamobilkita.webs.com/ rental mobil jakarta

    Nice article, thanks for the information.

  • http://www.debt-tips.com/blog/ Kris @ Debt-Tips

    Good article, but sometimes even good debt can be or become bad debt if you don’t manage the debt properly.

  • http://twitter.com/MariedOnABudget Diane’n'David

    Interesting article– thanks! My dad is a retired banker, and growing up debt was like another cuss word in our house! When I bought my first home, it was really hard for me to accept that I needed a mortgage and that debt could be good. But it’s really been a blessing to have this cozy little house! I bought a foreclosure that needed some TLC, and after renovation costs, it’s worth about 30% more. Debt really can be good when used for an appreciating asset (and saving a ton compared to renting!).

  • http://thefamilyceoblog.com/ Julie @ The Family CEO

    I think it’s too easy to label certain kinds of debt as “good debt.” I especially disagree with this statement: “When you take on student loan debt, you are rarely making a bad decision. ”

    During 2011, the amount of student loan debt hit $1 trillion and surpassed the amount of credit card debt in the US. That has huge implications for this generation of students, who may find it difficult to buy homes, change jobs, or start families.

  • http://www.cbc-international.co.uk/debt-recovery/ Debt Recovery Services

    Hi there david,

    Im really glad that you took the time out to explain this to all of us David. When people think of ‘debt’ they instantly think of ‘bad debt’ while getting into debt for something that will be likely to earn you money or is of great use to you isn’t at all frowned upon.

    Priyanka

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