While most people are reconsidering the issue of debt, many do not know the difference between good debt and bad debt. Debt has a negative connotation to it – most personal finance bloggers boast that they are debt-free. However, it is common knowledge that sophisticated investors welcome a healthy debt ratio. After all, leveraging a small amount of cash to make a large, calculated investment will deliver outsized returns relative to your initial equity input.
As a rule, good debt is money that is borrowed for investments that will offer a return, create additional income, or generally increase your net worth and financial security. Bad debt is money that is borrowed for things like material goods that are desired rather than things that are necessary. Often the interest rates on bad debt are higher than the rates on good debt, which in itself should deter Americans from pursuing access to them.
Examples of Good Debt
1. Student Loans
Student loans are often the first debt that people incur and are an investment in yourself and your future earnings. A college or graduate degree, even a prestigious license or certification, can raise your earning power by tens of thousands of dollars per year, resulting in millions over a lifetime. Many low interest college loans are available and some may offer loan “forgiveness” in return for working in certain professions, like teaching, nursing or the military, or working in the public sector for a specified number of years.
The interest on student loans is also tax deductible and those who choose to continue their education after they begin working may be eligible for a lifetime learning tax credit or tuition assistance from their employer. Tax deductible loan interest is one of the hallmarks of good debt. It is a government incentive to borrow money for worthwhile purposes that will offer financial rewards after the loan has been paid.
2. Mortgages
Regardless of where you live, you have to pay for your accommodations. Buying a house is a long term investment that helps people build wealth. Mortgage interest rates are usually low compared to other types of debt and, like student loans, mortgage interest on a primary home is tax deductible. Unlike other purchases, real estate tends to appreciate in value and a home can be sold to help finance retirement. Certain home improvements also net homeowners tax credits which can save a bundle on income taxes.
It is important to have a reasonable down payment and to buy a home that is affordable. Generally the best mortgages are 30 year fixed rate loans, but if you can afford a 15 year mortgage comfortably, consider it. Adjustable rate mortgages often have higher interest rates, balloon payments and homeowners may have to refinance within 2 to 3 years, paying additional points for the new loan. Borrowing too much with too small a down payment or high interest rates can result in an upside down loan where the borrower owes more than the property is worth.
3. Car Loans
Car loans are hard to classify as good or bad debt. If an old car needs constant repairs to keep it running, a new car may actually save you money. If you have to borrow money for a car, consider buying a late model used car instead of a new car, since the initial depreciation on a new car can put car buyers in an upside down loan. A late model used car also usually has lower insurance payments for collision and comprehensive coverage than a brand new car.
Extended warranties are usually not the best investment, but depending on the cost of the warranty, they can save money on major auto repairs. Some dealerships offer extended warranties on certified pre owned cars and they are also available through private companies. Make a reasonable down payment when financing a car to avoid owing more than the car is worth if it is totaled in a loss covered by collision or comprehensive insurance. The insurance company only pays the value of the car, not the amount of the loan.
Finally, the absolute best way to buy a new car is if you take advantage of 0% of .9% interest rates offered by car manufacturers. If you can buy a car without paying any interest for the next 5 years, make sure to include your interest cost savings when considering which make and model to purchase.
4. Medical Bills
Another gray area, loans to cover medical bills are not really a choice. While medical debt is responsible for more than half of all personal bankruptcies, providing life-saving treatment for a loved one is more important than money. Although medical bills, not covered by insurance, that exceed 7% of your yearly income may be tax deductible, the interest on loans to pay these bills is not. Medical care for loved ones is a priority and medical debt is always acceptable.
5. Business Loans
If a business loan is likely to grow your business, it should be considered good debt. Starting a new business or expanding an existing one is always risky, so before taking out a loan be sure to do your homework to insure your plan for your business is likely to be successful. The amount of interest on business loans varies and depends on how good your credit score is, the debt to income ratio, and your company’s cashflow. Interest on business loans may be tax deductible as a business expense, but this depends on the structure of your business. To start off small, you may want to consider the best ways to make money from home before diving into a full-scale commercial venture.
Examples of Bad Debt
1. Payday Loans
Some states have taken steps to outlaw or severely restrict payday loans because these short term loans have extremely high interest. Borrowing money on a payday loan often leads to borrowing more money each pay period. This can mean chronic high interest debt and may meaningfully reduce your disposable income. Payday loans are a bad idea unless you are certain you can pay off the loan in full on the due date without having to borrow more money to get through the next pay period.
2. Credit Card Debt
Another type of high interest debt, credit card debt is usually considered bad debt, at least if you are carrying a long-term balance. If you use a credit card and pay the full amount every month, or if you only use the credit card for specific, necessary purchases with a plan to pay it off in a limited time period, this debt can be acceptable. Using credit cards to pay for things you do not need like electronics, jewelry or a vacation will almost always lead you to overpay for your purchases. The average American has more than $10,000 in credit card debt, with interest rates of between 10% and 29.99% and making minimum payments often only covers the interest on these loans.
3. Borrowing From Retirement Plans
Borrowing from retirement plans is expensive since you may face substantial tax penalties for early withdrawal. You may also face penalties, like a loss of quarterly interest, from savings institutions. You can withdraw money to make a down payment on a home, but it must be paid back within five years or penalties apply. Not only that, but you have to pay income taxes on the money when it is withdrawn early and pay taxes again when the money is withdrawn during retirement. Since you will not be able to borrow to fund your retirement, it is best not to take money from retirement accounts unless absolutely necessary. Tax penalties may not apply to Roth IRAs and 401(k)s since they are paid from after tax income.
Having manageable debt is a fact of life, but if your debt becomes unmanageable and burdensome to your comfortable lifestyle, it can affect everything from your personal relationships to your health. Avoiding bad debt altogether and paying off good debt as quickly as possible can help anyone build financial stability and a secure future. Next time you are considering taking on any type of debt, ask yourself if this financial transaction will further your financial goals and provide you and your family with a better life?
This article is a guest post from Gary Dek, a finance blogger who writes about investing, making money, saving, credit/debt, real estate, and career and education advice at Gajizmo.com. Gary has worked at an internet company on their M&A team, as well as investment banking and private equity firms in California. He graduated with a degree in financial analysis and valuation and entrepreneurship.
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