This one we never learn in school or society. We only know that all DEBT is bad. he he he. DEBT can be categorized as GOOD or BAD and HORRIBLE.
Good Debt
Good Debt is used to buy something that either (1) will go up in value, or (2) produce income sufficient to justify the debt.
For most of us, examples of good debt include:
House – A home’s value can go down in the short term, but over long periods of time, it goes up in value. It also insulates us from rent inflation and offers excellent tax incentives.
Rental Property – It can both go up in value and produce income.
Education -A school loan can enable us to get an education that increases our earning potential.
Hence, “really good debt” is debt that builds wealth. If used properly, it can help us build wealth over time. However, not all school loans can be considered as “good” debt. A school loan on a computer degree can be considered good debt while many liberal arts degrees would qualify as bead debt.
The thing about good debt is that it can just as easily become bad debt. We’ll come back to this in a minute.
Horrible Debt
Horrible debt is debt used to finance a lifestyle with no significant assets to show for the money you’ve borrowed. Horrible debt includes debt used to buy clothes, eating out, vacations, or gadgets. These sorts of lifestyle decisions somehow force you to finance usually with very high interest rates and over a very long period of time.
Because there are no meaningful assets purchased with horrible debt, you can’t sell what you bought to repay the loan. You are simply spending today your future earnings.
Bad Debt
Bad debt is where things get interesting. It’s the grey area. It includes good debt gone bad and what I like to call avoidable debt.
Good Debt Gone Bad
Remember the examples of good debt I listed above? Borrowing to buy a home, for rental property, or an education can all be really bad debt in certain circumstances.
For example, borrowing far more than you can reasonably afford for a home is bad debt. Borrowing to buy a rental property when your own finances are not in order is bad debt. Spending $200,000 on a liberal arts education is generally bad debt, and I was an English major.
There are rules of thumb when it comes to a mortgage or school loan. Many say to keep your monthly mortgage payment to no more than 20% of your gross income. Likewise, some say to keep your school loans to no more than your first year’s income after college. These are worth considering as you make decisions.
The point is that we can’t blindly take on debt because some label it as “good” debt.
Avoidable Debt
The second type of bad debt is what I call Avoidable Debt. For most of us, car loans fit into this category. While the ideal is to pay cash for a car, I’m not a fanatic about avoiding car loans. I am a fanatic about borrowing to buy more car than you truly need.
It’s one thing to finance a $5,000 car so that you get to work and back. It’s another thing to finance a $45,000 car while other financial goals are not being achieved.