Good Debt vs. Bad Debt

In the last article, we examined how using a budget could help you get out of debt. Today, we’re going to examine one of the cardinal rules of any debt: distinguishing between good debt and bad debt. This is an important concept because all too often people attempt to pay off (or worse, don’t take on) the good debt while ignoring the debt that will really eat into your pocketbook. However, it is imperative that you always work as much as possible towards paying off, and never taking on, bad loans.

So what are some examples of bad loans? Essentially, all high interest rate loans for objects that will never appreciate in value are considered bad. Buying a flat-screen TV for $5,000 at 15% interest would qualify as a bad loan. The reason for this is that you will be paying $750 per year on top of the $5,000 for the TV and when it’s outdated in a couple of years, it will certainly not have appreciated in value.

These types of purchases lead to something that I like to call the “overlapping effect”. This occurs when you make one of these “bad” purchases and you cannot pay off the full amount before you want the new product. For example, suppose that you wanted that TV above and could afford to pay off $3,000 per year. At the end of two years you would have $162.50 left over. But suppose that a new technology comes out in two years and you really want a new TV. The old TV is worthless so you buy it and add another $5,000 to your debt. Problem is that you already owe $162.50 from the last TV so due to this residual effect means that you now owe $5,162.50. As such paying $3,000 per year and buying a new TV on a two year schedule means that you’ll never pay off the full balance.

As you can see from the above scenario, it is advisable to avoid the “bad” debt at all costs. So, then, what qualifies as “good” debt? Everything that is either vital to your daily living or appreciates in value could be considered “good”. For example, a basic car to get to work (not a Mercedes), student loans, or a house are examples of good debt. The reasons are that the first will help you make money, the second will help you get a better job, and the last should appreciate in value and provide you with a place to live. Even using leverage for good stock purchases can be potentially quite powerful. Look for high dividend stocks and use a little leverage to push the dividends as much as possible – this is an example of good debt.

This article has hopefully demonstrated some of the pitfalls of taking on bad debt and also help you identify opportunities to take on good debt. Debt is a powerful tool, that when used properly, can bring prosperity to the borrower. Look for these types of debt and capitalize on them while, at the same time, avoiding the debt that will just waste your money.