Understanding Good & Bad Debt

Debt is a sensitive subject for most Americans. The easy availability of credit, at least in the recent past, has thrust this issue into the forefront of the American consciousness. Until the recent downturn in the economy, the savings rate in America had fallen into negative territory. That means that Americans were not saving but going further into debt. The current recession has frightened Americans into saving and the savings rate has moved into positive territory for the first time in years.

The reality is, however, that most of us don’t have the financial resources to make major purchases in cash. Home, cars, etc., are often out of reach for most of us without credit. It would behoove each of us to understand that, while cash is still king, not all debt is bad. Understanding the difference between good debt and bad debt is relatively easy to grasp and will help us to avoid bad debt whenever possible.

Good Debt

Generally, good debt includes those debts that appreciate in value or create value. In other words, good debt can generally be viewed as an investment. Typical among good debts are student loans, home mortgages, some business loans and real-estate loans. Student loans can be viewed as an investment in yourself whose dividends will be reaped with higher income and advancement potential in the future.

Despite the recent precipitous drop in home prices, home values historically rise over time and the home itself can be viewed as an investment. Over the past 30 or so years, home values have increased an average of 6.5% per year. Some regions of the country, like Southern California, have experienced double-digit increases year after year. It turns out these inflated prices were partly the result of bad lending practices that artificially drove housing prices into the stratosphere.

The recent devaluations in home prices could be seen as a market adjustment just as overpriced stocks will occasionally adjust in the stock market. However, real estate values will most likely begin to rise again once the economy recovers. In fact, recent government figures indicate this may have already begun in some parts of the country.

Assuming debt in order to reduce or eliminate high interest debt may also be viewed as good debt. Assuming a home equity credit line at 5.5% in order to pay of high interest credit card debt would be viewed as good debt.

Likewise, refinancing a home in order to take advantage of lower interest rates could also be viewed in this light. The caveat is to not extend the repayment period of the original loan. If you refinance a 30-year 7.00% note with 20 years remaining into a 30-year note at 5.90% you may not come out ahead in the long run.  Rather try to match or even shorten your repayment period in the new loan. You must be diligent in crunching the numbers to be sure you come out ahead in the transaction.

Bad Debt

Basically, bad debts are those sthat can’t be viewed as an investment. Buying items with credit that depreciate in value rather than increase in value is bad debt. If you are disciplined enough to pay your credit card balances in full each month, then obviously this doesn’t apply to you. However, most Americans don’t have the discipline or financial resources to do so. Credit cards have become license for consumers to live beyond their means.

In light of this definition, purchasing just about any disposable or durable goods with credit can be classified as bad debt. Purchasing food, clothes, televisions, appliances, even automobiles qualify as bad debt as they are worth less than you pay before you even get them home. None of these items appreciate in value over time. If the balance is not paid in full each month, finance charges add to the debt and the devaluation adds to the gap between what the item is worth and what you end up paying for it.

Of course, I am not saying not to take out a loan in order to purchase a vehicle. Most people don’t have the money on hand to pay for a car in cash. Troubles arise when taking a loan allows you to buy more car than you can really afford. If we all paid cash for ours cars, many more of us would be buying smaller, more fuel efficient cars than actually do. Credit allows us to move up to better a car but comes with the increased debt load. When taking out a vehicle loan be certain to buy only what you can afford and put down as much as possible to reduce the amount borrowed.  This takes self-disciple but reaps benefits in the long run.  Work hard to negotiate the best interest rate and loan period. Generally, the shorter the loan period the less you will pay in interest and fees.

Purchasing groceries on credit is at the extreme end of bad debt unless, of course, you pay off your balance in full every month. However, if you are at the point of being forced to buy food with credit, you are in seriously dire straits and should seek the assistance of a debt or financial counselor.

You acquire good debt by make wise, disciplined financial decisions. You acquire bad debt by making unwise, undisciplined financial decisions. Debt is still debt, however, and it must be paid. Just because it is good debt doesn’t mean you should acquire it. That is where the wise, disciplined decision making comes in. You need to learn as much as possible about debt and then do the math to determine if borrowing makes sense for you in your particular situation. If it doesn’t, exercise the discipline and walk away. You won’t regret it!