My stance on debt is rather firm. I think that for the most part, if you can’t afford to buy something with cash, you shouldn’t buy it at all. At the same time, I realize that not all debt is created equal. In fact, you may have heard others use the phrases “bad debt” and “good debt” to describe different types of debt. This would imply that certain types of debt are actually beneficial. Is there really such a thing as good debt?
I Wouldn’t Call It Good Debt…
Credit allows us to buy things without having the full amount of money to pay for them. It gives us the ability to use them right now, at the expense of additional cost in the form of interest. Debt also allows us to spread payments over a period of time instead of having to pay all of the money upfront. Debt adds convenience.
Debt can also be used for its leveraging power. If the borrowed money is used productively to generate more money, it can create a powerful combination and result in larger profits. Of course leveraging through the use of debt can lead to equally large losses if the plan falls through.
Convenience and leverage are what makes certain types of debt beneficial. This so-called good debt can actually be used to help you reach your financial goals faster. I dislike using the term good debt because I feel it is often misused to classify potentially harmful debt as “good”. Nevertheless, some types of debt are better than others. Let’s look at some examples.
Typical homes cost a lot more money than an average family has in savings. It may take somebody decades to save enough cash to buy a home. At the same time, we all need a place to live. Renting can solve the problem, but it does nothing to increase your own net worth. It is simply an unrecoverable living expense.
A mortgage can allow you to purchase your own house much earlier in life. The down payment is all that is needed up-front. Due to interest, you will end up paying more for the house, but mortgage rates are typically low. You will also increase your home equity and net worth with each monthly payment.
While a mortgage may be considered good debt, it shouldn’t be treated lightly. Do thorough research to make sure you are getting the best mortgage rates before committing.
Many college graduates struggle with paying off their student loans. Financing a 4-year education in a private school with student loans alone is probably not a good idea. But if used in conjunction with other payment methods, such as federal student aid or scholarships, they can help you get an education to advance your career.
Robert from The College Investor has put together a great student loan resource page. If you are considering taking out a student loan, or are in the process of paying one off, I highly recommend you visit Robert’s website.
Starting and growing your own business can be extremely profitable, as it lifts the income ceiling of your 9-5 job. However, many businesses require large sums of start-up capital to flourish. You may have the greatest idea in the world, but without adequate funding nobody is doing to find out about it.
If used correctly, business loans can also be considered good debt. A detailed and thorough business plan combined with funding obtained through a business loan can be a great start for your successful business. Just make sure you will have adequate cash flow to make the monthly payments.
Real Estate Investment Loans
Investment real estate is a special type of business that tends to be especially capital-intensive. Similar to buying your primary home, it is hard to come by enough cash to buy rental property without a mortgage.
Just like with planning any business, it is important to conduct a profitability analysis to make sure your property will generate enough cash flow to cover the mortgage payments and other expenses.
But What About…
I would classify all other debt as bad debt. Even buying a car with an auto loan should be considered only as the last resort. It’s possible to buy a cheap, used vehicle for just a few thousand dollars if you need it as a means of transportation. It’s impossible to justify buying a brand new sports car when all you need is to get to and from work.
Consumer debt should be equally avoided. Credit cards typically have some of the highest interest rates of all loans and should only be used for emergencies and building credit.
What is your definition of good debt vs. bad debt?
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