Whether good debt or bad debt, we all know debt levels are out of control. The statistics are staggering. Collectively, Americans owe almost $1 trillion (yes, trillion with a “T”) in credit card debt. And that’s not even close to the largest category. Mortgage debt tops $9 trillion, auto loans another $1.25 trillion, and count another $1.5 trillion toward student debt.
If those numbers are too big to comprehend, consider that there is $40,000 of debt for every man, woman, and child in the U.S. (or a little over $100,000 per household). And that’s just personal/consumer debt. Don’t forget that the government owes another $21 trillion, or $64,000 per citizen, on top of that.
Any way you slice it, that is a lot of money. And the numbers just keep going up. Everyone knows that debt is bad, and will soon lead to the demise of civilization as we know it. That is the message trumpeted by almost all mainline personal finance gurus (looking at you Dave Ramsey) and media outlets.
So that’s it. Thanks for stopping by, just a friendly message to get going on that underground bunker and canned good supply for the impending apocalypse.
Oh wait, maybe there’s a little more to it than that. As always, life is shaded a little more gray than the black and white bullet points of the talking heads on TV. Could there be different kinds of debt? Maybe even *gasp* GOOD debt?
What is Good Debt vs. Bad Debt?
Do you know what wouldn’t exist without debt?
That smartphone in your hand. Or the computer you’re reading this on if you still live in the stone age. Heck, the entire internet wouldn’t even be around.
For better or worse, our entire economy is built on debt and the leverage it creates. If Steve Jobs had to wait until Apple had enough cash in the bank to pay thousands of engineers, designers, and assemblers to create the first iPhone, it would probably never have been built. But instead, Apple was able to take their idea to banks and private investors and get funding for what would become one of the most iconic and culture-changing hunks of metal and silicon ever produced.
In this case, debt was ultimately responsible for a major technological innovation, and created an enormous amount of wealth (for Apple directly, and society indirectly). So debt can’t be all bad, right?
It turns out that debt is just a tool, not inherently good or bad in itself. It allows you to spend money you haven’t yet earned now, with the expectation that you will pay it back in the future, plus a little extra for the trouble (i.e. the interest rate).
So what is good debt, and what is bad debt? Perhaps a good working definition is that good debt is borrowing money to pay for education, or an idea, or an asset that you believe will return more money in the future than it cost you to finance it now (i.e. an investment). And conversely, bad debt is borrowing money to pay for something that will decline in value, or has no productive purpose (i.e. consumption).
With that definition in mind, let’s look at a few examples.
These days you can buy almost anything with a credit card, but for the sake of argument these purchases mostly fall in the realm of consumption. It’s safe to say your groceries, cable subscription, and pumpkin spice latte addiction aren’t adding money to your bottom line anytime in the future.
Credit cards allow you to continuously spend more than you earn. As long as you can make that minimum payment, you can be lulled into a false sense of security that you can continue to spend your future income stream until it’s too late and it all comes crashing down.
The most dangerous thing about credit cards is the exorbitant interest rate – often 15-20% or more. That minimum payment seems manageable, but what they don’t tell you is that you will slowly be paying off that morning latte over the next 30 years! Almost the entire payment goes toward interest, digging you deeper and deeper in debt as you continue to outspend your means.
Verdict: Credit cards are BAD DEBT. Note that I am not talking about responsible use of credit cards where you pay off the balance in full every month and never incur interest charges. If you have the discipline to do this, you can turn the tables and the credit card companies will pay YOU to use them.
Wouldn’t it be nice if we lived in a world where you could save your pennies for a few years, find a modest house, and break open the piggy bank to pay for it? Unfortunately, that is not the world we live in. Unless you are fabulously wealthy (in which case you probably don’t need to be reading personal finance blogs), you have to borrow money to afford a house.
Housing is an interesting asset class. Everyone has to live somewhere. And historically, housing has appreciated at about the rate of inflation, so when you lock in a 30 year mortgage, you are paying off your house at today’s while the underlying asset continues to increase in value.
Since you don’t really have a choice of paying for housing (unless you live in a van down by the river, I suppose), it makes sense to compare a mortgage to the cost of renting a similar home. If you’re paying $1200 per month for your 2-bedroom apartment, and you can buy a condo next door with a $1000 mortgage payment, it might make sense to take on the debt to purchase what has historically been an appreciating asset.
Verdict: Mortgages can be GOOD DEBT if used responsibly. If you can buy and maintain a home for less than the cost of renting, it probably makes sense to take on debt to do so.
Vehicles are the definition of depreciating assets. The minute you drive it off the lot, you’ve already lost 11% of the purchase price. And after five years, you’ve lost more than 60% of the value. So that $30,000 car has cost you $18,000 in depreciation alone in 5 years. If you like to consume your depressing statistics in a visual format, Edmunds has a pretty infographic for your viewing pleasure pain.
While these days it is possible to get a ridiculously low interest rate on a car loan, you are still borrowing money (and paying interest) to finance something that is guaranteed to continue to lose value the longer you own it.
Sometimes, taking on debt to buy a car to get to work is unavoidable. But I would always recommend minimizing that debt if at all possible. Buy a high quality used car for $10,000 and put the difference into the stock market where it can grow over time rather than into a car that is guaranteed to be worthless in a few years.
Verdict: Car loans are almost always BAD DEBT. Unless you plan to keep your car in pristine condition for 50 years until it becomes a “classic”, I guarantee it will never be worth more than the day you drove it off the car lot. And let’s be honest, regardless of age, your Honda Civic with the “sport” package is not destined for classic car status EVER.
In the ideal scenario, student loans are an investment in your biggest asset: you. A good education can pay dividends for your entire life. On average, a bachelor’s degree will add $2.3 million to your lifetime earnings compared to only completing a high school education.
However, a little bit of common sense is required. We’ve all heard the story of the guy or girl who amassed $100,000 in student loan debt in pursuit of a sociology degree at a top-rated university, only to end up working at Starbucks and living in their parents’ basement because they can’t afford rent AND their student loan payments.
Don’t get me wrong – I think liberal arts are important, and anyone with a real passion in a subject should do anything they can to pursue it. But you need to have a realistic plan. If new graduates in your chosen field are making $30,000 a year with limited upside in the future, you should probably not be taking on 6 figures of debt to get to that point. Look at in-state schools, work your butt off to get as many scholarships as possible, find a side hustle you can do to make more income while you work your career in the field you are passionate about.
Verdict: Student loans can be GOOD DEBT or BAD DEBT depending on your chosen school and/or field of study. A lot more emphasis needs to be put on helping high school students understand the ramifications of the choices they make before they are trapped in massive debt with no way out.
Often good debt or bad debt is determined by what you do with it. Is it an investment that will pay dividends long into the future or just an excuse to consume something now that you can’t yet afford? It can be difficult to delay gratification in our consumeristic society, but ultimately good financial habits require discipline and purpose.
Take a few minutes before plunging into a large financial decision and ask yourself, “what is the return on investment of this purchase?” If there is no long term benefit, it would be wise to think long and hard before committing.