A long while ago, I wrote about the idea of 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.”
Since then, I’ve started questioning whether or not there is ever a good debt. Is any debt good?
Let’s look at some specific situations where people might argue that a loan is a good idea.
What about a car loan? Many debts that are considered “good” are often solved by making lifestyle changes, such as moving to a different location, switching jobs, or looking for alternative housing. There are occasional rare situations where a debt is truly the best option, but most of the time, there is a simple lifestyle change that will keep you out of debt. For example, if you don’t have a car and you must have one in order to get to and from work, a car loan might be a “good” loan. Of course, if you’re in a situation where you don’t have a car and you don’t live near where you work, moving closer to your job might make more sense than taking out a loan.
What about a 0% interest loan, like a special cash advance offer on a credit card? That could also potentially be a “good” loan. With a loan like this one, however, you will eventually have to pay back the full balance, which means taking on risk when investing it or settling for very low returns. You’ll also have to invest some time in getting the loan and making sure it’s repaid, which might make the small returns for safe investment not worth it. This type of loan might be useful in reducing the interest burden when repaying other debts (such as using the 0% interest loan to repay the balance on a high interest credit card), but it’s not a good deal on its own. I don’t even view this as additional debt, just a debt transfer to a lower interest situation.
What about business loans? As long as you are keeping the risk of a business loan separate from your personal finances, there are many situations where business loans make sense. In those situations, however, it isn’t you personally that’s liable for the debt – it’s the business. I would be extremely wary of business loans that leave you personally liable if things go wrong.
What about a quick profit situation, like a real estate loan where you can quickly flip the property you buy? I would put that under the umbrella of a business debt.
What about a student loan? If you have a clear understanding of the path you’re going to take and are committed to that path, then a student loan makes sense as a method of significantly increasing your long-term earnings. I wouldn’t take out a student loan until I had some idea of what I wanted to do, however. A student loan is a good debt if you have a clear plan and are committed to that plan.
What about a home mortgage? You’re going to have some expenses related to living no matter what you do. If you can find a situation where a home mortgage and the extra costs of home ownership add up to a monthly cost comparable to what you would get with renting, then a home mortgage can be a sensible move. A home mortgage can be a good debt if your monthly living expenses don’t inflate significantly when switching from renting to owning.
These scenarios cover many of the common situations people might find themselves in when it comes to debt. If you’re ever in another situation where you’re considering taking on personal debt, consider these three things.
First, is this something I actually need? Unless the item you’re considering is something that you truly need to survive, going into debt is a pretty poor idea. Most things we think of as needs are actually “wants.”
Second, is there a lifestyle change I can make that will meet the need I’m trying to address? If you need transportation, moving might make more sense. If you need a change in physical location, a different rental arrangement might make more sense.
Finally, do I need it now? Is this something I can delay to a later date? For instance, if your car can last for a while longer, start saving as much as you can now so that you can pay for a replacement in cash in several months or a year.
Good debts do exist. They can provide opportunities and benefits that simply don’t exist without debts. The personal finance problem many people have is that they use debt to solve problems in their life where debt is not the best tool to use. Rather than looking at lifestyle changes or delayed gratification, they use debt.
Don’t use debt to solve your problems unless you’ve seriously considered every other alternative. Debt is never good if you’re not considering all the options.