I’m often asked if a particular kind of debt is a good debt or a bad debt. That question is usually followed up by questions like, “Should I pay off my debt or invest?”
Anyone in debt at one time or another has faced this same dilemma, but the answer is a difficult one because there are a number of factors in play, including a number of very personal factors.
- What are you overall financial goals?
- How MUCH of this particular debt to you have?
- How long will it take to pay off this “bad” debt?
- Are there emotional strings tied to the debt that are causing problems elsewhere?
Obviously, personal opinions on what is debt (good or bad) vary considerably, too. I personally consider student loan debt a relatively bad debt, but not nearly as bad as IRS debt or debt to payday lenders.
Others consider student loan debt an investment in their future earnings, which I also tend to agree with (to a point), which is why I’d rank student loan debt somewhere in the middle.
I’m sorry to say, I experienced nearly every kind of debt prior to my financial turnaround, so I had plenty of opportunity to develop my own personal debt ranking system. Feel free to use it to motivate you towards putting together your own get out of debt plan.
The Ugly
IRS debt. Of all the “uglies” to owe money, I can’t imagine any being more ugly than the IRS. They can garnish wages without a court order, and outright ignoring them can result in jail time. Not to be messed with.
Car title/payday loans. In my town, I’ve noticed that as the economy has worsened, more cars are in the sign-your-financial-life-away-for-$200-at-300%-interest establishment parking lots. Sad.
Personal loans with baggage. By baggage I mean loans attached to bad relationships, such as owing money on a car you shared with an ex-spouse, or a personal loan financed by your father-in-law, who like to remind you how much you owe him every time you see him.
The Bad
Credit cards. Credit cards, as a tool, can be quite useful. However, credit card debt is vile. When I was deep in debt, I felt like I was working for the bank. My paycheck came in, and just as quickly as it arrived, it disappeared in minimum payments which barely cut into the balances after interest charges accumulated. It kept me awake at night, caused anxiety throughout the day, and limited my opportunities. Bottom line – being in debt sucks.
Upside down car loans. Car loans are not necessarily evil, unless you have no money to put down, buy new and drive off the lot owing more than the car is worth. Getting out of an upside car loan is not easy, so if you do finance a car purchase, consider gently used and using a trade and/or down payment to preserve some equity in the deal.
Enormous student loans. I emphasized “enormous” here because borrowing some money to finish off a degree often yields a nice return, considering college graduates usually earn more over the course of a lifetime. However, I don’t think that is an excuse to rack up over $100,000 in student load debt for a degree program in a field with starting salaries around $45,000.
Business debt. I’ve started and failed at a number of entrepreneurial efforts over the years. Fortunately, the one smart thing I did was not borrow a lot of money to finance these start-ups, so their failure didn’t haunt me for years to come. I recognize that many businesses need to borrow start-up capital to fund operations until revenues are flowing, but doing so puts the business (and employees) at enormous risk.
The (Slightly) Good
Mortgages. In a perfect world, people would be able to save up enough money to buy a home with cash. While that is certainly do-able, it isn’t practical for most of us. So, I concede that a reasonable amount of mortgage debt is not bad (and certainly not ugly).
However, as with student loan debt, the emphasis should be on reasonable. If your mortgage represents more then half your monthly income just because some “creative lender” allowed it, your home will not feel like a blessing. And you think getting out of an upside down car is tough, try an underwater mortgage.
When answering the question, “What is bad debt?” consider whether or not the money borrowed is for something that will appreciate over time. This may or may not be the case with real estate, making mortgage debt an acceptable debt in most cases.
Similarly, student loan debt is a somewhat acceptable form of debt (again, in small doses) as it often leads to higher earnings in the future.
Using that same logic, it’s easy to see why charging groceries to a credit card and not paying them off is bad debt. Three months later, the groceries are gone, but the debt is still around, accumulating interest and causing indigestion.
This post was included in the Festival of Frugality – Spend It Edition
Having recently accumulated credit card debt (3 months of emergency fund weren’t enough for 6 months of unemployment), it’s definitely causing anxiety even though we know we’ll be able to pay it off by summer time. That’s why our next emergency fund will be for 6 – 8 months.
Sorry to hear about that string of unemployment, Paul. I know several who were caught with a short emergency fund, even though they were within the standard 3-6 months range. I’m actually advocating people keep a full one-year emergency fund after they pay off debt.
Thanks FD. I was just reading Emergency Funds For Different Kinds Of Emergencies. I especially like the Mortgage Fund and Family Health Insurance Fund ideas. These were our biggest concerns as we have two small girls and feared losing our home or getting real sick. Thankfully, it never came to that.
I think that accumulating credit card debt over the month is okay, only if you pay the balance off in full and the end of each month.
Agreed. That’s what we do with our credit card. Most of our monthly bills are automatically charged to the card and I make one single payment each month to pay it off.
When it comes to using the credit card, I don’t consider the balance a debt unless I’m billed and subjected to interest. However, since I am borrowing money from the bank the minutes I swipe my card, I supposed I should classify it a very short term debt.
That’s how I have it setup in my Balance Sheet within Excel. My total credit card debt is classified as “Current Debt” just like my debt dealing with the energy company and water company (given they charge based on what you used in the past). However, to keep it going from “Current Debt” to “Installment Debt”, I pay those accounts off in full by the due date of each billing cycle. For such services like Time Warner with the internet service we have, they charge you in advance of time, not in the past like the utility companies, as such, those such bills are considered as “Pre-Paid Current Assets” from the time they are paid on my Balance Sheet, and accrued into expenses as the time expires for the duration of such service time periods.
I’m in credit card debt right now and trying to get out of it in 2011. Hoping to put the money I’m anticipating from tax returns towards the debt to put a nice dent in it.
That’s a great use for your tax refund. I’d also recommend updating your W-4 at work so that you do not receive a large refund next year, rather you receive an extra bit in your check all year to help pay down that debt even faster.
Here’s to debt freedom in 2011!
That is if you aren’t already claiming “EXEMPT” on the federal return. We claim “EXEMPT” on the Federal W-4 form and we still get about $5,300 back from the federal IRS via the Additional Child Tax Credit and Make Work Pay Credit.
As for state based on the state’s current IRCs, I am not allowed to claim more than the number of exemptions I can claim on the actual return, and if I was allowed, I would be adjusting it so as we play the break even game. However, since we can’t do that, I just have to wait until I get the refund back from state that amounts to between $400 and $450 each year as a result of the fact they only give us half of the exemption credit throughout the year instead of the full amount.
I’d move student loan debt higher up on the “bad” list for two reasons: one, people usually take it out when they are young and inexperienced, and two, you’ll have it until you either die or repay it in full. Basically, it’s a permanent decision that’s often made early on without a realistic concept if its long term impact.
As for where I would place it on the list, it’s a depend type deal. If you had to fully fund college yourself, it most definitely would fall as bad debt in my eyes cause the level of the education you get from that 4 year degree isn’t much more than what it is for that high school degree (when the first 2 years minimally is essentially 100% repeats of what you had in high school). Not only that, but the cost of that 4 year degree compared to the annual wage difference of without vs with the degree, the cost of that higher education is well higher in most cases than all of that additional future wages brought back to current value via the Present Value formula as taught in Accounting shows.
On the other hand, if you are only having to fund 20% of that total education expense yourself, then it may make very good financial sense to do it.
Good debt is when the asset yo bought with it grows at a higher rate that the cost of the loan. Home mortgages usually qualify over time and some business debt.
@Jackie
I’d agree w/ FD – if it is used properly it is ok.
For example, I have a repayment plan that is in a fixed interest rate of ~1.6 over the next 12 years or so. It’s going to cost me ~4k in interest for a loan balance of ~27k. I’d rather pay 4k of interest over 12 years (avg of 28 per month) and have the free cash flow then pay off the balance.
When student loan debt is used wisely and with purpose it can be a good thing, but I agree it can be a weight around one’s neck if not used properly.
I couldn’t have said it better myself. Excellent break down. The only debt that should be considered is debt that ultimately helps to increase your net worth. The only debt that does this, is a mortgage. Whether it’s for a house, or for land, or both, it should go up in value eventually. The thing with land, is that there’s a limited quantity available. We can’t just fire up the ‘ole factory and make more, like with a car. The more time that goes by, the more people will be wanting land. Thus creating value.
Really enjoyed this. Others may disagree with this but I would rather have student loans to repay than forego or delay going to college. My husband and I both had to take out student loans but we both have six figure incomes now and are in our early 30s. We both have family members and friends who didn’t want to take student loans and have never finished college. At this point they’re all married with kids so making the decision to go back to college would be both a financial and logistical burden on their families.
I wasn’t happy to have student loan debt of course but I’ve sure enjoyed the income that came from that investment and I’m appreciative that both my husband and I have our evenings and weekends to spend with our kids rather than trying to work and go to school.
I found this article very insightful. I had always considered all forms of debt to be bad, just because they meant that you were spending money that you don’t have yet. Come to think of it, student loans and mortgages are things that we wish all of us could not bother with, if only we could afford paying for school fees and houses outright, but since this si the reality we’re living in, then i guess it’s better to owe the bank for your home and education, than say, 6 pairs of shoes and a HD television.
I’m glad you had an “ugly” category. Personal loans feel ugly for both the giver and receiver in many cases, especially since it’s so easy to default on an agreement because there are usually no consequences to the borrower except a strained or ruined relationship.
Another way to look at this is that its less important how you describe the debt and more important that you come up with a plan to deal with it now, and prevent getting into more debt in the future.
Nice post. I would add that business debt is kind of a ‘hindsight is 20/20′ idea. Many very sucessful businesses accumulated large amounts of debt at the beginninng. So I think it comes down to a solid business plan, both financial and operatonal, before you borrow a cent. If your homework is done correctly, business debt could be a very good thing long term.
In a perfect world.. there would be no mortgages! see the Venus Project for more details. Jacque Fresco’s vision of the future is eutopian for sure, the awesome thing is with modern engineering we can build that eutopia! Trust me he’s done all the homework and dedicated his whole life to it. Businesses are bigger than all political forces. Businesses need to understand that we can continue along the boom and bust model of enconomics (shocks) or we can transistion to a truely sustainable model where the total carrying capacity of the Earth is evaluated and everybody has their needs met.
Generally, I place no “Installment Debt” as good debt. There are exceptions though, but I look at things totally different than what has been pointed out.
People think of homes appreciating in value, but in all actuality, just like anything else, a home is man made and thus must be maintained and costs money to do that. As such, I still put all “Land Improvements” on a depreciation schedule. The only way a home appreciate assuming it keeps it’s real value is if inflation goes up. As such, I look at home value appreciations as more of a function of inflation. The other way it appreciates in value is by doing things to the home that adds additional usefulness of life to it such as a roof replacement or a new furnace/AC, which even such costs has to be capitalized and depreciated over their respective useful life time period.
The one main way I look at something rather if it’s a good debt or a bad debt:
Good Debt would be for those items that either increase income by a larger amount than the cost of that item with it’s total finance charges, or does it decrease overall expenses for the household with the finance charges added to such expense should you take the debt route?
Example? When I was first renting, I didn’t have the fund and the rates were too high, thus made getting a mortgage a bad debt cause the cost of the home was more expensive than it was to rent on an accrual basis of Accounting. By 2005, I was able to have some funds saved up and with the rates down low still at that time prior to them starting to jump up, the cost of owning a home including the financing cost of a mortgage we would have to take out was less than the total cost of renting based on our needs. Of course, the other question to ask with that situation, given how long a mortgage is expected to last (at least 10 years), do we have a good enough cushion to be able to cover a longer time period? Given my set of skills, I felt very confident as not many can match me with my computer skills on the software side. Not only that, but with a strong work ethic and being quite versatile in what ever the task may be, it makes me that much more valuable of an employee to the company. As such, it has worked out as such for me having been through 3 company changes and over the last 11 years, there’s been several rounds of lay offs, which I haven’t fallen victim to, including the last one when 74% of the work force was laid off in Feb of 2010.
Yes, I look at this stuff from a very strong mathematical point of view, but I also take into account of needs vs wants. While I may not necessarily made all the right choices, but I certainly have done it at least 90% of the time.
As for my early years in college, I was more so influenced by society’s point of view with regards to that college education until it came time to transfer and then came hard knox. So much for social views. I had to develop my own views and make my own choices from that point on forward. As far as I’m concerned, colleges these days are all only about making that mighty dollar for several reasons:
Quality of education very poor as you don’t learn new stuff until either the junior or senior year which for me was the senior year as all the other stuff were repeats compared to high school.
They won’t admit to the fact what’s taught in vocational high schools is the same stuff as what’s taught in college, though may be from a different point of view.
They treat you like you can’t learn outside of the classroom such as for every one day of class you miss, that drops your final course grade by one letter grade. Some classes like lab classes, I can see for being required to be in class for, but for text book type courses, I personally didn’t learn in the classroom, but rather outside of the class via the text book itself. I mean it’s as if you are being treated like you are being baby sat in school. Let’s face it, employment in this case gives me a lot more freedom than college ever did.
Guess part of it is cause I learn different from other people, large part cause of the LD primarily in language I had to deal with growing up, which was created by a high fever of 102 and a right ear ache combined at the age of 10 months (which that did directly trigger the epileptic seizures until I had the laser brain operation done in July 1991 to be cured of them things permanently). I’m glad to say I have not had any since 2 days after the operation. Some may question that, but after all of the things I learned and while I can’t prove it to be a definite fact, with supporting evidences, I can still prove to a high probability it was at that point of time by that medical issue that caused the LD issue in addition to the seizures.
Maybe you thinking I went to a very good school when I was in high school, but I don’t think so. The difference wasn’t so much the school, but the determination in me as I not only had to be good at something meaningful to others to get any sort of proper treatment by others, but I had to be #1 at it. If you aren’t #1, then you are a no body. Until that happened and I had beaten the adults at their own game, which I had to learn and stay within their rules to do it, I was basically constantly bullied and beaten daily only for school officials to claim I was the trouble maker and my guardians sided with them all cause they didn’t want to face their political fears of what would happen to them if they were to admit such issues were taking place. The only good thing college had for me, I no longer had to deal with the daily beatings as by that age, it’s considered illegal.
Anyhow, I don’t hold high regards for our education system and the level of quality of our education system today has majorly degraded as compared to 30 years ago. Not only that, but it still has a lot of the same social issues as it did back then. Yes, adults know more of the issues, but no, they haven’t dealt with them too well and are failing in that area as far as I’m concerned. It’s just like when I was in school, I had 3 life strikes against me (all 3 listed in this message), thus like in baseball, 3 strikes and you are out, thus how I was treated for the most part until that one thing came into play, which for me was computers on the software side.
We’d be a lot more careful before incurring debt if we considered the future happiness that must be sacrificed to repay the loan. Read my recent post about this subject at my blog, http://wp.me/pZTwu-cZ
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The older you get the uglier all debt gets.