Is Low-Interest Debt ‘Good Debt’?

For the past several years, the United States has been in a period of very low interest rates on many types of loans. Home loans can be had below a 4% interest rate – that’s substantially below what’s normal historically. Car loans are at a similar low point in terms of interest rates, too.

Because of these low rates, many financial gurus like to talk about the idea of “good debt” and “bad debt.” They often separate these debts based on some combination of interest rate and purpose into two categories, one of which usually includes a home mortgage and student loans (and perhaps a first car loan), and another which includes everything else, particularly credit cards.

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In earlier times, the logic was that you should pay off all of your debts as fast as possible and strive for debt freedom. The logic then, however, was based on the fact that interest rates were relatively high. Home loans below 4% haven’t really ever existed before this for extended periods.

So, it comes down to this. Is there such a thing as a “good debt”? Or is the traditional view that all debts are “bad” a reasonable view?

Here’s my take on it.

First of all, my feeling is that debt itself, regardless of interest rate, is a shackle. You’re locked into debt payments each and every month, regardless of the interest rate. Those payments require you to have a higher income level in order to pay them off than you would need to have without that debt.

Think about it. If you have a credit card debt that requires a minimum payment each month of $100, you need to be bringing in $100 a month more than you would without that payment. If you have a car payment that requires you to make a $300 payment each month, then you need to be bringing in $300 a month more than you would without that payment.

That same phenomenon is true for every debt that you have.

The counterargument against that is that the item you’re getting from that money you borrowed is both valuable enough and easy enough to sell that if you were in a pinch, you could recoup the borrowed money, or else that the item you bought is necessary for you to earn money.

So let’s walk down that road a little bit.

A student loan is basically illiquid. You can’t sell what you get from a student loan to anyone, at least not directly.

The idea behind a student loan is that you’re going to get education and certification because of that investment, and that education and certification is going to increase your income enough to pay for the student loan itself, the interest on that loan, and the lost wages from the time spent studying.

That’s not always a guarantee, though, and that’s why we see many students in situations where they’re buried beneath a mountain of student loans and having to use other forms of debt just to keep their heads above water while they pay off those debts.

It works out well for some. It does not work out well for others.

Is it a “good debt,” though? I think that a student loan is a reasonable option on the table, particularly for someone who knows why they’re going there and what they wish to study, and has the internal skills to make the college experience a success. In other words, it is possibly a “good debt” for the right person, but it’s often not a “good debt” at all.

What about a home loan? A home loan uses a house as collateral, meaning that if you can’t pay the debt, they take the house. I tend to view all home loans as essentially “rent to own” arrangements, where you agree to rent the house from the bank for a certain number of years upon which you’re handed the deed to the house.

Most of the time, a home grows in value over time at a fairly slow rate (in some situations, it’s faster growth; in others, it can drop in value), which means that when you sell it, you’re going to theoretically walk away with more cash than you put into it.

But is that a good debt? Well, you’re going to have to pay for housing one way or another, so I think a mortgage on an entry-level home is a good debt. However, I think a mortgage on a home that’s anything much above an entry-level home stops being good debt for the reason described above – it forces you onto a high-wire act where you have to have a high income to keep paying the mortgage.

My feelings on a car loan are similar. If you don’t have a car and need one to get to work, a car loan to get you a car is better than nothing at all. However, having said that, a car loan to buy a nice car isn’t what I would call good debt.

A car loan to buy a new car is actually a pretty significant financial mistake, as the second you drive the car off the lot, the car immediately depreciates significantly and you’re underwater on that loan. You have to make a significant number of payments to even have the possibility of being able to escape them, and those payments are often quite high. Plus, you’re facing the challenge of having to sell that car if you’re in a financial pinch.

What about investments, then? Many people encourage the use of debt in order to invest. For example, some might argue that an opportunity to borrow money at 4% to invest in something with an average annual return of 7% is a good idea.

I think this is an awful idea, at least in terms of personal debt. There are situations where you might wish to do such a thing within the structure of a business for which you are not liable, but if you do this personally, you’re putting your personal finances at serious risk.

Why? You might earn more in investments, but past performance in investments is never a guarantee of future returns. While you’re hoping for those returns, you’re locked down in debt payments — and if that investment ever goes awry or you can’t pay those bills, you’re going to be in an awful financial state.

The only debt I would remotely call a “good debt” is one that is purely to get you started. It takes care of a basic need, like just getting back and forth to work or keeping a roof over your head. A student loan might qualify here if you’ve taken care of every possible prerequisite you can outside of school, you know exactly what you’re going to study, and you’re going in as prepared for success as you possibly can; a big debt to “find yourself” is a mistake because you can engage in that without going into debt (like saving up to backpack around the country or around Europe for a while).

Debts for things like a nice car or a home that’s anything bigger than a starter home are not good debts. They might be debts that you’ve convinced yourself that you need, but that does not qualify them as good debts.

Again, the reason is that you’re locking yourself down into the high-wire act of debt payments for something you purely want. A brand new car is a want, not a need; a very basic used car might arguably be a need. A large home is a want, not a need; a very basic starter home might be a need in some situations.

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Going into debt for something you want and don’t need is merely an amplification of something that’s already a bad choice. The bad choice in question here is buying something that you want when you can’t actually afford to do so. When you can’t afford to do it and buy it anyway, that’s a mistake; when you have to use debt to do so, it’s a mistake that will haunt you for a long while.

So, is there such a thing as “good debt”? In my view, there is, but it’s very narrow. It’s for a entry-level used car or a small starter home or schooling that you’re primed to succeed at. Debt for pretty much anything else is a debt for something you want, not something you need, and that’s never a good trade for the kind of high wire act that such a move introduces into your life.

Good luck!

Trent Hamm

Founder & Columnist

Trent Hamm founded The Simple Dollar in 2006 and still writes a daily column on personal finance. He’s the author of three books published by Simon & Schuster and Financial Times Press, has contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and his financial advice has been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.