Debunking the Good Debt vs. Bad Debt Myth
There is a conventional wisdom in financial circles that debt is either good or bad, depending on its purpose. While this view isn’t overly harmful, neither is it adequate to help understand when a person should or shouldn’t use debt.
Good Debt vs. Bad Debt
Many people do not know the difference between good debt and bad debt. In fact, many do not know that good debt exists at all. There are many examples of good debt.
The conventional wisdom goes like this: Debt that is backed by appreciable assets, such as real estate, is good. Debt in furtherance of one’s career — such as student debt — is also good. In this light, the debt is viewed as a tool that enables one to advance financially in a way that would not be possible without it. Hence it is good debt.
Meanwhile, debt that is backed by a depreciating asset, such as a car, is bad. Revolving debt, such as credit card debt, is also bad. The wisdom here is that these debts do not support financial growth.
The conventional wisdom has us draw nice neat lines between good and bad debt. It advises us to attack them accordingly: Eliminate credit card debt and auto loans, then deal with other long-term debt as your means allow. In many cases, following this “wisdom” will not cause a great deal of harm. But in some cases, it will. Debt is more complicated than that — it’s a tool. When it’s appropriate to use this tool is more complex than the single factor of “good debt vs. bad debt.”
Examples of Good and Bad Debt
It’s easy to find unsettling examples of the conventional wisdom failing.
When the real estate market crashed in 2008, many people were left underwater or upside down on their mortgages. In other words, they owed more than the market value of the property. Try telling someone who owes a million dollars on a $500,000 property that he has good debt. Somehow that doesn’t seem to make sense.
Or consider a recent college grad who accumulated massive amounts of student loan debt in pursuit of a career, but doesn’t have meaningful employment prospects. It’s unlikely that she will find solace in the supposedly good quality of her debt.
The wisdom behind bad debt also has its own stories that go against common thinking. For example, if I am going to purchase a car for cash, but instead take advantage of a manufacturer’s zero-percent-interest loan — leaving my money invested and working for me — is this now bad debt? It would be a sound financial decision. The car loan would be merely a tool that I employed to better myself financially based on the fact that I was going to buy the car anyway. Now I simply have a financially advantageous way to do so. Clearly, the conventional wisdom does not apply in all cases.
Unconventional Thinking: Using Debt as a Tool
There is a reason that there is an abundance of examples of the conventional wisdom failing.
Debt is merely a tool. It doesn’t know what you’re using it on.
But debt comes about — or doesn’t — as a result of another financial decision. And therein lies the key to the issue. Debt can allow us to take advantage of opportunities to better ourselves financially. In these cases, we may want to use the tool of debt, as it would allow us to gain a degree of financial success that we could not attain without it.
Many mortgages are good examples of this use of debt. But you need to make sound financial decisions before taking out a mortgage. This means decisions about not over-extending yourself, making a sufficient down payment, having adequate reserves, and getting homeowner’s and disability insurance. These decisions, along with the details of the debt itself, ultimately determine whether the debt will end up being a good or bad choice.
Debt is simply a factor in a more complex financial decision. Homeownership can be a great boost to long-term financial success, and debt can help facilitate that. But a decision about real estate can become a bad one because of whatever mistakes made it bad — not solely because of the mortgage.
Let’s take a look at some auto loan scenarios. Conventional wisdom places auto loans into the “bad debt” bucket. But since we know that debt is a tool in support of another financial decision, is this always true?
For many people, an auto loan is a financial necessity. Consider a recent college graduate with a promising new career who has no significant assets other than his ability to earn an income. If he needs a car to get to work, an auto loan could be an appropriate tool.
You can certainly make a case that the car should be reliable, reasonably priced for his income, etc. And it doesn’t necessarily even have to be a new car. Lots of people buy used. But having a car — even with a loan — could be an appropriate financial decision.
For some people, nursing an old clunker for a period of time is a viable alternative, but it isn’t a mainstream solution. For many people, the risks associated with an unreliable vehicle and maintaining said vehicle are not reasonable.
But what if the car in question isn’t a necessity? Can debt be an appropriate tool for a vehicle that you don’t really need?
Again, it depends on the specifics of the situation. If our young college graduate takes out a second auto loan to purchase a sports car, many would consider that a poor use of debt. If you think about it, they consider the purchase of the sports car a poor financial decision — not the debt itself. Debt is just a part of that decision.
But let’s say that our sports-car purchaser is not a fresh college graduate with no assets. Perhaps our purchaser is a successful businesswoman who wants to get herself a sports car to enjoy on her days off. Let’s say that she has very little other debt, is well on track to funding retirement, maintains a healthy cash reserve, and has a secure source (or sources) of income.
Do you find yourself balking at the thought of using debt to buy what is essentially an expensive toy? This can be a very telling thing to look at.
Our businesswoman is making a financial decision to have this vehicle, and she may or may not use debt to fund it. The key is that if it’s affordable for her, there’s nothing wrong with her using debt in this scenario. She makes a financial decision and chooses to take out debt or not. It’s really that simple.
Stepping back from the emotion behind the asset or the reason for the debt helps to place it into perspective. You don’t buy a home for the mortgage tax breaks — you buy a home because it makes financial sense. The tax breaks, like the mortgage itself, are simply a factor in a more complex financial decision.
The intent of the conventional wisdom is fine: Use debt for things that help you, not for things that hurt you. But the lines are not always simple or clear.
We need to carefully consider each of our financial decisions to determine which course of action is best for our long-term financial health, as well as our other wants and goals. In this context debt is a factor in a decision — a possible method of funding something that we want to do financially. If we make good financial decisions, we won’t have bad debt.