Is it Bad to Have Debt? The Case for Good vs Bad Debt
We live in a society where, for most of us, debt of some sort just can’t be avoided. A foundation of successful capitalism itself is built on the concept of credit and debt.
Debt allows us the ability to buy or do things that can be beneficial, but can also be detrimental if it gets out of hand.
A survey from financial firm John Hancock found that 69% of workers stress over their finances.
When looking at the data, it’s not hard to see why.
Credit card and student loan debt reached an all-time high at the end of 2019, each topping over $1 trillion dollars, and the average American household carries over $137,000 in debt.
So the question is, is debt good or bad?
Trying to crawl out from under a mountain of debt can be a struggle, and enough to lose sleep over. If paying off debt was easy, we’d all be debt free.
But one way to stress less over your finances is to determine what debt you have might be helpful, and what debt is harmful.
Focus on paying off the bad debt, and take comfort in knowing there are future gains to be had from your good debt.
How to Determine Good vs Bad Debt
You can find the difference between a good debt and a bad debt by asking yourself a couple simple questions.
Does it increase my net worth?
Is there future or lasting value?
Is it necessary for daily living?
Do I have cash available to pay for it?
If it has future value, or is helping you manage your finances better, then it can be considered as good debt.
If there is no lasting value and you don’t have cash to pay for it, then it can be considered as bad debt.
There is also the matter of having too much debt. Whether the type of debt is good or bad, having too much debt is always bad. For lenders, a debt to income ratio of over 43% is a major red flag, and can prevent you from acquiring loans for things such as a mortgage. To determine your monthly debt to income ratio, add up your monthly bills and subtract that from your gross monthly earnings. If it’s above 43%, it’s imperative to pay down as much debt as you can before even thinking about adding new debt.
So, what has value, and what doesn’t?
Types of Good Debt
Another way to look at “good debt” is to think of it as investing in yourself or your future. Some debts are necessities for survival. Some debts assist us in furthering our career or income earning potential. Here are some examples.
We all need a place to live, so you might as well live in a place that also gains value every year. Historically speaking, house values have increased between 6% and 7% a year since 1964.
To put it in perspective, if your house has an initial value of $200,000 and appreciates at half that average (3.5%), then once your 30 year mortgage is paid off, that investment will be worth $561,359.
A debt that turns into profit is a good debt to have.
Rolling your high-interest debt such as credit cards onto a low interest debt such as a personal loan won’t erase your debt, but it will make paying it off much quicker. You’ll pay a lot less on the debt in the long run.
Other good uses would be home improvements that will save you money on utility bills or increase the value of your home.
According to the Bureau of Labor Statistics in 2016, the median income for a worker with a high school diploma was $679 a week. The median income for a worker with a Bachelor’s Degree was $1,435 a week.
Student loans are one of the fastest growing industries with regards to consumer debt, but if you’re buying an education towards a well-paying career, then taking on that initial debt is worth it.
Small Business Loan
Starting your own company and working for yourself has a much higher income potential than working for someone else. It is riskier, as statistics show that one-third of small business fail to survive after their first two years.
However, if you’re ambitious, have a good work ethic, and some business savvy, then borrowing money for your own business can be one of the best investments you’ll ever make.
Types of Bad Debt
Debt that is high-interest, and anything that loses value after puchasing can be considered bad debt. If it’s not a necessity and you don’t have cash to pay for it, then taking on that debt is a bad idea. Here are some examples.
Credit cards are known as revolving debt, meaning they’re intended to be paid off each month. The cost of not paying it off comes in the form of some of the highest interest rates (currently 19%).
Over 189 million consumers own at least one credit card, and the average credit card debt per household was $8,398 in June 2019. This indicates a lot of people are not able to pay off their credit card each month, and having a credit utilization ratio over 30% can also negatively affect your credit score.
Eliminating credit card debt should be a first priority.
That big screen flat TV, or designer clothes might be nice to have, but they’re not necessities, and worse yet, once you buy them, they’ll quickly lose value.
If you buy a $1,000 TV on that 19% credit card and make the minimum monthly payment, you’ll end up paying almost an additional $1,000 just in interest before it’s paid off. Ouch.
If it’s not a necessity, and you don’t have the cash for it, then it’s a bad debt.
Automobiles are often the second most expensive life purchase we make, behind a house. The big difference is that while houses generally increase in value over time, a car decreases in value as soon as it’s driven off the dealer parking lot.
The good news is car loans have relatively low interest rates, however, splurging on a new and expensive car that will be worth far less than what you end up spending on it, is never a good financial decision.
Payday loans have notoriously high interest rates, even higher than credit cards, and also often incur additional fees on top of the interest.
You may be in a hard spot and need some quick cash, justifying that you’ll pay it back on your next pay check. But there are better options, and if you can’t pay it all off immediately, you’ll quickly find yourself in a hole you can’t get out of.
There are certain life events, situations or emergencies where we can’t escape from going into debt.
But debt in itself is not a bad thing, provided it’s being put towards good use with potential to improve your future financial outlook.
The key is to borrow responsibly, only go in debt when there’s no other option, and only borrow the exact amount you’ll need.
Make it a goal to pay down high interest debt, or debt that isn’t adding any value to your life.
Knowing your good debts are really just you investing in your future will help you sleep at night.