What’s the difference between good debt and bad debt?

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What’s the difference between good debt and bad debt?

Debt is complicated. Much like The Force, debt has a light side and a dark side. We generally tell people it’s a bad idea to be in debt, but that viewpoint is too simplistic. Case in point: we tell teenagers to take tens of thousands of dollars in loans to pay for college.

Unfortunately, there’s not a lot of education about debt out there, and most people don’t figure out the difference between good and bad debt until they’re struggling to pay off a high interest credit card.

What is good debt?

When you use debt to buy something that may increase in value or otherwise have a large return, that’s "good debt." Of course, put the word "good" in scare quotes – some personal finance experts would rather refer to it as "better debt" versus "worse debt," with the understanding that all debt is inherently bad.

Also note that good debt is called "good" because it allows for potential growth – financial growth is very rarely guaranteed, and there’s always some built-in risk to taking out debt.

Let’s run through some examples:

Mortgage

A house isn’t just a house: it’s one of the most significant financial investments you’ll ever make. The most basic strategy when it comes to real estate investments is to buy a house, live in it for thirty years, and then sell it and use that money for a retirement yacht.

A mortgage can also help you maintain a good credit score – as long as you keep making your monthly payments on time, you’ll be considered a dependable lendee.

Another big reason mortgages are considered good debt? Your interest payments are usually tax deductible.

Is there risk? Yes, of course – you can’t assume that housing prices are going to rise, and any number of factors could affect your home’s price in thirty years. Short-term investments are risky too – if you sell your home and it’s not enough to pay back the bank, you could be on the hook for multiple mortgage payments.

Student loans

Yep – despite the massive student loan crisis everyone keeps talking about, student loans are still generally considered to be good debt. Statistics show that the more education you have, the higher your yearly salary will be. While this doesn’t hold true across all career paths, it’s commonly accepted that you really need at least a Bachelor’s Degree if you want to make it in America these days.

Like with mortgages, interest payments on your student loans are typically tax deductible.

Is there risk? Let’s put it this way – Go to state school and get your degree in computer science? You’ll probably be able to pay off your loans. Go to a more expensive private school and get a degree in just about anything else? You’re going to have a tougher time making monthly payments once they start rolling in.

Small business loans

You start a business to make money. You get to be your own boss, too, but that’s just a side benefit compared to making (hopefully) more money than you would as a salaried employee. Depending on the scale of your ambitions, a small business loan is one of the best ways to get the capital needed to ramp up your new business.

Is there risk? Fifty percent of new businesses fail within the first four years. So yeah, I’d say there’s some risk.

How to tell if your debt is good debt

To figure out if your current or new debt is "good debt," ask yourself a few basic questions:

  1. Does what I’m buying have the potential to increase in value?

  2. Are the interest rates low?

  3. Are payments on the interest tax deductible?

If you can answer yes to at least the first question, most people would probably qualify it as "good debt." However, to really solidify it, try to be able to answer yes to either one (or both) of the other two questions.

What is bad debt?

When you use debt to buy something that immediately decreases in value, that’s considered bad debt. Bad debt is the worst kind of debt you should have – it is nothing but a drain on your finances, and should be eliminated ASAP.

Let’s run through a few examples of bad debt:

Credit card debt

Surprise, surprise.

Here’s the correct way to use credit cards: only charge what you can afford to pay off each month, and then actually pay that off so that you don’t have to pay interest on it.

Here’s the way most people use credit cards: charge a bunch of stuff they can’t afford, then pay the monthly minimum and shove their fingers in their ears.

It would be one thing if any of that debt was used to something that could potentially grow in value, but most people use it to buy gasoline, groceries, and clothes – things that either immediately lose value or are consumed entirely.

If you already have credit card debt, check out our article on how to pay it down.

Auto loans

You know how a new car immediately loses value when you drive it off the lot? That’s the big reason against taking out an auto loan. By the time you’re done paying your loan, you’ll have paid more than the sticker price for a car that’s likely worth less than half of what you paid for it.

It makes much more sense to buy a used car. Then, put the money you would be paying on an auto loan into a bank account and save for a slightly better used car, which you can afford within the year. Keep doing this until you have enough for a pretty nice used car.

And if you already have an auto loan? You should start moving aggressively to pay off the remaining balance.

How to tell if your debt is bad debt

All you have to do is answer one question:

  1. Is what I bought with this debt worth more than it was than I bought first bought it?

If the answer is no, you officially have some bad debt.

Getting out of debt

Need a little help getting out of debt? Check out some more of our resources:

-> 6 steps to pay off your debt

-> 7 ways to take control of student loan payments

-> Meet Earnest, a good student loan refinancing company

-> Budgeting 101: your basic needs

Image: TangoPango