Good Debt, Bad Debt

By Philip Brewer on 13 October 2007 (Updated 28 June 2013) 14 comments

There are two ways to look at whether debt is good or bad. The less important way has to do with the terms of the debt itself — how high the rate is, whether it's fixed or variable, any prepayment penalty. The more important factor in determining whether debt is good or bad is how you spend the money. From best to worst, here are the four categories of debt that I use. (See also: Control Your Debt With an Annual Clean Sweep)

1. A productive asset.

The only really good debt is debt used to purchase a productive asset. If you run a coffee shop that's losing customers because your baristas are having to wait to get to the one espresso machine, then borrowing money to buy a second espresso machine would be good debt. If you're a landlord, then using a mortgage to buy a small apartment building would be good debt.

Student loans fall into this category as well, if the degree will increase your future earnings.

The key item here is, will whatever you're buying earn you enough more to service the debt? If so, it's good debt.

2. Something you can easily afford, but don't have cash for.

A mortgage on your home usually falls into this category. (I say "usually," because it's become all too common for people to buy houses that they really can't afford, hoping that rising incomes and rising property values will bail them out. That sort of debt falls into the next category.)

As an aside, a lot of people like to imagine that their mortgage falls into the previous category, on the grounds that their home is an "appreciating asset." Home appreciation, though, is an artifact of growing incomes and expanding cities, and is not a law of nature. Hard economic times could very easily depress home prices and keep them depressed for years. Unless your home is actually earning income somehow (by letting a room out to a border, perhaps, or by earning fees from Hollywood as a film location), then it falls into this category.

Other small debts can fall into this category, especially for a young person looking to establish credit. (Back in the days before credit card companies pushed cards onto every college student with a pulse, you could read whole articles with advice that boiled down to: pick something that you were going to buy anyway, take out a loan for it from your bank or credit union, make payments on time, make the last payment a little early.)

3. Something you can barely afford, but have to have.

For most people, a car loan falls into this category. (I'd like to suggest that a lot of such people have never given bicycling, walking, and taking the bus adequate consideration, but that's neither here nor there.)

In the United States, medical care expenses often fall into this category.

These are the debts that drive people into bankruptcy, because anything you can barely afford leaves you vulnerable. What if there's a little hiccup in your income? What if there's another unavoidable expense?

4. Something you don't need, whether you can afford it or not.

I'm not going to bother making a list here. Things in this category are different for everybody, and yet all the same.

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Although the lenders lobby would have you believe that debt in this category is what drives people into bankruptcy, that's rarely true. That's not to say that this category doesn't cause a lot of pain. There aren't many people who don't have credit cards — and there aren't many people with credit cards who haven't at some point found themselves at the end of the month with more owed on their cards than they can pay. Do that a few months in a row and suddenly the minimum payments on your credit cards start looking like an expense category of their own (which they aren't).

Getting a bit over your head buying stuff you want hardly ever leads to bankruptcy, though. What leads to bankruptcy is buying stuff that you simply have to have and then running into a problem (job, health, family, business, economy) that either cuts your income or raises your expenses to the point that you can't service the debt.

What does this mean?

First, stay as close to the top of this list as possible. It can seem tricky to distinguish between the "stuff you can easily afford" and the "stuff you don't need," but it's not, really. Maybe when you're in the stage in life when you're setting up your first household (and need basics like furniture and kitchen appliances) it can be confusing, but there's really very little that you can easily afford but don't have the cash for, except a house.

Second, be especially careful with the "stuff you can barely afford, but have to have." People put themselves through a lot of unnecessary pain buying stuff they don't need, but those purchases rarely ruin their lives. These do. If you can barely afford it, be very, very careful. Comparison shop. Buy the least you can. Make do with what you've got as long as you can. Very often, just a few months of "making do," can change a "barely afford" to a "easily afford" by letting you save up a larger down payment. Sometimes it'll teach you that you were simply wrong in thinking it was something you had to have.

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Guest's picture
jtimberman

There is no such thing as good debt. That is a lie and a myth.

Using debt to invest brings something into your investment strategy: A high degree of risk.

If you don't have the money to buy something, then you can't afford it. Small business owners get their ears nailed to the wall using strategies like, borrow some money to grow the business or acquire additional assets and equipment.

If you never borrow money, and always pay cash for purchases and investments, then when you gain returns on those assets, or earn more money from monthly income, you have this strange thing.

Money.

If you borrow money, even for "good" debt, then when you earn your monthly income, you have to give some, or much of it to banks or other creditors.

I'd rather keep my money.

Guest's picture
Kevin

Here is a good article "Is All Debt Bad?" It provides some good examples.

Hope this helps

Kevin
Allstate Insurance Advocate

Guest's picture
Scott

Nicely laid out...the type of debt (business, car, home) is only one part of the equation. The terms of the debt are another.

An example of this might be financing a new car at 7% interest (probably bad) versus financing a 2 year old car at 2% interest (probably good).

Keep kicking tailbones, Philip!
Scott

Guest's picture
Dwight

Even "good" debt is unwise if you can find any way of avoiding it. Pay for that productive asset by temporarily cutting out a luxury that you can do without in the short term.

(I learned this one the hard way.)

Philip Brewer's picture

It's true that borrowing to expand means taking on some risk. Of course, just opening your doors to customers exposes you to some risk--your customers might steal from you, or slip and fall and then sue you.

Given that there's no such thing as zero risk, the real question is, does the reward adequately compensate you for the risk you're taking on? If you're running a small business, you probably already know how to do that sort of analysis--comparing the extra revenue an expansion would generate to the costs of the expansion itself.

You always have the option of taking on no debt and growing your business only as fast as you can fund the expansion with internally generated capital. The thing is, in a resource-rich environment, that's a losing strategy. Your competitors, growing much faster than you with borrowed money, will win in the long term. (In a resource-poor, slow-growth environment, you'd come out ahead.) For the past 60 or 70 years, we've been in a resource-rich environment. Things may be changing. But that doesn't mean there's no such thing as good debt, it just means that you need to be more careful, more conservitive.

Guest's picture
Dwight

I agree with you. The point I was trying to make is that we shouldn't spend money on luxuries as long as we have debt, even "good" debt. If we choose to stay in debt in order to have luxuries, that would be no different than borrowing for the luxury.

I might make an exception for mortgage debt if we are on track to pay it off in 15 years. Fee people would choose wait that long to have a few of the finer things in life.

Guest's picture

The only "good" debt that I can think of is a mortgage. After realizing how much my wife and I initially spent on car payments, credit card payments, and other debt, we've realized that all debt is bad debt. Borrowing to help buy a new Espresso machine might be good, but it's a risk. What happens if your business still goes under? Then you have a (fairly) worthless asset and still have to make payments on it.

The problem with looking at debt like that is that many people fail to take into account risk. There's really no such thing as a "sure thing", so it's unwise to make a habit of borrowing money to pay for something that may or may not actually have a return on investment.

So I would put everything except a house (a primary residence only) into the "bad debt" category. It may be an overly simplistic view, but I think it's also the most frugal and wise.

Nora Dunn's picture

Philip, your article is bang-on.

I have to disagree with those people who say that all debt is bad debt. That is simply not true. Although this is a prudent frugal attitude that will most likely keep you out of financial trouble in life, it also won't make you millions either. (I use the word "millions" figuratively as well as literally). 

Going into debt for luxuries is absolutely a bad idea. I agree completely. But borrowing money to make money can be a great thing if done properly. 

All business people have to take a risk to make it. Like Philip said, just opening your doors is a risk. And yup - that espresso machine won't do you much good if you have to close your doors, but if you don't stick your neck out there an try to fulfill that dream of being a cafe owner / barista supreme, then you'll never know what could have been. And saving up the cash to open a restaurant in a reasonable time frame is almost impossible. 

I'd also like to point out an interesting fact about millionaires.....most of them have been bankrupt at some point. They simply have the mind frame, business prowess, and just plain guts to hang it all out there. Sometimes it works, and sometimes it doesn't. But those who lose their millions also statistically get it back within years. And they don't do it by saving every penny and never borrowing. 

The concept of leveraging (borrowing to invest, be it in a business, equities, or a property) is not a new one.  By doing so, you can make a down payment on a $100,000 item, and even though the bank owns most of it, you are reaping the benefits of a $100,000 item growing in value. Even if it makes only 2%, and you put $10,000 down, your actual return on investment is 20%. Not to mention the fact that the $100,000 might help you open the business of your dreams, or help you to get an extra sum of money each year in rental income, etc. 

It's all about risk versus reward. We make these calculations every day. Do we want to risk the chances of being in a car accident for the reward of getting to work quickly and easily every day? Do we want to risk borrowing money for a business that might go belly-up for the reward of fulfilling a dream and achieving financial independence?

The answer is different for everybody. It's all a matter of personal comfort. But please don't make sweeping statements like "there is no such thing as good debt" because that might not be true for everybody.  

Guest's picture

I agree with jtimberman, it's all bad debt ! If you have to share your paycheck with creditors it's bad.

When you get someone to pay your debts, now that is good debt ! For ex. if a renter pays you rent to pay the mortgage it's good debt. Because you are not paying for it.

If my side business income can pay my household bills/expenses and mortgage so my paycheck goes all to me. That's good debt !!!!!!!

Guest's picture

That gem that most millionaires have declared bankruptcy is just wrong. Sounds like someone needs to go back to the basics and read Millionaire Next Door.

Guest's picture
Guest

Does it make any sense for the purposes of this conversation to distinguish between personal debt and debt that is legally secured by the assets of a business?

Guest's picture

Well explained article! I think this is a great way to explain and educate people on how they can avoid accumulating debt in this recession. Good debt is still inadvisable however, it is important to completely avoid the bad debt and then slowly work your way through reducing any debt.

Guest's picture

Great article! This is a very interesting approach in communicating the idea on how one should think about debt. I do believe that any kind of debt should be avoided. There are always ways in which one can cut down the amount of debt or accumulation the of it.

Guest's picture

I only have bad debt (student loans and a car payment), and a month-to-month lease. I feel so free. I'm not sure I'd want to buy a house...