When you hear people talking about good debt vs. bad debt, you may wonder what they mean. After all, isn’t all debt bad? Isn’t it always better to pay for your purchases in full?
Theoretically, if you never needed credit, this might be true. But the fact is, most people need credit extended to them at some point. Even those people who pay cash for their cars will probably need a mortgage one day. And most consumers enjoy the convenience of using a credit card to shop online and to track their purchases, even when they pay the bill in full each month and don’t carry any debt.
So one of the first examples of acquiring good debt that consumers usually encounter is getting their first credit card in order to establish credit. If you have no credit cards, no loans and no debts, it’s fairly easy to get a credit card, because you are not much of a risk.
But if you want to borrow money — say, $15,000 to buy a car — and you have no credit history, and thus no credit score, this can be a problem. Perhaps previously you always went to the Bank of Mom and Dad when you needed money. This has its advantages — like no interest! But one disadvantage is that there is no official record of you paying back the money. (In fact, you may not have paid it back, and there isn’t a documented record of that, either.)
So in order to gain a reputation as a good credit risk, you need to borrow some money and pay it back. A good and easy way to do this is with a credit card. Even if you aren’t a spendthrift and you’re a good budgeter, if you’re the sort who’s a bit disorganized, be careful to set reminders to make your payments on time. One late payment could seriously set back your plan to establish credit in your name.
Beyond establishing good credit, determining whether a debt is good or bad will depend on your financial status and particular situation. Under some circumstances, getting the money or an item you need may be worthy of creating a debt, and may, in fact, be considered a good debt. However, unnecessary or avoidable debt is bad debt.
Good Debt vs. Bad Debt: Sometimes, It Depends On Circumstances
1) Car Loans
Although it is better (read: cheaper) to pay cash for a car than to finance it, not everyone has this luxury. But your established credit will allow you to get a lower interest rate on a car loan, should you need one.
On the surface, a car loan seems bad. A car costs a lot of money, and you will pay a hefty chunk of interest on a loan to finance it. According to Kelley Blue Book, the average cost of a used car today is $19,400. Used-car loan interest rates are almost twice that of new car rates — 8.5 percent. So the average used-car loan will cost you $4,481 over five years.
The average price of a new car is $33,525, and the average interest rate is 4.5 percent, so the total interest you would pay over five years is $3,975. Your car payment, however, would be $625 for this loan, versus $398 for the used car.
The used-car/new-car debate has raged on for as long as there have been cars. Some people swear by new cars, and some would never buy one. A new car loses value the moment you drive it off the lot, meaning that the newness factor is worth money. You can avoid paying this by buying used, but no two used cars are alike. You could have bad luck with a used car and end up paying a lot of money for repairs, and this is one of the reasons interest rates are so high with used cars — they’re risky.
Whether a car loan is a good debt or a bad debt to take on depends on whether you need a car, or whether you need that car. For instance, if you need a car to get to work and yours breaks down irreparably, taking on a car loan is good debt, because otherwise, you would not be able to work. Which type of car you choose, how much it costs, whether you can afford it and how long it takes you to pay it off are all part of the good/bad decision-making process.
2) Student Loans
Another example of what might be considered a good debt is a student loan. This may be hard to believe, with all the talk today about the evils of student loan debt. However, any debt that you take on to make money is good debt. Like the example of the car you need to get to work, a student loan finances an education you need to get a better job and make more money.
The controversy over student loans is based on the skyrocketing cost of an education. Most experts would likely agree that education is a worthwhile investment. But how much should you invest? $10,000? $20,000? $200,000? There must be a limit. But it’s hard to say what it is.
If your goal is to make big bucks in business, an MBA from Harvard will likely open more doors for you than one from a little-known school. So sometimes the extra cost is worth it. But it’s hard to tell when.
Roughly speaking, it’s probably foolish to take on tens of thousands of dollars’ worth of debt to prepare yourself for a career in a low-paying field. Noble though it may be, it doesn’t make fiscal sense, so in some situations, a student loan may be considered bad debt.
Good Debts to Have
1) Mortgage Loans
A mortgage is an example of good debt. The interest on a mortgage almost always ends up costing you more than the principal on the loan. This can be a shocker to first-time home-buyers. Interest on home loans is low compared to car and student loans, but a mortgage takes a long time to pay — usually between 15 and 30 years. However, during this time, the value of real estate generally increases enough so that you make a worthwhile profit when selling the house.
If you bought the house with the cash you would save significantly on interest, but few people have enough money saved up to pay cash for a home, so in most cases, this is unrealistic. Because real estate almost always appreciates in value, taking on a mortgage is considered good debt.
2) Small-Business Loans
Taking out loans to finance the startup of your business can also be an example of a good debt. Forbes says 8 out of 10 new businesses fail within the first 18 months, which is a pretty dismal rate. But success is possible, and many people make millions in their business ventures, so budding entrepreneurs keep trying. Your chances of success are based partly on luck and partly on your idea for your startup. Good ideas have better chances of succeeding, but what makes an idea good is subjective.
When you apply for a small business loan, you will be at the mercy of this subjectivity, because if the lenders don’t like your idea, you won’t get the money. Alternative funding methods include taking out a personal loan, which may be a good option if you don’t need a lot of money to start your business. And of course, you can consider investors, friends or relatives for help with your funding.
Bad Debt: Credit Card Debt
Credit card debt is almost always bad. A credit card is good to have for emergencies and to use in places that don’t take cash, like car-rental agencies and Sweetgreen. You should only charge purchases on your credit card that you can pay for when the bill comes.
It is possible for some credit card purchases to be considered good debt. For instance, if you are in an accident and need medical care but don’t have insurance, a credit card could cover the cost. Your health is always more important than money.
You might be able to put your college tuition on your credit card, but it would probably be cheaper to take out a student loan. Paying for car or home repairs like a broken furnace is another type of emergency you may put on your credit card.
It’s better to have an emergency fund in times of crisis because it helps you avoid interest fees, but sometimes there are more emergencies than funds. If you get caught in a trap where you’ve maxed out your credit cards, whether due to emergencies or bad choices, you may want to consider debt consolidation. But is debt consolidation good or bad? It can be either. Check out this National Debt Relief article to see whether a consolidation loan might be a good choice for you.
When you’re considering good debt vs. bad debt, you must weigh the risk that the debt will work in your favor. Good debt is debt that will eventually net you more than you pay back.