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Good Debt and Bad Debt

This article was written by in Debt Reduction. 16 comments.

Misuse of credit can destroy a family’s financial life. A household can crumble under the weight of debt, whether it has increased from a poor house-purchasing decision, a drastic change in the real estate market, a shopping addiction, an unexpected medical bill, or the lack of preparedness for an emergency. It’s no surprise people consider debt to be “bad.”

Is there any situation where debt can be “good?”

I have a problem with the good debt vs. bad debt argument. Good and bad are polar opposites, and most issues tend to sit somewhere on a spectrum between two extremes. In fact, issues don’t often sit; they can shift position. The requirement to declare anything, particularly “debt” as a concept, as either good or bad is oversimplification. There’s a tendency to want to make issues simple. Catchy soundbites reducing issues to the most basic terms attract people, and no one ever won a Presidential election while talking about nuances.

See-sawPeople who are looking to sell you something, like car salesmen, college recruiters, investment professionals, and real estate brokers, are more likely to be willing to point out how debt can be used effectively.

  • In real estate transactions, debt allows more families to afford a house, and in some cases, that could mean a healthier environment for raising children. Leverage also helps you reflect a higher rate of return if your home value increases and you decide to sell.
  • If you can borrow money at a low interest rate and use that cash to invest at a higher rate of return, you are using someone else’s money to benefit yourself financially. You can pocket the difference in interest rates or rates of return.
  • Getting a college education increases your lifetime earning potential, and going into debt for a bachelor’s degree could pay off.
  • If you work in a career where image is important, a higher-priced and otherwise-unaffordable car could help you succeed in your business.

Risk makes debt dangerous. There’s a risk that house prices go down. Since the housing bubble burst, that risk should be more apparent. Leverage may amplify your return, but it also makes losses more severe. You could lose your house. If your hot investment doesn’t pan out, you might not be able to pay back your borrowed money. If you find yourself in a career not earning much money, you could struggle to pay off your student loan debt. Using debt to focus your image doesn’t always pay off.

You can only determine whether a risk, like borrowing, is worthwhile after the fact. Hindsight provides perspective. If borrowing allowed you to triumph financially, it was “good” debt. If the debt was unmanageable or caused financial ruin, it was “bad” debt. Taking on debt to purchase an asset that increases in value would always be “good,” while using debt to finance an asset that decreases in value would always be “bad.” The problem is being able to accurately predict the future. The assets we hope will increase would be a house, an investment portfolio, lifetime earning potential, and career opportunities.

The determination of whether debt is “good” or “bad” also depends on the individual or household involved. What could be a good use of debt for one family might not be a good use for another.

There are often other options rather than increasing debt. While it may be expensive to attend an out-of-state private college, you could save money by enrolling in an in-state public college or by taking advantage of grants and scholarships. The Consumerism Commentary Podcast interview with Zac Bissonnette, author of Debt-Free U: How I Paid for an Outstanding College Education Without Loans, Scholarships, or Mooching off My Parents, can offer more insights on how to obtain a valuable college degree without going into debt.

If you are able to postpone desires until you’ve diligently saved for a purchase, you can avoid debt and its possible pitfalls. Not everyone has the opportunity to save, though. A college graduate without any money might need to buy work-appropriate clothing in order to get a job. The credit card comes out, and she buys a week’s worth of outfits to get her to the first paycheck. This may not be “good” debt, but if she didn’t earn and save enough money while achieving her degree, it could be a short-term necessity.

Then again, another way to look at this need for credit to prepare for the first week in a professional environment is an excuse for not following a solid financial plan over the course of her higher education and the start of her life as an adult.

In another example, a savvy investor could use borrowed money to invest in a business that succeeds. Financial analysts can often determine whether a risk is acceptable, and individual investors can use the same approach. For example, if you could borrow a sum of money at an introductory rate of 0% APR on a credit card for 12 months with no fee, as new customers of this Discover More Card offer can do right now, deposit that in a savings account with 1% interest, you can keep the proceeds as long as you pay the credit card bill on time each month and in full by the end of the introductory period. Back when interest rates were higher, this “credit card balance arbitrage” was a more worthwhile endeavor.

Today, however, most investments that would make borrowing money from a 0% APR credit card worthwhile are riskier than a savings account. Even when the safe interest you could earn was more favorable, there was always a risk of missing a credit card payment and owing penalties and interest to the issuer. If you completed the arbitrage scheme and succeeded in increasing your bank account balance, you’d consider that debt to be good. If not, the debt would be bad.

Do you believe that all debt is bad debt, or are there some situations where it’s worthwhile to pay interest and accept the risk of defaulting?

Updated May 5, 2014 and originally published January 10, 2012.

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About the author

Luke Landes is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about Luke Landes and follow him on Twitter. View all articles by .

{ 16 comments… read them below or add one }

avatar 1 Anonymous

Like you said, it’s going to be relative. Yes, there are situations where someone goes in to debt and eventually comes out with a profit. Then they look back and think of that as good debt. Other times they’re not so fortunate, and it’s bad debt.

I would say student loans are most often considered good debt, but even there it will come down to what you do with your degree.

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avatar 2 Anonymous

I would replace the words ‘good’ and ‘bad’ with ‘acceptable’ and ‘not acceptable’ debt. I think acceptable debt includes mortgage debt (only after you are able to put 20% down) and student loan debt (limited to a few thousand dollars per year) and maybe a car loan (if you put at least 20% down and take no more than a 3-year term). Just my $0.02.

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avatar 3 Luke Landes

I think acceptable vs. unacceptable could be a good way of looking at it. 20% down on a house has become a de facto standard, but why? Why is fine to be leveraged at 80% but not 81%? It’s arbitrary… And different households have different situations.

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avatar 4 Anonymous

To an extent, I agree with Money Beagle about “acceptable” vs. “not acceptable” – I have two rental houses with mortgages, and I view that debt as “good debt” since I make a profit on both houses; that said, they’ll make more profit when the debt is paid off, so I guess that means it would be better NOT to have the debt. On the third hand, the interest rate on both mortgages is SO low (less than a third the rate of return I get on the houses in the first place) that if I can borrow more money at the mortgage rate to buy more houses, I absolutely will; and in the future, if I can makes significantly more in an investment than I would pay in interest on a line of credit against one of these rental houses, I would absolutely take out the line of credit.

So, I definitely feel there are many “acceptable” debts that can easily be considered “good” by the holder.

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avatar 5 Anonymous

In a perfect world, we wouldn’t need debt, because over-regulation and taxation wouldn’t rob the average worker of more then 50% of his/her income. That being said, we have to live in the world that we actually live in, and that requires good credit – and much to my dislike – some borrowing. I too reject the words “good” and “bad” and would replace them with “probably necessary” and “absolutely ridiculous” – with a sliding-scale in between. Thanks for the thoughtful post on the subject. Rock on! -NCN

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avatar 6 Luke Landes

Thanks for your comment, NCN! Without credit, in this hypothetical world, we’d probably be living a much less rich life. Housing developers would have to build houses people could afford with cash, ending McMansions for the middle class. The gap between the wealthy and the working middle class and poor would increase. Credit helps level the playing field in the consumer economy, but it comes at a cost…

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avatar 7 Anonymous

Interest and taxes reduce money available for spending. Spending drives the economy, taxes and interest simply increase the size of banking monopolies and government. Eliminate even HALF of the average Americans tax burden – and eliminate the burden of debt – and folks would have MORE than enough money to buy homes, invest, and grow the economy. Some, limited use of credit would always exist – but it wouldn’t have to be the norm. The current financial situation of our country proves (at least) one thing – Even very, very smart people (educated at some of our finest colleges and universities) are foolish when it comes to the use of credit. In a very short time, the use of credit can become addictive, for individuals, companies, and governments.

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avatar 8 qixx

I tend to look at it as all debt is “good” debt. It is the poor use of that “good” thing that makes it seem bad. OR another way to look at it is debt is neither “good” nor “bad” ever. I’ve been told my view seems a lot like this view than an all debt is good view.

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avatar 9 Anonymous

One of the intersting things about debt is that you can load up huge, and if you die, you don’t have to pay it back!

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avatar 10 Anonymous

Haha isn’t it interesting how it works.

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avatar 11 qixx

The estate does have to pay them back if you wanted to leave anything to those after you’ve gone. And just because you don’t have to pay it back does not mean the credit company (or someone who buys the debt) won’t harass your family in an attempt to get them to pay your outstanding debt.

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avatar 12 Anonymous

You personally don’t have to pay it back though. Your dead, it’s no longer your responsibility.

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avatar 13 Anonymous

Flexo, the examples you gave are for things that have the potential to become good debt. So many people actually go into debt for things that have no potential to become good debt. Some people actually put vacations on a credit card knowing they won’t be able to pay it off right away. I’m also thinking of college students who use credit cards to fund a lifestyle they can’t really afford. It’s one thing to put legitimate expenses on credit, but living large on a credit card is really irresponsible, in my opinion.

Taking out a mortgage on a house can be good debt, but these days much more caution is wise. If you are living in a dangerous area, you need to think of every option to change that circumstance, especially if you have a family. But buying a house is not the only option.

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avatar 14 Anonymous

Great topic to discuss. I was in debt with my college degree. However, without that degree, I wouldn’t have gotten the job I have now. So that debt was good debt. Other than college, I try and not getting anything unless I have the cash to pay for it. What are your thoughts on someone going into debt on a wedding ring? :)

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avatar 15 Anonymous

Let’s take a look at an example of “good” debt. Borrowing for or from a depreciating asset is generally considered bad debt but leveraging an appreciating asset can be good debt. Even though there is always risk involved, paying some substantial medical bills by borrowing rather than cashing in an investment account might, in the long run, increase rather than decrease your bottom line. Right now interest rates are low and even though investment value has been relatively flat, dividends are still flowing. If those dividends (and even minor value increases) are greater than the interest expense you’re “in-the-money”. I did this is 2009 and even though the market value of the investment account has only gone up a little the dividends received add up to $5,134 more than my entire interest expenses. If the trend holds – in two years my bottom line will have increased rather then decreased once the debt is paid off.

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avatar 16 lynn

For some families, no debt is good debt.

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