Contrary to what your grandparents may have told you, not all forms of debt are harmful to your finances. There is such thing as “good debt”. And when used correctly, good debt (like mortgages, student loans, etc) can help fast-track your wealth building.
Of course there’s a grey area between good debt vs. bad debt. So it’s really important to know the difference and make sure you don’t overload with either types.
Let’s delve into the differences, some examples, and help you navigate good debt vs. bad debt choices in your life…
Good Debt vs. Bad debt
Generally, good debt is seen as an investment in yourself — like taking out a loan for school or a business loan to launch an entrepreneurial venture.
Borrowing money for assets that appreciate in value, like getting a mortgage on a house (in most cases), is also considered good debt.
On the flip side, money borrowed for possessions that decrease in value is definitely bad. Sadly, that describes many of life’s basic necessities like clothes, cars, and that 80-inch, 4K, curved-screen TV needed to host your big game party.
| Good Debt | Bad Debt |
| Borrowing money against something that will appreciate in value 👆 | borrowing money against something that will depreciate in value 👇 |
Examples of Good Debt
Here are some classic forms of good debt.
Mortgages – For most of us, there is probably no better debt than a mortgage. Likely the second biggest financial decision you’ll make (the first is choosing a spouse 😉), a mortgage is the path to homeownership.
Home Equity Loan or Line of Credit – These are basically offshoots of a mortgage. You can usually get a low-interest loan using your house as collateral. Many people use these to pay off higher-interest debts like credit cards.
Small Business Loans – If you have enough ambition, savvy, and luck, borrowing money to start your own business could be the best investment you’ll ever make.
Student Loans – Yep, college is expensive! But student loans tend to have lower interest rates, especially if they’re federal student loans. The idea is that you’re buying an education that will lead to a higher-paying career than if you didn’t go to school.
Examples of Bad Debt
When people talk about bad debt, this is what they are talking about…
Car Loans – For most of us, a car is a necessity. But that doesn’t mean you need to buy the biggest, flashiest car available and go broke with a large amount of debt. Car loan interest is not tax deductible and vehicle values can depreciate up to 20% in the first year, and over the first five years fall to around 40% from the original price.
If you absolutely must finance a vehicle, do it the smart way by following these rules.
Personal Loans – Incurring debt for expenses like a vacation or new clothes is probably not a wise choice. The thrill of buying that stuff only lasts a little while, but paying off the debt can last AGES and end up being a money suck.
Payday Loans – These are short-term, small-amount loans meant to be repaid with your next paycheck. And they should be avoided at all costs! This is what we call toxic debt because it often comes with insane interest rates as high as 600% – not kidding! Financial experts strongly caution against these types of loans.
Credit Cards – If you pay off your bill in full each month, credit cards can be a wonderful tool. But if you carry a revolving balance month to month, you have a big problem. Many credit cards carry extremely high interest rates of over 20%, digging you into an even deeper hole.
Good vs. Bad Debt Grey Areas
Sometimes it’s not so easy to distinguish the difference between good debt vs. bad debt. It might depend on your own financial situation or other factors.
Certain types of debt may be good for some people but bad for others:
Borrowing (at low rates) to pay off debt (at high rates) – For folks who are already in debt, taking out a debt consolidation loan from a bank or other reputable lender can be beneficial.
Debt consolidation loans typically have a lower interest rate than most credit cards, so they allow you to pay off existing debts and save money on future interest payments.
The key, however, is making sure that you use the cash to pay off debts and not for other spending.
Borrowing to invest – If you have an account with a brokerage firm, then you may have access to a margin account. This allows you to borrow money from the brokerage to purchase stocks or bonds.
But buying on margin is super risky. Because if the investment doesn’t make money, you can quickly lose all your capital.
Related articles:
- Pros and cons of consolidating student loans
- When to Consider Refinancing Your Student Loans
- Best credit cards for unemployed people (and those rebuilding credit!)
Debt-to-Income Ratio
So, how much debt is too much debt?
Just because there are good forms of debt out there, does that mean it’s OK to take out millions in loans?
No. Good debt can quickly turn bad if you become over-leveraged. And that happens quicker than most people think.
A great way to keep your debt levels in check is by figuring out your debt-to-income ratio.
Simply add up your monthly debt payments and divide them by your monthly gross income.
For example, lets say you have $3,000 per month in total debt payments (made up of a $2,000/m mortgage, $500 car payment, and pay $500 a month for credit card debts)
And let’s also say your gross monthly income is $6,000.
This means your debt-to-income ratio is 50%. Each month from your paychecks, 50% of the money goes towards debt obligations.
This is a really bad debt situation. Best practices are to keep your debt to income ratio well under 35%. (and for credit reports, anything over 43% debt-to-income ratio is a red flag to potential lenders!)
No matter your mix of good debt vs. bad debts, it all adds up to BAD if there’s too much in your life!
Too Much Good Debt
Here’s an example of when good debt can become bad debt.
We might all agree that locking in a mortgage at 3% for 30 years is considered good debt. BUT, if your down payment was $0 (financed the entire house), plus you have an unstable job and are stretched to make payments, we might now consider this as bad debt. Because one small cashflow hiccup could get you missing payments, risking a HUGE financial setback.
A lot of Americans use their HELOC for silly reasons as well, treating their home equity like a piggy bank to take vacations or to buy other items they want.
Another great example of how good debt can become bad debt is getting student loans for a degree that turns out to be irrelevant. If you take on copious amounts of debt for a specific career niche, and then never pursue that career, this could been seen as bad debt. Student loans are immune to bankruptcy, they must always be paid back.
If you do opt for college, it’s important to minimize the debt you take on by going to a cheaper school, or by working a part time job to borrow less. It’s true, minimal student loan debt can act as a good form of debt that will boost your job prospects & income for decades.
But keeping that balance low, borrowing strategically is key to ensuring that you don’t bite off more than you can chew, signing yourself up for decades of hefty payments.
All in all, using good forms of debt excessively or improperly quickly turns them into bad debt. Be careful!
Good Rule of Thumb (anything under 7% interest)
Remember this one thing: somewhere around 6-7% is the magic number that separates low-interest good debt from high-interest bad debt.
That’s the interest rate that acts as a divider in our current market. Anything higher than 7% you’ll want to pay off sooner than later, and anything lower than that, there is a good chance you can take those extra payments and invest the money instead to make a big enough return to make it worthwhile.
Deciding whether to use excess money to invest or pay off debt is a very nuanced topic. We discuss it in great detail in this HTM podcast episode.
Should You Always Pay Off Debt First?
Conventional wisdom tells us that getting out of debt is smart. And while generally that might be true, we’re here to explain how that approach may not be the best decision for you.
If you’ve locked in a mortgage at 2.75%, it’s smart to keep that mortgage around for as long as possible.
Why?
Because putting extra money into paying off that debt means you are missing out on investing opportunities elsewhere. Your money can be earning a much higher return rate if invested in something like board index funds.
Oftentimes keeping low interest debt around while you’re able to invest and maximize your returns elsewhere will easily make the most sense when you’re looking at the numbers.
What is your comfort level with having loans? If you’re in a rush to pay off all of your debt, why? If you’re blindly paying off debt without considering why, now’s the time to start asking yourself. From a numbers standpoint there is good debt and there is bad debt.
Tips on Managing Your Debt
A few last notes for keeping a healthy relationship with debt…
- ALWAYS pay your minimums at the very least and always pay on time to avoid huge interest/penalties. Your credit score takes a massive hit if you miss even 1 payment.
- Rule of thumb 7% [see above]. If your debt is above that rate, consider putting more of your resources toward it.
- Consider refinancing debt, or signing up for a 0% credit card, to lower the interest rate and pay balances down quicker.
- If your employer offers a company match for retirement savings, you’ll want to continue to take advantage of that. Even if your credit card interest rate is at 22%, you still can’t beat a 100% match.
- Set a goal for eliminating all the higher interest rate debts you have. Don’t just let them exist. Create a strategy and attack.
- If you already have debt, don’t be in a rush to pay off ANY low-interest rate debt (mortgage, student loans, car loan, etc.), IF you invest that money instead. Instead invest/save for the future with a lower tax burden. For example, we have mortgages, but we’re not paying them off early due to the low interest rates and tax benefits.
- If you’re considering taking on new debt – Try and keep debt to a minimum, see debt-to-income ratio notes above. Shop around for the best rates and banks who are keeping costs down.
Recommended Debt Payoff Methods
Is debt keeping you up at night? There are two specific, user-friendly, repayment strategies experts recommend that can put you on the path to debt freedom: debt avalanche and debt snowball.
- Debt Avalanche method: start by crushing debt with the highest interest rate and work your way down.
- Debt Snowball method: start by eliminating debt with the lowest balance and work your way up.
Since the debt avalanche method focuses on highest interest loans first, it naturally eliminates bad debt before any good debt is paid down. We like this strategy and recommend it to most people consumed with bad debt.
Debt Assistance Resources
If you are in crippling debt, (like when your debt repayments are over 50% of your take home pay), or if you have extreme anxiety about your debt, consider getting help! It’s free from non-profit organizations like NFCC.org or Money Management International. Both of these organizations offer resources to help you make a plan to get your debt paid off more quickly.
Also, lots of folks find it helpful to have a tool where they can track debt payoff progress. We really like Undebt.it because it’s a free, mobile-device friendly tool that helps you come up with a debt payoff plan (and stick to it!). This tool caters to whichever debt strategy you feel works best for you.
The Bottom Line:
Whether it’s borrowing for a degree, home, car, or new business, the final factor of whether it’s good debt or bad debt is this question: Will this debt pay me back more than what I put in?
The key to using debt in your favor is to never borrow more money than you can handle. Remember, borrowing money is a lot easier than paying it back. Smart borrowing can be convenient and help you achieve important goals like buying a home, a car, or going to college. Having too much debt can make it difficult to save and put additional strain on your budget. Consider the total costs before you borrow—and not just the monthly payment.
Also, carrying debt (whether it’s good or bad) can limit our lifestyle options and create undue stress and anxiety. Some people want to pay off debt quickly because they hate it and can’t mentally stomach it. We want you to try and remove emotion from the equation because from a numbers standpoint it might make sense to keep that debt around a little longer, allowing you to pursue other meaningful financial goals at the same time.
Related:
- 15 Habits of Debt-Free People
- Best ways to boost your credit score
- Debt Avalanche vs Snowball methods (can help you prioritize paying down bad debt while keeping good debt longer)
- Reasons most people lose money in the stock market (investing with leverage!)
