Debt has become a common thing in the average American’s life. We take out loans to buy big screen TVs. We borrow money to get shiny new cars. We even borrow money to get our own money. When are we as American’s going to get to the point where enough is enough? Personally, I got to that point a few months ago. However, there is always the argument of good debt vs. bad debt. So, what’s the difference between good debt and bad debt?
Good Debt
Technically, good debt is debt that will create some type of value in the future. For example, you go to college (and take out student loans) with the thought that you will make more money over your lifetime because of a degree. In other words, by going into debt to get a degree, you will have a larger income than by not having that degree.
Mortgages are also described as good debt because it is something that increases in value and there are tax incentives on the debt (deductions, credits).
Some individuals also believe that going into debt is good if you can get a higher return somewhere else. For example, if you can get a 4% loan and earn 8% in the stock market, you should borrow the money. Is there such a sure thing though? I don’t think so.
Bad Debt
Bad debt is debt that does not give you any type benefit towards your financial being or create value. For example, if you use debt to buy consumer goods and you don’t pay it off at the end of the month. You will be paying a lot of money (in the form of high interest rates) over the long run. Bad debt can include vehicles, credit cards, payday loans, etc.
Isn’t It All Bad?
I am a believer in Dave Ramsey who says that all debt is bad (other than a 15 year fixed rate mortgage). While I was in school, I believed that student loan debt was a fact of life and it would definitely pay off in the end. Thinking that caused me to take out student loans and spend my income (however small it was) on frivolous things. If I just would have spent that income on education, we definitely wouldn’t be in the predicament that we are in. Looking back, I don’t think my student loans were ‘good debt” no matter how much additional income it will help me get in the future. The stress alone is probably going to knock off 10 years to my life!
I am guessing that there is going to be some pretty good discussion on this topic. This is one of those areas that’s just like politics. Either you’re on one side or the other and neither likes the other. Please share your thoughts!
Good topic. Just had an extensive 1,700 word post on why being debt free is NOT a good idea! Definitely a lot of debate, so it’s good to see you guys question debt here as well.
Best, FS
.-= Financial Samurai´s lastest post ..Financial Samurai $1,000 Giveaway & Your Chance To Make Millions Over Your Career! =-.
Oh, and for the record, I think debt is fantastic if used properly. It allows you to live well beyond your means. It’s just when you go binge borrowing that we get in trouble.
.-= Financial Samurai´s lastest post ..Financial Samurai $1,000 Giveaway & Your Chance To Make Millions Over Your Career! =-.
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Debt is not all bad – and I am actually debt free and never had consumer debts (hence I couldn’t care less about Dave Ramsey). Nope, I don’t think debt should be used to live beyond your means – this is actually the example of a bad reason for debt, but it can however be used to make more money or to hedge against inflation.
If all debt had been bad, we wouldn’t have modern banking. After all, CDs is a form a loan – a loan we give to banks so that banks could lend this money to someone else. Without banking, we’d have to pay somebody to keep our money safe.
Businesses use loans to expand, as initial capital or to manage cash flow. Some types of businesses may operate without credit. But others can’t. Shipping businesses for example cannot operate without credit: they get paid only after they deliver the goods, but the crew need their payment upfront. Medical research may find it difficult to operate without credit too – it takes years and years before a promising new drug makes it to the market (if it does), but clinical studies require $$$. Many a great inventions that we have we got because of credit.
While borrowing at 4% and investing in stock market is a very risky strategy at least unless you have enough additional capital stashed in safer places or secure cash flow that would allow you to repay your debt if the market tanks. But taking a 30 year fixed mortgage (yes 30 years) and buying, for example, tax free AAA municipal bonds is a safer bet and may be have an attractive risk-benefit profile under some circumstances. For example, last fall and earlier this year, the yields on AAA municipal bonds were higher than mortgage rates. Considerably higher for those whose mortgage is tax deductible (as the interest on municipal bonds is tax free). A low interest mortgage is also a hedge against high inflation. Think 1980s with their double digit interest rates on CDs. People with 30 year fixed mortgages taken in the 70s had single digit rates and they were nicely earning double digit CDs and watched inflation reduce their debt to nothing. Now, we may not get inflation – I have mixed feelings on that, but then any type of investment strategy carries risks. Including putting your money in index funds.
Similarly, student loans can be smart or stupid. Now – you may say how in your specific case student loans hadn’t been necessary. But just because something is true in one case doesn’t mean it holds for everyone. Would you mind explaining how a doctor who doesn’t have rich parents could avoid student loans? Hints: medical schools are expensive, even state medical schools; medical education is really full time so nope, you cannot work and study, there are no scholarships for medical schools. But a loan taken to get a medical degree would probably pay off i.e. it is a good investment. A loan taken to get a liberal arts degree is likely not to pay off. I.e. in some cases student loans are a bad investment, in others – a very good one.
In some cases – extremely high medical or legal bills, for example, the debt might be a necessary evil. Dave Ramsey’s style X months emergency fund will not help you with mid to high 5 digit or even low 6 digit medical or legal bills. Is this type of debt bad? It’ll probably be difficult to repay, so yes it is bad, but most of us would rather be alive and in debt than dead.
With the exception of (real) emergency cases as well as cases of people living beyond their means, taking or not taking a loan is an investment decision. And as any investment decision including a decision to invest in stocks it can be less risky or more risky, can turn out good or terrible in hindsight. Incidentally, in my case keeping a 30 year mortgage and putting money in a bank instead of prepaying a loan on my previous property turned out a great decision: having extra cash NOT locked in my home enabled me to keep this old property and rent it out when I upgraded. This resulted in my being able to sell it with a nice gain in a few years and repay the mortgage on the new property with a single check.
BTW – it’d be interesting to have a poll on correlation between people’s view about whether or not debt is OK under some circumstances and respondent’s net worth. I think you’d be surprised at the answers.
You make some amazing points and I can agree with you on all of them. I guess you can say that I dislike debt because I don’t know how to handle it and probably never will. Obviously, you have a great grasp on the upside to debt and it’s usefulness. I wish that I was in that type of position. Since I am on the other end of the spectrum, I just imagine I’ll never be able to see debt as a financial tool.
.-= Chris´s lastest post ..Debt Update: October 31, 2009 =-.
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Debt is one of the best financial tools in the world… if it’s the right kind of debt.
Especially in regards to real estate investing, it would be impossible to have as much financial incentive and gain as we have without going into “good debt.” Likewise major companies wouldn’t be able to grow as much without having debts. Lacking funds limits growth and return.
I agree with you that student loans aren’t really “good debt” they’re kinda in between. Having an exact career is an investment that lasts 30-40 years in which the investment is recovered. It seems a tad pointless to make that investment and not buy into the career idea.
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I have about 25k student loan at 0% interest for the whole time I take to pay it off (because it is govt. funded loan, I only have to pay what I borrowed. Not interest or any other charges). Right now I have about 30k in saving and I was wondering if I would be better off paying off all the loan now or make the mandatory payment and invest the rest in stocks.
Would appreciate any advice. Cheers..
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Hi there, great topic to talk about. I guess that debt is just fine when you know how to manage and use your finances wisely , but then, if you just want to live a materialistic lifestyle using it, then you are going to be in big trouble. Thanks for sharing. Great post.