Good Debt vs. Bad Debt in Today's World

by Womens Toolbox • Member { View Profile }

Debt does have a few useful purposes: it allows us to establish a credit history (hopefully a good one) and enables us to acquire things before we have the all of money to pay for them.

Conventional wisdom breaks down debt into two kinds: good debt and bad debt. The theory goes, when debt is used to acquire items that will appreciate in value (or increase over time) it is "good" and when debt helps us buy things that steadily depreciate (or decline in value) it is "bad".

For example if you want to buy a house but can’t pay cash for the whole asking price, getting a mortgage-a loan secured by the value of the house-will enable you to purchase it. Provided you’ve done your homework on the location, condition and comparative pricing of the house and you can afford the loan payments, this would seem to be a smart move taking on "good debt." The common belief is that a home will increase in value over time while the mortgage loan is gradually being paid down, resulting in an increase in your net worth (asset value minus debts). A student loan is considered “good debt” because it will enable you to become more educated, increase your net worth, and make you eligible for higher-paying jobs with a better career path. Additionally, taking out a loan with an interest rate of 4% to purchase a stock paying a dividend of 7% should be a profitable and thus a “good” move.

On the other hand if you want to buy a car but don’t have the money to pay up front, you may be able to get a car loan to finance the purchase. This is also a secured loan, backed by the value of the car. However, if you’re purchasing a new car and have taken out a loan that is 85% of the purchase price, it’s highly likely that the value of the car will be less than the loan value within a year. A new car will lose about 15% of its value as soon as you’ve left the dealer lot and within the first year it will probably decline in value another 5-10%. At that point you will find yourself “upside down” where your loan value is more than the value of the car.

Unfortunately, over the last 3 years we’ve come to realize that this “good debt/bad debt” theory hasn’t held up well in terms of the “good debt“ adding to a person’s net worth. According to the updated Case-Shiller 100-year chart tracking the inflation-adjusted value of homes over the last 100 years, the current trend is projected to take home values back to where they were in 1985. The stock market has taken a dive and some major companies have cut their dividends. Many college graduates are carrying loads of student loan debt with no job offer in sight.

It is true that the Fair isaac Corporation (FICO) scoring model gives bonus points for having a mixture of good and bad debt: e.g., mortgage, car loan, credit card, personal loan, student loan. However, given what we’ve experienced recently, debt isn’t “good” just because it falls under an assumed scenerio. In fact, of late most of our economic assumptions have gone out the window.

The only certainty is that a loan is a debt that has to be paid back. Whatever is purchased with the help of that “good” loan or “bad” loan may go up or down in value over time. Debt is still debt. The trick is to only borrow what you need and what you can afford to pay back. Ideally, you should save up until you can put a large down payment on a house. Then getting a mortgage allows you to own and live in a nice home where you can easily afford the mortgage payments, insurance and taxes., and this cost of living compares favorably to what you would pay if you were to rent. The cost of shelter is a basic expense that needs to be paid regardless, like the cost of food or electricity.

Before buying a house or a car, picking a college, or purchasing an investment with borrowed money, plan and save way ahead of time, become an educated consumer, and understand the consequences. Ask yourself these two questions: What’s the worst that could happen ? Does it make sense to get into big-time debt or are there other ways to get what I need and can afford? If you don’t like the answers then don’t bury yourself in debt, “good” or “bad”

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