Good Debt vs. Bad Debt

IMG_35882 by eric731 on Flickr!One of the most common ideas that personal finance writers bring up is the distinction between “good debt” and “bad debt.”

There are several fairly similar definitions of each kind of debt, but generally they either revolve around the terms of the debt (low interest rate debts – usually below 7% or so – would be “good debt”) or the purpose of the debt. For example, debt taken on that allows you to purchase an asset that retains value (such as a house or an education) is often considered “good debt” while debt that is used to purchase things that rapidly decrease in value or have no tangible value at all (like credit card debt) is considered “bad debt.”

My take? I think the idea that there is debt that is inherently “good” and there is debt that is inherently “bad” is wrong. It’s fairly simple to find example where a debt that is “good” in one situation is “bad” in another.

For example, take a person living in New York City with all of their friends and family available via train or subway stops. For that person, a car loan is almost assuredly a “bad debt.” However, for a person that lives in rural Wisconsin with their job more than forty minutes away, a car is necessary for employment, so a car loan is probably a “good debt.”

Another example? A debt at 7% when the Federal Reserve has the interest rates high (as they were circa 1980) enabling you to buy CDs at 11% (as they were circa 1980) is almost assuredly “good debt.” However, a debt at 7% now with interest rates as low as they are is almost assuredly “bad debt.”

In a nutshell, I don’t buy the “good debt” versus “bad debt” idea. That doesn’t necessarily mean I think all debt is “good” or all debt is “bad,” I just disagree that there are clear rules that tell you when debt is okay and when it is not. Instead, if there really is a distinction between good and bad debt, I argue that it revolves around the distinction between want and need.

Here are a few principles to consider.

Know the difference between wants and needs. You should never take out debt for something you want, though you may be in situations to take out debt for something you actually need.

For example, if you’re taking out a loan to buy a car because you need it, don’t get a bigger loan to get a “sweet” car because you want that nicer car. Go with a lower-end model that serves your need.

Sometimes telling between wants and needs is easy. You don’t need things that are for entertainment purposes only. You don’t need high-end versions of expensive items. Those are things that you should save for, not incur debt for so you can have them now.

Another example: my wife and I took out a home loan after much discussion because, with a young child and another one on the way, we were simply running out of room in our tiny apartment. Our loan rode the fine line between want and need – we bought a larger house than we needed at the moment (but far smaller than what we could have been approved to buy), but we also anticipate having more children.

Spend less than you earn. Every single pay period, you should strive to spend significantly less than you earn. That gives you a large amount of “left over money” which you can then save for the future – and, yes, some of that savings can be for items that are “wants.”

Practice patience. Many people get into debt trouble simply because they are impatient to acquire the things that they want.

Instead of waiting until they have the cash in hand to buy that flat-screen television, they put it on the credit card, pay it off in bits and pieces (fighting against a 19% APR), and wind up spending a huge premium just to have it now.

Alternately, they could start saving now, actually save less than the cost of the television (thanks to interest rates in the savings account), and purchase the television with cash, incurring no debt.

A few months of patience can save hundreds of dollars, and it can also provide time for shopping around for the best price on the item, saving hundreds more. Patience, particularly when it comes to wants, pays huge dividends.

From my perspective, it’s not so much a matter of “good debt” and “bad debt” – it’s a matter of knowing the difference between wants and needs, planning ahead for both, and being patient, particularly when it comes to wants. With those principles in hand, you’re much more likely to find success managing debt than by following a generic list of “good debts” and “bad debts.”

Trent Hamm

Founder of The Simple Dollar

Trent Hamm founded The Simple Dollar in 2006 after developing innovative financial strategies to get out of debt. Since then, he’s written three books (published by Simon & Schuster and Financial Times Press), contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.