Good debt and bad debt
The amount of personal debt is ever increasing, and
a large part of the reason is that credit has never been easier
to get. Whereas credit card issuers previously looked for customers
who could repay, today card issuers relish the chance to reel in
those who'll continuously charge beyond their means at 18 or 20
But debt is a complex concept. Not all of it is good
-- a fact a surprising number of people fail to realize until they're
in the hole -- and yet not all of it is bad. When used intelligently,
debt can be of tremendous assistance in building wealth.
One of the secrets, therefore, to being smart with
your money is to differentiate between good debt and bad debt. While
the differences often seem logical, it is a logic that apparently
is missed by many Americans.
"When you buy something that goes down
in value immediately, that's bad debt," says David Bach, CEO
of Finish Rich Inc. and author of The
Finish Rich Workbook. "If it has no potential to increase
in value, that's bad debt."
"Good debt produces cash flow, and bad debt doesn't,"
says John Waskin, CEO of Bill Free / American Credit Counselors,
a nonprofit debt counselling service in the U.S. "If you go
into debt buying an apartment building that will produce revenue
and deductions, that's good debt. Mortgage debt is good debt. You're
borrowing money, but you're getting a tax advantage and can write
off interest on an asset that's appreciating over time. Plus, you
get to live there."
Robert D. Manning, a professor of finance at the Rochester
Institute of Technology, also recommends taking on debts that are
tax-deductible, and debts that produce more wealth in the long run.
"If you are talking about reducing current debt,
that's where it starts to get nuanced," says Manning. "If
you take a home equity loan because you have 17 percent credit card,
and you go with a 6 percent loan that's tax-deductible, that's good
These general rules of thumb set some clear delineations
-- buying a home or refinancing to get rid of excessively high rates
is usually good debt, as is generating debt to buy high return stocks,
bonds and other investments.
The concept of bad debt comes in when discussing the purchase
of disposable items or durable goods or, in general, the use of
high interest credit cards.
"The problem is, people don't realize that credit
cards are just plastic cash," says Chris Bender, Communications
Manager for the National Foundation for Credit Counseling in the
U.S.. "They think when they pay with credit cards they don't
have to pay for it quickly, and so they don't keep track of what
"When you hand someone cash, it's a psychological
wake-up. 'Why, I just gave away $40.' When you charge something,
you don't see the money go, and in your mind that makes a difference."
But buying on credit isn't the same as buying with
cash, because cash doesn't make you pay interest on items as they
drop in value.
"When you buy clothes, they're probably worth
less than 50 percent what you pay for them when you walk out the
door," says Bach. "So if you borrowed to pay for them,
that's bad debt."
Not to mention what that debt could potentially do
to your credit rating.
"Your debt-to-income ratio shouldn't go above
20 percent," says Rob Harol, Credit Card Category Manager at
"If you find yourself above that, it doesn't look good on credit
reports, even if you're making payments on time."
When it comes to buying durable goods that won't contribute
to wealth generation, Bach offers a basic rule of thumb.
"My grandma used to say that if you're going
to buy something that doesn't go up in value, and you can't afford
to pay cash, then you can't afford it."
Exacerbating the bad debt factor is that people will
apply for store credit for the savings, offers that say if you open
a credit card account today, you can take 10 percent to 20 percent
off the cost of your purchase. What people often don't realize is
how much of that savings will be destroyed by the high interest
rate on the card if they fail to pay for the items immediately.
"You can open a store credit card account,"
says Bach, "and what they're not telling you is that after
the first few months, the rate jumps to 20 percent or greater."
Driving into debt
Another bad debt area is auto debt. While most people need
an automobile, and the ultimate cost of an auto is higher than many
people can pay in one lump sum, the way people go about it -- namely,
purchasing more car than they need -- turns it into bad debt.
"People can afford to pay cash for a car,"
says Waskin, "but not the car they see themselves in from an
ego extension standpoint. So you buy a car at a much higher rate
than a house, and that asset is worth less the day you drive it
off the lot."
Bach considers auto debt a Catch-22.
"People borrow to buy cars before homes,"
says Bach, "and that's unfortunate. For most people, their
first major loan is a car loan. That's guaranteed to go down in
value. So you really want to borrow less. For example, instead of
rushing out to borrow to buy a $50,000 BMW, you'd be better off
buying a $25,000 car."
Harol reminds us that just a few years ago it might
have made more sense to buy a car at 6 percent or 7 percent, and
then invest in other avenues and earn 10 percent or higher on your
money, than to pay off the car. Now, of course, with traditional
market investments substantially riskier, that is no longer the
The best type of debt is debt that builds wealth over
the long run, and the No. 1 example of that is mortgage debt.
"Home values have increased an average of 6.5
percent a year over the past 30 years," says Bach. "So
when you borrow to buy a home, chances are that's good debt. You'll
Bach heavily promotes the idea of homeownership, saying
that everyone needs to own where they live.
"About 40 percent of Americans are renters,"
says Bach, "and the fastest way to wealth in America is buying
where you live."
Bach cites some shocking numbers to back this up.
"The average renter has a median net worth of
$4,000, and the average homeowner has a median net worth of about
Manning also emphasizes what a good time this is to
build wealth through debt.
"This is the most advantageous time ever to be
in debt," says Manning, "in terms of opportunities to
get low income loans, or to renegotiate or refinance."
One of the reasons so many people seem mired in bad debt (both
Bach and Waskin report that the average American carries approximately
$8,400 in credit card debt) is that financial education is virtually
"This type of common sense stuff isn't taught
in school," says Bach, "and most Americans don't realize
how bad high-rate credit cards are hurting them."
"We are stupid people when it comes to financial
education," says Waskin. "Only 40 percent of high school
students receive any economic training. We don't teach kids how
to balance a checkbook, what a credit card is, paying rent. We just
say, 'Figure it out.'"
"People are getting in debt before they have
a job," says Manning. "Education is important. We used
to encourage kids to save, and that has been missed. Students now
refer to their credit cards as yuppie food stamps. They see cards
as entitlement, and see they will be in debt all their lives."
Waskin says that the way to fix this is to educate
kids on the difference between good and bad debt, and to return
to some basic fiscal common sense.
"We need to go back to the fundamental values
our parents and grandparents had, saving for a rainy day,"
says Waskin. "The best thing you can do is hope for the best,
but plan for the worst."