Good debt and bad debt
Debt is a concept as intricately
intertwined with America these days as baseball, Mom and apple pie.
The amount of personal debt in this country 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 percent
or 20 percent.
But debt is a complex concept. Not all of it is
good -- a fact a surprising number of Americans 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 is investment debt that creates value; for example,
student loans, real estate loans, home mortgages and business loans,"
says Eric Gelb, CEO of Gateway Financial Advisors and author of
"Getting Started in Asset Allocation."
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 debt."
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 using high interest credit cards and not
paying the balance in full.
"The trouble is most people are not organized
enough to retire the entire balance before the due date," says
Every month that you make a partial payment on your credit account
you are charged interest. The disposable or durable item you purchased
continues to lose value, and the amount you paid for it continues
"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
Not to mention what that debt could potentially
do to your credit rating.
"Total personal debt should not exceed 36 percent
of your total income," says Gelb.
Keeping the debt-to-income ratio in mind, it's also important not
to miss payments.
"Missed payments are trouble," he says. "A representative
of Citibank said if you don't pay within 30 days, they report that
to the credit bureaus."
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."
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.
When is it worth it?
"What we would normally consider bad debt can
turn into good debt in certain circumstances," says Catie Fitzgerald,
a personal finance coach and registered investment adviser in Henderson,
Nev. "If you use debt to buy a car that gets better gas mileage
than your old vehicle, you could end up better off financially."
Bach considers auto debt a Catch-22.
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."
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 build value."
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
Bach cites some shocking numbers to back this
"The average renter has a median net worth of $4,000,
and the average homeowner has a median net worth of about $150,000."
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 Americans seem mired in bad debt
(Bach reports that the average American carries approximately $8,400
in credit card debt) is that financial education is pratically nonexistent.
"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."
Fitzgerald advises teaching your children the difference
between good debt (debt that's used to buy assets that grow in value
over time) and bad debt (debt that's used to buy things that will
lose value) early on.
Gelb opts for a more hands-on approach. "Give your children
an allowance (without strings) beginning when they're in kindergarten
and offer them the opportunity to perform extra jobs around the
house for money. Stop buying them everything, and teach them how
to make choices with their own money-buying decisions." The
mistakes they make will help them learn and grow.
"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."
Fitzgerald recommends teaching by example. Treat credit
cards like emergency safety nets and your children will likely learn
some money management skills. "If you have to use your credit
card, immediately revise your budget, paring back on nonessential
spending. Allocate the saved dollars to a pay-off plan to bring
your debt balance down to zero as soon as possible," she says.
Hunt contributed to this story.