M. asks: What is good debt and bad debt?
Growing up I was instructed by my grandma that all debt is bad and there is no such thing as good debt.
But maybe it is time to reevaluate this old opinion. My grandma is long dead and she will not complain.
There are several definitions/opinions on separating the good debt from the bad.
One definition is going just by the interest rate. The high interest rate makes the debt bad and the low interest rate makes the debt good.
Another definition separates the debt by ability to generate income and go up in value (good debt) versus purchase of depreciating assets which lose value with time (bad debt).
The third definition I found is a distinction by secured versus unsecured.
Secured are loans that have a collateral: a house, a car or anything tangible that can be repossessed in case of default.
Unsecured loans are credit card balances or medical bills.
This explains why the credit card interest rates are higher then a mortgage - if the loan is unsecured, the lender carries a higher risk and the higher interest compensates for that risk.
Consolidating this three definitions, an example of a good debt would be a mortgage, and examples of a bad debt would be a car financing and credit card balance.
But is it really so?
I try not to use the terms "good" or "bad" because they don't reflect the reality very well. Nothing is just simply good or bad. I usually use the terms "useful" and "not useful" to clarify things.
Let's see if that will work with bad and good debt too.
A loan allows you to acquire an asset now, instead waiting until you save up enough money to buy it paying cash. The interest rate is the cost of services for you to have that money available now.
If you want to buy a house, you would not like to save for many and many years. If you need 20 or 30 years to save that amount, the life will go by without a house. In this case you would get a loan and pay the interest for that service. Is this good? I don't know. Is it useful? Definitely.
If you want to buy a car to drive to work and you have to finance the car? You will pay for the service to get money now and to have the car now. That will make you able to drive to work. Is it good? No, the car will depreciate... Is it useful? Yes.
You would like to take out a loan to pay for college education. Is it useful? I would say it will depend on the degree.
If your degree will get you a good income later - it is useful.
If your degree will not get you a good job that will not be useful.
If you meet someone at that college who will get a great job with a great salary later, and all you get is a "Mrs. degree" when you marry that person - it world be quite useful...
You would like to buy a boat which you will rarely use and it will just generate costs and bad feelings that you should have used it more often - that is not useful at all. Instead of paying for service to get the loan for the boat you better pay for the service for renting a boat those couple of times.
You see how it works. You can apply the "useful or not useful" test to your own examples.
Here are my own examples:
The car loan for my car falls into cheap and useful. Over the term of car loan (3 years) I paid $1,500 for the service of the money being available for me to buy it. I did it when I got my job and didn't have much in savings. I needed a reliable car and to pay $1,500 was ok.
The mortgage falls into expensive and useful. With the mortgage the monthly payment was the same as my apartment rent but the house provided much more space. The costs for that service over 30 years would be $148,201 but with paying additional principal I shortened it to 8 years and the costs were only $33,659. But still it falls into the expensive category. (See my post on if you should pay off the mortgage early here).
I put the boat into cheap and not useful category. The example is for a smaller boat which you can pay off in few years (comparable to a car). Compared to mortgage costs it is cheap but I have no interest in a boat and it is not useful for me.
The credit card debt is in expensive and not useful in my example. But for some people it might move into expensive and useful in some emergency situations. To minimize this kind of expensive debt even if it is useful, an emergency fund is very helpful.
In summary, I would apply "useful" debt and "not useful" debt instead good and bad debt. And I would apply it not in general terms but to a particular situation and person.
