Good Debt vs. Bad Debt

by Washington Federal Team on January 3, 2012

Debt represents an obligation, naturally creating a negative connotation. But debt is a complex concept that isn’t black and white. Not all debt is bad, and when paired with savvy financial planning, debt can be a powerful tool for building wealth. To determine whether it’s good or bad, ask yourself whether it’s financing something that’s appreciating or depreciating. Typically, if the debt is financing something that’s growing in value, it’s good debt. If debt goes to finance something with declining value, it’s bad debt.

Good Debt 

Good debt can be leveraged for investment, transportation and education purposes. Ranging from self-improvement to revenue generation, good debt comes in a variety of forms:

Boost Your Credit Score

Using credit cards responsibly is a perfect example of good and bad debt. By maintaining a low balance and paying if off each month, you can effectively build credit history and boost your credit score. However, if you rack up excessive charges, fail to make timely payments, and  incur interest charges, credit cards can quickly fall into the bad debt category.

Education

Taking out a student loan should be an investment in your future. A student loan is a temporary financial obligation that should advance your career and earnings potential. The idea is to go into a little debt now in order to make more money later, with the extra income going to repay your initial debt.  Be careful about taking on student loans for careers that may be fulfilling, but offer generally lower salaries.  .

Investments

When used to make a carefully planned investment, debt can be a good thing. Typically associated with a positive ROI (return on investment), buying a house is generally considered good debt. But it’s important do your homework. Research the neighborhood, the school systems, and the value of similar area properties. Avoid buying more house than you can afford, as delinquent mortgage payments can easily transform a positive investment into a negative. Business debt for funding inventory, receivables and expansion is usually good debt.  Debt to buy stocks, bonds or mutual funds is speculative, only good if you win and unsuitable for most consumers. Before borrowing money to buy a stock ask yourself if losing all your investment is worth the potential return.  If you’re going into debt to make a purchase or investment, consider that your credit score will impact the interest rate you will be offered.  Generally, anything over 10 percent (particularly in the current interest rate environment) is too high.  Paying too much in interest expense will make it difficult to recover your original investment, let alone make a profit.

Work Necessities

Cars, because of quick depreciation, are not traditionally considered good investments. But if a car is necessary for employment or travel to and from work, a car loan becomes a valid expense that protects your income. By purchasing a vehicle with a low price-point that that meets your needs for basic transportation, you can count your car loan as necessary debt.

Bad Debt 

Bad debt is a term related to disposable goods, depreciation as opposed to appreciation and, ultimately, more owed than initially invested.

Delinquent Balances

In the best case scenario, disposable goods, which depreciate almost instantaneously, should be purchased using liquid funds. However, this isn’t always plausible, and more often than not, a loan or credit card takes the place of cash. In this scenario, a plan should immediately be implemented to repay the amount in full. Trouble ensues when an individual fails to make timely payments, or, rather than paying the full balance, opts, instead, to pay only the monthly minimum. With rapidly accumulating high-interest rates, the original purchase price is small in comparison to the amount that’s now owed. Worst of all, until paid in full, the amount will continue to increase, which hurts your wallet and your credit score.

Unnecessary Expenses

Unlike student loans, some expenditures and their resulting debt have no way of boosting your future financial situation. For instance, if you go into debt in order to take a vacation, the cost you incur has no potential financial value — no matter how relaxing it may have been. The same can be said for buying on credit a pair of shoes or an expensive stereo system, neither of which benefits your future financial health. Perfect examples of bad debt, these items are easier to live without than to go through the pain of painful expense of paying for them.

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