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The following is a post by MPFJ staff writer, Kevin Mercadante, who is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.
We live in a world that’s awash in debt.
Complicating this fact is that debt has become so common in the average person’s life that we may not even perceive the threat that a truly is. That can cause us to take on debt that we would be far better off avoiding. At a minimum, we should develop a hierarchy as it applies to debt. We may decide that there are certain times that we should go into debt – and others when we just need to walk away from it.
This is the essence of the good debt versus bad debt debate. We know that certain debts are just plain bad. Credit cards and other types of consumer debt are in this category. Then, there other debts that we might think of as good debts - and sometimes they are, but not always. But is there really such a thing as good debt?
This is hardly scientific, but I think that before we decide that a debt is a good debt – that is, one worth taking – we should ask a few important questions to help us decide:
Is what is being purchased with the debt life-altering in a positive way?
Is there a decided absence of reasonable alternatives to taking on the debt?
Will the debt put me in a hole that I’ll never get out of?
If the answer to any of these three questions is “no”, then what we are looking to purchase will not result in anything like good debt. If we use such questions as a litmus test of the debt, we will come up with a very short list of good debts – and even then there will be limitations.
A home mortgage - within limits
There can be times when taking a mortgage to buy a home is something close to a necessity - in many cases it really isn’t. Shelter is an absolute necessity, but owning the shelter that you live in isn’t always. But if you have a growing family, you may eventually need to own a home. Or if you have a business with certain physical assets that cannot be stored in an apartment or rental home, you’ll need to own.
On the flip side, if your purpose for buying a home is to trade up to McMansion, the home mortgage-as-good-debt argument turns into a leaky boat. Assuming that your purchase is a necessity, it’s obvious that you will be unable to pay cash for the house. If you need to buy, there’ll be no alternative to taking on a mortgage. Right there, the home mortgage will improve your life in a positive way, and there really aren’t any reasonable alternatives to borrowing in this case.
So far, it looks like a good debt situation! Where home mortgages get sticky is in that last test question - will the debt put me in a hole that I’ll never get out of? The answer to this question essentially separates good debt from bad when it comes to mortgages. If you’re buying a home that fits well within your budget, you’re making a large (more than the minimum) down payment, and taking a loan will be paid off in a reasonable amount time (certainly nothing longer than 30 years), the mortgage qualifies as good debt. If on the other hand, you are buying a home is at the upper reaches of your ability to afford, putting little or nothing down, and might even need to take a 40 year mortgage, you’re probably stepping into the bad debt zone. You’ll have a mortgage that can in fact put you into a deep hole that you’ll never get out of. A debt isn’t suddenly good just because it’s called a mortgage. It’s your ability to reasonably afford it, as well as the necessity of the purchase that make the difference.
Student loans - within even tighter limits
One of the biggest problems with student loans today is that it is effectively debt without parameters. You need to qualify for just about any loan you take based on your financial position. But student loans are the exception. You can get the loans without any income, assets, or credit history, and that’s what has made so many students take on more than their share of debt.
Like housing, a college education has the potential to improve your life, and for many students there really are no viable alternatives. This would seem to make student loans good debt by default. But the problem with student loan debt is its potential to put you in a deep hole – much in the same way as over buying a house with an out sized mortgage will. Once you have these loans, they are nearly impossible to get out of. You’ll have no asset to sell to payoff the loan, and generally cannot discharge them in bankruptcy. That’s a deep hole – especially if the debt is large.
If the debt is beyond your ability to repay in a reasonable fashion, than it is not good debt no matter what else it will do for you. Even though “the system” doesn’t impose limits on how much student loan debt you can take, you need to do this yourself. Decide how much debt you think that you’ll reasonably be able to handle with or without a college degree. (Many people take student loans but don’t graduate; they still owe the debt.) If you are borrowing anything beyond this limit, you’re voluntarily accepting a bad debt arrangement.
Medical debt usually is good debt, even if we don’t think of it that way
We don’t often think of medical debt in connection with debt, good or bad. But, the incidence of medical debt is on the rise, owing to higher deductibles and greater reluctance by insurance companies to pay for medical expenses.
Unless you are borrowing to pay for elective surgery, debt that is incurred to cover medical expenses almost always has a positive impact on your life, and lacks in any reasonable alternatives. This is an expense category where you often have to take on debt even if it will put you in a deep hole. If it’s a choice between saving your life or that of a loved one, and avoiding debt, you’ll naturally choose to save the life. Does this make medical debt good debt? I think so - even if it doesn’t feel like good debt. Medical debt is virtually a category all its own. Let’s call it necessary debt.
What about car loans?
I don’t think of we can reasonably say that car loans come under the good debt label in any way. Sure, it’s close to impossible to buy a brand-new car without going into debt.
But, unlike the categories above, there’s always an alternative here. You may want a new car, but it’s unlikely that you absolutely need one. You can always buy either a less expensive new car, or a used one. With cars, it’s very possible to buy a vehicle that you can afford without going into debt at all. In fact, borrowing money to purchase a car is usually motivated by a lack of willingness to wait until we are able to afford the kind of car that we want to buy. That makes the good debt argument here very weak at best.
How about you all? How do you define good debt versus bad debt?
Share your experiences by commenting below!
***Photo courtesy of http://www.flickr.com/photos/90994597@N05/8268391582/sizes/n/in/photolist-dADEKy-acpH9H-9
