Is Any Debt Actually Good? Breaking Down the Myths Between Bad and Good Debt
Types of debt that typically fall into the good debt category can include mortgage financing, education financing, and business financing.
August 10, 2021
Asking the question “What is the difference between good debt and bad debt?” will get you as many different answers as the number of sources you consult.
For example, the popular Mr. Money Mustache blog calls all debt an emergency. At the same time, those in real estate investing have long used OPM — other peoples’ money — to preserve their own capital while making deals.
To better understand when debt can be considered good debt or bad debt, let’s take a closer look at different types of debt, how they’re commonly used and whether being debt-free is truly worth pursuing.
What is good debt?
Definitions of good debt vary, but one of the most common interpretations is that it’s the type of borrowing that either increases:
Your net worth
Generally speaking, good debt involves low interest rates, comfortable repayment schedules and reasonable certainty that the financial impact of taking on the debt will be greater than the cost of the interest associated with having borrowed the money.
Types of debt that typically fall into the good debt category can include:
Mortgage financing, as borrowing to buy a house, results in the acquisition of an appreciating asset.
Education financing, especially if the education you receive opens up doors to higher-paying career opportunities.
Business financing, when that funding helps start or grow a profitable enterprise that builds personal net worth.
What is bad debt?
On the other hand, bad debt commonly refers to debt that’s used to purchase depreciating assets. Bad debt is typically associated with high interest rates, inflexible or time-limited repayment schedules and a loss of value in the asset financed over time. Ultimately, though, any debt that’s financially burdensome to carry can be considered bad debt.
Common examples of bad debt include:
High-interest credit card debt
Personal loans or lines of credit, especially when they’re used to finance discretionary purchases, such as clothing, consumer goods or vacations.
The grey area between good and bad debt
While the examples of good and bad debt above may seem straightforward, grey areas exist.
Real estate, for example, doesn’t always appreciate — despite the impression today’s white-hot housing market might give. During the Great Recession, homeowners lost $16 trillion in net worth, and roughly 10 million people lost their homes to foreclosure. Holding an underwater mortgage certainly isn’t good debt.
Auto loans also fall squarely into the grey area category. Vehicles are generally considered to be depreciating assets (today’s used car market anomaly aside). But as 45% of Americans have no access to public transportation, cars are often necessary for getting to work. For this reason, they fulfill the good debt criteria of helping people increase their income or improve their net worth.
Even within debt classes, grey areas exist. Take student loans.
Total student loan debt in the US topped $1.6 trillion in 2020, and more than half of all American students take on debt to go to college. But while taking on loans may grant some students opportunities to access high-paying professions through education they couldn’t otherwise afford, borrowing huge sums to enter low-paying fields won’t deliver a worthwhile return on the investment.
The debt mix that’s right for you
If there are no clear answers as to which debt types can be considered good or bad, how can you ensure you’re making good decisions for your financial future? Keep general guidelines for good debt management in mind rather than deciding your debt mix based on debt type.
For instance, it’s generally better to be debt-free. Yes, situations exist where it can make sense to borrow money at low interest rates if doing so lets you either get out of higher interest rate debt or earn a greater rate of return than the interest you’re paying. You also need to build credit to qualify for credit in the future. That said, by default, being in debt means being beholden to someone else. True freedom comes from being debt-free.
Of course, being debt free may not be realistic for everyone. Whether you leverage debt for large purchases or you’re trying to work your way out from past decisions, use the following guidelines to manage debt more responsibly:
Debt ratios can help you make smart choices. Mortgage lenders want to see a debt-to-income ratio of 43% or less to qualify you for a home loan. Some sources recommend your auto loan take up no more than 10% of your gross monthly income. While ratios like these aren’t universally applicable, they can help keep you out of trouble when you’re thinking about how much debt to take on.
Lower interest rates are almost always better. Interest rates are the cost you pay to borrow money — the lower your interest rates, the less you’ll pay to be in debt to someone else. However, one caveat is that consolidating high-interest debt into a lower-interest bundle is only a smart choice if you’re sure you won’t run your balances back up.
The faster you can get out of debt, the better. The less time you owe money to someone else, the more time you’ll spend being financially free. Not only does this mean attempting to pay off any balances you accrue as quickly as possible, but it also involves seeking out debt with the shortest possible terms you can afford. As an example, although you’ll pay more per month, a $250,000 mortgage paid off on a 15-year term instead of the usual 30 years can save you more than $100,000 in interest payments over the life of the loan.
Deciding whether or not to take on debt isn’t as simple as answering the question, “What is the difference between good debt and bad debt?” There are many grey areas in the world of debt, and ultimately, it’s up to the individual to determine based on their preferences and finances.
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(1) To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) Will be between 7.90% - 29.99% per year, and will be based on your credit history. The APR will vary with the market based on the Prime Rate.
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