Good Debt and Bad Debt

You might think from my last post (see Getting Started - Rule #2) that I believe that all debt is bad. But that's not the case. Sometimes it's OK, and even a good thing to go into debt. How can you tell good debt from bad debt?

The difference between good debt and bad debt lies in what you plan to do with the money. If you are borrowing money to pay for ordinary expenses, like food and clothing, then that is a bad thing. On the other hand, borrowing money to buy a house can be a good thing.

What's the difference between these two cases? For one thing, the house has a long term value that generally goes up over time at about the rate of inflation. The last 10 years have been an exception to this rule, where the prices have shot up and then fallen, but in general this is true. A second difference is that a house provides a service to you over the long term. It gives you shelter and saves you from having to pay rent.

When you put up money today to receive something of value in the future, then this can be an example of good debt. I say "can be" since it all depends on the cost of the loan and the amount of value you expect to receive. You have to do the math to figure out if it is really worth it or not.

Another example of potentially good debt is when you borrow money to go to college (or for any type of education or training). If the training you receive provides you with more income in the future, then you can use that extra income to pay off the debt.

The last example is buying a car. If you can't afford to buy a car, and you need one to get to work, then taking out a loan to buy a car makes sense. The car also provides a service to you, while it lasts, but unlike a house, the value of the car declines over time. In cases like this, you need to make sure that you will have the loan paid off before the car's useful life is over. The other thing about cars is that they will start to cost you money for maintenance as they get older. So it's best to pay off a car loan over a 3-5 year period (for a new car), so that when the big ticket maintenance items start to happen, you will already be paid off.

So, to sum it up, debt isn't good and it isn't bad. It's what you do with the money that counts.