Not all debt should be avoided.
We’re constantly reminded that being in debt is bad, and getting out of debt as fast as possible should be a top priority. There is certainly a difference between good debt vs bad debt. There’s a good reason not many people enjoy being in debt, and some types of debt certainly should make us nervous. However, there are a number of good arguments for taking on certain kinds of debt.
Good Debt vs Bad Debt: What’s the Difference?
Most people know that some forms of debt are almost universally bad ideas. Borrowing via payday loans, buy-here-pay-here car lot financing, high-interest personal loans and credit cards that aren’t paid off every month are great examples of debt.
You should be reluctant to assume these types of debt. Debt like that often traps people in a spiral of increasing interest payments. This can be difficult, if not impossible, to recover from.
So, what is good debt and bad debt? A simple way to explain good debt vs bad debt is Robert Kiyosaki’s quote, “Bad debt takes money out of your pocket. Good debt puts money in your pocket.”
Good Debt
However, some debt actually helps your financial situation! Taking on manageable debt, such as credit cards that get paid off on time can be helpful. It helps credit bureaus see you as a good risk. Establishing a track record of regular, timely payments on debt builds your credit history.
A solid credit history of good debt vs bad depth increases your ability to borrow money when you need to.
It’s not uncommon for high-income individuals to avoid taking on debt simply because they don’t need to. Instead, they can pay cash for just about anything they need or want. But when those people are ready to make larger purchases for which they need to borrow money, they might be surprised with rejections. This is because they haven’t established a history of paying down debt.
This can be especially true for successful small business owners who earn enough to pay cash for most purchases. Because business owners don’t generally draw a guaranteed income, lenders often consider them a higher risk than regular salaried employees. Combine that with a lack of credit history, and even very well-off business owners can find themselves struggling to get approved for loans.
If a business owner intentionally takes on debt and makes regular, on-time payments, lenders will see a loan to them as less risky. They’ll be more likely to approve loan applications.
There are even ways to make money with debt. If you have a large purchase to make for which you could pay cash, you could instead take a loan for the purchase. Then, you could put the cash into an investment with a higher rate of return than the interest payments on the loan. The money you would have spent to make the purchase would instead earn you interest!
Your overall gain will be reduced by having to pay interest on the loan. But the alternative is to pay cash for the purchase up front, and not have that money available to invest.
Good Debt vs Bad Debt Examples
When looking at good vs bad debt you need to understand that these examples are not an exhaustive list.
Good Debt Examples
These are some common examples of good debt:
- Mortgages: With a mortgage, you are able to purchase a home, an asset which can appreciate in value over time. As the property value increases, so does your equity, potentially leading to financial gains down the road. You may also benefit from tax deductions on interest payments made on the loan. For these reasons and more, mortgages are often seen as good debt vs bad debt that can be leveraged for long-term success.
- Business Loans: Borrowing money to start or expand your business can result in greater returns. The capital provided can be put towards investments that will eventually lead to increased profits and successful growth. With the right repayment plan, a loan can help you leverage resources and provide the opportunity for long-term success. This is what makes it good debt and not bad debt.
- Student Loans: By investing in an education, you can gain valuable knowledge and skills that will open up new opportunities for career advancement and higher earnings. As such, student loans can be seen as good debt and not bad debt as they offer the chance to gain an education that will pay dividends in the future.
Bad Debt Examples
These are some common examples of bad debt:
- High Interest Car Loans: High-interest auto loans may seem like a great option in the short term, but they can quickly turn into a nightmare. Due to rapid vehicle depreciation, you may end up owing more on the loan than the car is worth. It's important to know your options and understand the risks of high-interest auto loans before you commit.
- Consumer Loans: Taking out loans for purchasing depreciating assets can be a risky decision. Not only do these items lose value quickly, but it can also be difficult to pay back the loan in full. It may seem tempting to take out a loan for items such as electronics, vacations, or clothing. This is considered bad debt as the cost of repaying the loan will outweigh any potential benefits from the purchase. This type of consumer debt is generally not considered good debt, but bad debt.
- Payday Loans: When you need quick cash, these loans can be tempting. Unfortunately, these loans have the potential to create a trap of bad debt that’s difficult and expensive to escape. With fees and interest rates that quickly add up, people are often left with more debt than they started with. This makes this type of loan one of the riskiest forms of borrowing.
When Good Debt Turns Bad
A word of caution: Good debt can turn into bad debt if you aren’t careful. Let’s explore an example of good debt turning bad. Credit card debt is good until you are unable to make complete monthly payments. Once that happens, you begin losing money because of interest charges. This is something to keep in mind when thinking about good debt vs bad debt.
Credit card interest rates are often higher than 20%. It’s hard to find a lower-interest credit card because most cards today offer points. While marketed as essentially free money, credit cards quickly become expensive if you must pay interest on your charges! That “free money” is financed by people who pay those high interest rates.
Another trouble spot for credit cards is when people tire of paying the high interest rates. Instead, they refinance the debt via a low-interest home equity line of credit. This is a very dangerous tactic. If you reach the point where you are unable to pay your debts, you can discharge credit card debt through bankruptcy.
However, if you refinance your credit card debt to one secured by your house, you could lose your home if you can’t pay. Think very carefully before risking an asset like your home by using it as collateral to pay down debt.
Which Debt to Pay First?
If you have bad debt and good debt, you might be wondering which one you should prioritize. While good debt can help you make money, bad debt racks up high interest rates.
How do you know if you should prioritize bad debt vs good debt?
It depends: a common strategy for debt repayment is to pay off debts with the highest interest rates. This often includes bad debt, and you save money on interest over time.
However, if you haven’t built the habit or pattern of paying off debt, it may be better to start with smaller debt. This can help you to build momentum and motivation. You may pay more in interest overall, but it can be psychologically rewarding and help keep you on track.
A financial advisor can help you establish a debt repayment plan that makes sense for your life. You don’t have to worry about if you should pay your bad debt vs good debt on your own. A solid strategy can help you reduce your risk and recover from financial strain.
Debt is Complicated: Seek Guidance
We’ve seen how debt, despite its reputation as being a universally bad idea, can be good. It can also be necessary to accomplish your financial goals. Wise use of debt can give you access to milestones like mortgages or car loans when you need it.
But you must be careful not to take on more debt than you can keep up with. At Asset Preservation Wealth & Tax, we help our clients understand the difference between good and bad debt. We counsel them on using good debt vs bad debt as a tool to accomplish their goals.
It’s always a good idea to consult with a professional when considering financial moves like using debt to your advantage. With proper guidance, you can make well-planned debt moves to improve your access to capital without undue risk to your financial future.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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