Debt can be destructive. The interest you pay on your debt can consume your net worth and income, and the monthly payments on your debt can make it hard to make it from one paycheck to the next. Dave Ramsey and other finance experts are quick to condemn debt. Yet, we often hear about ‘good debt.’ Does such a thing exist? Or is all debt bad?
Debt on a Spectrum
Of course, not all debt is created equal. There are a number of variables that determine how destructive debt is. There is certainly debt that you should avoid at all cost. But how do we decide where on the spectrum a certain kind of debt lands?
The interest rate and total interest you pay on you debt in question is one of the most important factors in the quality of debt. The interest rate is the percentage of the total balance that is collected by the lender. Debt with high interest will end up making the financed purchase cost far more in the end than the initial purchase price. A higher interest rate will also significantly increase your monthly payments on the debt. So obviously, debt with higher interest rates is worse than debt with lower interest rates.
Are You Financing An Asset or Liability?
Assets appreciate and earn you money over time while liabilities lose value and/or cost you. In general, financing something that depreciates is worse than financing something that gains value over time. In most cases, debt on an asset is better than debt on a liability.
A house is a good example of an asset. Not only does the value of the house appreciate over time, owning the house also saves you from paying rent. And even though a house comes with other expenses, these are typically less than rent.
A vehicle is a liability. True, many people like to call their vehicles an asset, and in the business world, this is the case. But the business world also uses more complex accounting methods to separate the vehicle’s depreciation as its own liability. So as far as we are concerned, a vehicle is a liability. Vehicles depreciate in value, and cost you in insurance costs and maintenance costs.
That brand new sports car may still be running maintenance free a year from now, but now its no longer the newest car on the road, doesn’t have the new car smell, and probably won’t still be worth the $450 per month (plus insurance) you’re paying. Saving up for a car would mean avoiding interest charges and monthly payments you can’t afford. Not to mention that your car savings will earn you interest in the mean time.
Is the Alternative to Debt Worse?
In an ideal world, you’ll never be ‘forced’ to take out debt. But sometimes, either due to poor planning or an especially unfortunate string of events, the alternative to taking out debt is worse than debt itself. Often this is the case when someone racks up medical bills because of health problems or an injury. Complicating the problem further, sometimes the individual also takes an income hit because he or she is not able to work as long. Although you can take steps to plan for these situations, such as ensuring that you are properly covered by medical insurance and that you have enough saved for medical costs, it is impossible to prepare and plan for every possible situation.
In these situations, debt may be necessary. However, this doesn’t make the debt ‘good’. As soon as you are able, you should still make every effort to eliminate this debt. In some cases, renegotiating the debt or in extreme cases even declaring bankruptcy. Although bankruptcy is a nuclear option, it may be a better option than being a slave to that debt for the rest of your life. Sometimes you really do need a fresh start. However, don’t take this option lightly.
Length of the Debt
One rule of thumb when taking on debt is never take on debt that will last longer than the value of the purchased item. You don’t want to end up making payments long after the purchased item has any value to you. Most consumer purchases fall under this category. When you buy a new shirt on a credit card, and don’t pay the credit card off in full, you’re likely going to be paying for that shirt long after it has any value to you. Not to mention that the shirt is now much more expensive because of the interest you’re paying for it.
Back to cars, often you’re stuck making payments on a car long after it is worth that amount to you. The recent trend of 6, 7 and even 8 year car loans is making this even more of an issue as consumers are being lured into purchasing far more car than they can afford and are stuck paying for them as they depreciate faster than the car loan is paid down.
Does the Debt Fit in Your Budget
Perhaps the worst kind of debt is that which doesn’t fit in your budget. If you get stuck with payments that keep you from contributing enough to your retirement and emergency funds, you are without question too deep in debt. If you are going to pick up debt, evaluate how the monthly payments of that debt affect your cash flow, and evaluate how the total debt (and the purchased item) affect your net worth, both now and in the future.
But is There Good Debt?
So some debt is obviously better than other debt. But is some of that debt ‘good debt’, or is it still all bad? I lean towards a very cautious yes. I think having no debt is best of all. Not having debt makes you more resilient to hard times and frees up your cash flow. However, there are times when taking on a reasonable amount of debt may be prudent.
Financing a ‘want’ is seldom prudent, if ever. High interest debt is another huge no-no. Paying double-digit interest rates is a quick way to suck the life out of your finances and trap you in a vicious debt spiral.
However, if a debt checks all the ‘good’ boxes in the variables above, you might consider it. For example, a 15-year mortgage is typically low-interest and will not outlast the value of the house. A primary residence is both an asset and a need. Arguably, taking on debt to buy a home is better than renting (although renting does have upsides). And as long as you buy a house you can afford, a mortgage is something you can fit in your budget, especially since it eliminates your rent payments.
I also know financially savvy people who will take out a low-interest car loan even though they have the cash to buy the car outright. They reason that while they pay off the loan, they can invest the cash and earn more than the interest that they are paying on the car loan. Again, the debt is low-interest and indirectly allows the holder to purchase an asset. I’m a little more hesitant to recommend this, since there is more risk involved, but definitely understand how it improves one’s financial situation.
So yes, I do think good debt exists. However, before rushing into any debt, carefully consider how it will affect your cash flow, your net worth, and your ability to react to life changes. Be sure that the debt is not simply enabling you to purchase more than you can really afford. And think ahead to the future. Don’t take on debt that you will regret in a few months or years.
While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.